KRATOS DEFENSE & SECURITY SOLUTIONS, INC. annual report, FY2020

Kratos Defense & Security Solutions, Inc. — FY2020 Form 10-K Summary

Business context and reporting period

Kratos is a defense technology and government contractor focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity, rocket and hypersonic systems, missile defense, turbine technologies, C5ISR and training systems. The company operates through Kratos Government Solutions (KGS) and Unmanned Systems (US).

The filing covers the 52-week fiscal year ended December 27, 2020, with comparative results for the fiscal year ended December 29, 2019. The fourth quarter of fiscal 2020 generated revenue of $206.4 million, operating income of $9.0 million and net income attributable to Kratos of $78.1 million, including a significant non-cash tax benefit.

Financial performance and key metrics

Metric	FY2020	FY2019	Change
Revenue	$747.7 million	$717.5 million	Up 4.2%
Gross profit	$203.2 million	$190.0 million	Up 6.9%
Gross margin	27.2%	26.5%	Up 70 basis points
Operating income	$29.3 million	$38.0 million	Down $8.7 million
Operating margin	3.9%	5.3%	Down approximately 140 basis points
Income from continuing operations	$80.3 million	$10.9 million	Up $69.4 million
Net income attributable to Kratos	$79.6 million	$12.5 million	Up $67.1 million
Diluted EPS	$0.67	$0.11	Up $0.56
Operating cash flow from continuing operations	$44.7 million	$28.9 million	Up $15.8 million

Product sales increased 12.2% to $499.0 million and represented 66.7% of revenue, compared with 62.0% in 2019. Service revenue decreased 8.8% to $248.7 million.
KGS revenue increased 0.8% to $560.7 million. US revenue increased 15.9% to $187.0 million and represented 25.0% of total revenue.
Product gross margin increased to 27.5% from 24.6%, while service gross margin declined to 26.6% from 29.6%.
SG&A increased to $144.5 million from $130.8 million, partly due to stock-based compensation increasing to $21.0 million from $11.0 million. R&D increased to $27.0 million from $18.0 million.
The $73.5 million income tax benefit included an approximately $80.1 million non-cash benefit from reversing a significant portion of the valuation allowance on U.S. deferred tax assets. This benefit was the primary driver of the increase in reported net income.
Cash and cash equivalents were $380.8 million at year-end, compared with $172.6 million in 2019. Working capital was $567.2 million.
Net cash used in investing activities was $87.3 million, including $51.5 million for acquisitions and $35.9 million of capital expenditures. Capital expenditures included approximately $18.1 million for the US business, including Valkyrie aircraft being built in advance of contract awards.
Financing activities provided $247.7 million, principally from a $240.4 million net equity offering completed in June 2020.
Total debt was $301.5 million net of issuance costs, including $300.0 million principal amount of 6.5% senior secured notes due 2025. No borrowings were outstanding under the $90.0 million revolving credit facility; letters of credit totaled $5.9 million and reported availability was $71.9 million.
The company reported approximately $922.2 million of backlog at year-end, compared with $601.2 million in 2019. Management expects to recognize approximately 51.0% in 2021 and 18.0% in 2022.

Material changes versus the prior comparable period

Revenue growth was driven primarily by increased unmanned systems production, microwave products, modular systems, rocket support and the ASC Signal acquisition. These gains offset lower legacy services, commercial satellite, training and commercial turbine revenue.
COVID-19 caused supply-chain disruptions, supplier delivery delays, restricted access to customer locations and reduced demand in certain commercial aerospace, power and satellite communications activities. Travel, social-distancing and range restrictions delayed several drone, rocket and tactical systems programs.
The company completed acquisitions of Technical Directions, Optimized Performance Machining, ASC Signal and 5-D Systems. ASC Signal contributed approximately $21.9 million of revenue and $1.1 million of operating income in 2020.
Operating income declined despite higher revenue and gross profit because of increased SG&A, stock compensation, R&D and corporate expenses. Corporate activities produced a $23.0 million operating loss versus $13.3 million in 2019.
The company issued approximately 15.5 million common shares for $240.4 million of net proceeds, increasing shares outstanding and strengthening liquidity but causing dilution.
Goodwill increased to $483.9 million from $455.6 million. Goodwill represented approximately 31% of total assets and remains sensitive to government funding, program performance and future unmanned systems awards.

Guidance, outlook, commentary, risks and unusual items

Management did not provide a specific revenue or earnings forecast in the filing. It expects available cash, operating cash flow and revolver availability to fund anticipated working capital and capital expenditures for at least the next 12 months. Management intends to continue investing in unmanned systems, satellite communications, cybersecurity, microwave electronics, turbine technologies, hypersonic systems and other DoD priority areas.

FY2021 DoD appropriations were described as $695.9 billion, down $9.7 billion from FY2020. Continuing resolutions, debt-ceiling disputes, appropriations delays, budget reductions or a government shutdown could delay awards, restrict new starts, reduce funding and impair collections.
U.S. Government customers accounted for approximately 73% of revenue. The U.S. Air Force represented 22.5% and the U.S. Navy 12.5% of 2020 revenue, creating customer and program concentration risk.
Approximately 75% of revenue came from fixed-price contracts. Cost overruns, technical problems, supplier failures, schedule delays or inaccurate estimates could reduce margins or result in losses.
COVID-19 impacts remained difficult to estimate and could continue to affect operations, supply chains, customer access, production, testing and demand.
The company faces substantial debt service obligations, including the $300.0 million notes due in 2025, restrictive debt covenants and potential interest-rate risk associated with LIBOR-based borrowings.
At year-end, approximately $11.5 million of unbilled receivables related to a training program terminated for convenience remained subject to settlement. Approximately $10.0 million of unbilled receivables were subject to a dispute with an international customer, which had asserted counterclaims. Management recorded no adjustment.
The company remains in dispute with the buyer of its former Public Safety & Security business over an approximately $8.0 million closing working-capital adjustment. The resolution has not been recorded.
DCAA audits and reviews remain ongoing. The company has submitted incurred-cost claims through fiscal 2018, while audits have been completed through fiscal 2017; potential future adjustments cannot be reasonably estimated.
The company had $18.5 million of noncurrent uncertain tax-position liabilities and a $2.5 million guarantor liability. It also had $25.4 million of unrecognized tax benefits at year-end.
Management and Deloitte concluded that internal control over financial reporting was effective, although ASC Signal, acquired June 30, 2020, was excluded from management’s assessment and represented approximately 1.0% of assets and 2.9% of revenue.
No cash dividends or share repurchases are expected in the foreseeable future, and both are restricted by the company’s debt agreements.

Important facts an investor should verify

Whether the $922.2 million backlog converts to revenue on the stated schedule and how much is funded versus unfunded.
Progress, funding and profitability of the Valkyrie, Skyborg, BQM-177A, BQM-167A, GBSD and other unmanned systems programs.
Whether COVID-19, supply-chain constraints, testing restrictions or government budget actions cause further delays or margin pressure.
The collectability and ultimate resolution of the $11.5 million training-program receivable and the approximately $10.0 million international customer dispute.
The outcome of the approximately $8.0 million PSS working-capital dispute and ongoing DCAA audits.
The sustainability of profitability excluding the approximately $80.1 million non-cash tax valuation-allowance reversal.
Operating cash flow conversion, elevated unbilled receivables, inventory growth and the company’s ability to fund production without additional equity or debt.
Debt refinancing or repayment capacity ahead of the 2025 maturity of the 6.5% senior secured notes.
Potential goodwill impairment if forecasts, unmanned systems awards, government funding or international expansion do not meet assumptions.