Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed this unaudited Form 10-Q for the 13-week quarter and 26-week six-month period ended June 28, 2020. 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, and related products and services. Reportable segments are Kratos Government Solutions (KGS) and Unmanned Systems (US).
Financial Performance and Position
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Total revenue | $170.4 million | $187.9 million | $339.3 million | $348.3 million |
| Gross profit | $46.0 million | $48.1 million | $91.8 million | $93.0 million |
| Gross margin | 27.0% | 25.6% | 27.1% | 26.7% |
| Operating income | $2.9 million | $9.0 million | $7.6 million | $17.2 million |
| Net income attributable to Kratos | $(0.7) million | $3.9 million | $(0.9) million | $7.0 million |
| Diluted EPS | $(0.01) | $0.04 | $(0.01) | $0.06 |
- Q2 service revenue declined 14.7% to $62.9 million, while product sales declined 5.9% to $107.5 million. Six-month service revenue declined 7.2% to $126.5 million; product sales increased 0.4% to $212.8 million.
- SG&A increased to $36.0 million in Q2 and $70.9 million for the six-month period, with stock-based compensation contributing to the increase. Research and development expense increased to $6.0 million in Q2 and $11.7 million year to date.
- Interest expense was $5.6 million in Q2 and $11.0 million year to date. The company reported a continuing-operations loss before taxes of $2.4 million in Q2 and $3.6 million for the six months.
- Cash provided by continuing operations was $10.8 million for the six months, compared with $20.0 million in the prior-year period. Capital expenditures were $14.1 million and acquisition spending was $15.5 million.
- Cash and cash equivalents increased to $397.2 million at June 28, 2020 from $172.6 million at December 29, 2019, principally due to $240.5 million of net proceeds from a June equity offering.
- Long-term debt carrying value was $296.0 million, including $300.0 million principal amount of 6.5% senior secured notes due 2025 and approximately $0.5 million of equipment financing obligations. The revolving credit facility had no borrowings, $5.7 million of letters of credit, and $61.2 million of net borrowing base availability.
- Total assets were $1.419 billion and stockholders’ equity was $824.5 million at June 28, 2020. Net contract assets were $152.0 million, including $186.4 million of unbilled receivables and $34.4 million of contract liabilities.
Material Changes Versus Prior Comparable Period
- Q2 revenue decreased 9.3%; six-month revenue decreased 2.6%. KGS revenue declined 11.7% in Q2 and 5.8% year to date, while US revenue was approximately flat in Q2 and increased 8.5% year to date.
- Revenue reductions reflected completion of foreign military sales and satellite infrastructure programs, contraction in legacy government services, lower commercial turbine demand, and COVID-19-related impacts. These declines were partly offset by growth in microwave products, rocket systems, C5 modular systems, ballistic missile targets, and other US programs.
- Gross margin improved despite lower revenue because of product mix, with product margins increasing to 27.3% in Q2 and 26.6% year to date. Service margins declined to 26.6% in Q2 and 27.7% year to date.
- Operating income declined materially because lower revenue and higher SG&A and R&D more than offset the gross-margin improvement. The company moved from net income to a net loss attributable to Kratos.
- During the six months, Kratos acquired Technical Directions, Inc. for approximately $10.5 million and Optimized Performance Machining, Inc. for approximately $1.8 million. On June 30, 2020, after the reporting date, it completed the $35 million acquisition of ASC Signal.
- Kratos issued 15.525 million common shares for gross proceeds of approximately $252.3 million and net proceeds of $240.5 million, increasing shares outstanding and materially strengthening liquidity.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
- Backlog was approximately $683.4 million at June 28, 2020, including $569.6 million funded, compared with $620.3 million total and $545.4 million funded at June 30, 2019. Management expects approximately 46% of remaining backlog to be recognized in 2020, 29% by 2021, and the balance thereafter.
- Management expects 2020 capital expenditures of approximately $23 million to $26 million, including $17 million to $20 million for capital aerial targets and related support equipment.
- Management believes cash on hand, operating cash flow, and available credit will fund anticipated working capital and other needs for at least the next 12 months.
- COVID-19 caused supply-chain and transportation disruptions, supplier delays, restricted access to facilities and customers, delayed demonstrations and exercises, and lower demand from certain commercial aerospace and power customers. Management did not expect a material impact at the filing date but stated that the ultimate financial effect could not be reasonably estimated.
- Approximately $11.5 million of unbilled receivables relates to a government training program terminated for convenience. Kratos also disputed approximately $10.0 million of unbilled receivables with an international US-segment customer. Management determined that no revenue or receivable adjustment was required at June 28, 2020.
- The company remains in a dispute over approximately $8 million related to the closing working-capital adjustment from the 2018 sale of its Public Safety & Security Solutions business. Discontinued operations produced a $0.6 million loss for the six months.
- Defense spending, appropriations, continuing resolutions, government shutdowns, contract cancellations, bid protests, customer concentration, subcontractor performance, cybersecurity incidents, product defects, competition, leverage, acquisitions, and COVID-19 are identified as material risks.
- Kratos maintained a full valuation allowance against certain U.S. and foreign deferred tax assets. Management stated that a significant portion could potentially be released within the following 12 months if sustained profitability provides sufficient positive evidence, but timing and amount remain uncertain.
- The company was in compliance with the senior notes and revolving-credit covenants, and management reported no event of default. Disclosure controls were evaluated as effective at June 28, 2020.
Important Facts for Investors to Verify
- Whether COVID-19-related disruptions, customer access limitations, supplier delays, and commercial demand weakness persist or materially affect revenue, margins, and cash flow.
- The collectability and timing of the approximately $11.5 million terminated-program receivable and the approximately $10.0 million international customer receivable under dispute.
- Execution, funding, and conversion timing of the $683.4 million backlog, including the $569.6 million funded portion.
- Integration and performance of the TDI, OPM, and post-period ASC Signal acquisitions, including their effect on leverage and capital spending.
- Future liquidity needs, covenant compliance, and refinancing or redemption considerations for the $300.0 million of 6.5% senior secured notes due 2025.
- The potential outcome and timing of the approximately $8 million PSS working-capital dispute and other government contract audits or cost claims.
- Whether sustained profitability supports release of deferred-tax valuation allowances and improves reported earnings.