Kratos Defense & Security Solutions, Inc. — 2018 Q1 Form 10-Q Summary
Reporting period: Three months ended April 1, 2018; comparative period ended March 26, 2017. Results are unaudited and cover 13-week periods. Kratos operates primarily in defense technology, unmanned systems, space communications, microwave electronics, cyber, missile defense, and related national-security markets. The Public Safety & Security business was classified as discontinued operations following the February 28, 2018 agreement to sell it.
Financial performance and position
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Total revenue | $143.0 million | $132.0 million | Up 8.3% |
| Gross profit | $40.8 million | $36.1 million | Up $4.7 million |
| Gross margin | 28.5% | 27.3% | Up 120 basis points |
| Operating income from continuing operations | $7.0 million | $1.4 million | Up $5.6 million |
| Income (loss) from continuing operations | $1.3 million | $(10.1) million | Improved |
| Net loss | $(2.2) million | $(10.0) million | Improved |
| Net loss per share | $(0.02) | $(0.13) | Improved |
| Operating cash flow from continuing operations | $6.5 million | $(5.4) million | Improved $11.9 million |
Product sales increased 17.1% to $97.0 million, while service revenue declined 6.5% to $46.0 million. Unmanned Systems revenue rose 78.2% to $27.8 million, driven by aerial-target production and recent awards. Kratos Government Solutions revenue declined 1.0% to $115.2 million, reflecting reductions in legacy government services, partly offset by satellite communications, microwave products, training solutions, and ASC 606 effects.
SG&A was $29.8 million, or 20.8% of revenue versus 22.7% in the prior period. R&D declined to $3.6 million from $4.4 million. Operating margin was approximately 4.9% versus 1.1% in Q1 2017. Interest expense declined to $5.1 million from $8.2 million following the 2017 debt refinancing.
At April 1, 2018, cash and cash equivalents were $127.8 million versus $130.5 million at December 31, 2017. Total assets were $1.01 billion and stockholders’ equity was $512.5 million. Principal long-term debt was approximately $300.5 million, with a carrying amount of $294.1 million.
Capital expenditures were $6.7 million. Total cash, cash equivalents, and restricted cash decreased $2.7 million during the quarter to $128.2 million. Continuing-operations cash flow was partly offset by $3.1 million of operating cash outflow from discontinued operations.
Material changes versus the prior comparable period
- Revenue increased $11.0 million, primarily from higher product sales and substantially higher Unmanned Systems production.
- Gross margin improved due mainly to product mix, increased production volumes, and migration of certain platforms from development to production.
- Interest expense fell by $3.0 million after the November 2017 refinancing reduced principal from approximately $431 million to $300 million and lowered the rate from 7.0% to 6.5%.
- Q1 2017 included a $2.1 million loss on extinguishment of debt; no comparable loss was recorded in Q1 2018.
- ASC 606 was adopted on January 1, 2018 using the modified retrospective method. The adoption reduced opening equity by $0.2 million and increased Q1 2018 revenue by $7.7 million, cost of revenue by $4.2 million, and operating income by $3.5 million. Prior-period results were not recast.
- Discontinued operations generated a $3.5 million loss versus $0.1 million of income in Q1 2017. The 2018 loss included approximately $2.0 million of cost adjustments on mass-transit security projects and $0.8 million of transaction expenses.
Backlog, outlook, liquidity, and risks
Remaining performance obligations were approximately $551.8 million at April 1, 2018, including $495.4 million of funded backlog. Management expects to recognize approximately 55% in 2018, an additional 26% by 2020, and the balance thereafter. Management stated that comparable backlog under ASC 606 was approximately $587.8 million at March 26, 2017; adoption reduced the current-period backlog measure by approximately $138.6 million.
Management expects $23.0 million to $26.0 million of fiscal 2018 capital expenditures, including $14.0 million to $17.0 million for unmanned aerial systems. It also expects to spend an additional $5.0 million to $7.0 million on non-capital internal development for the LCASD program.
The company expects approximately $70 million of net cash proceeds from the pending sale of Public Safety & Security, subject to a $69 million purchase price, working-capital adjustments, transaction services, and related fees. Closing was expected in the second quarter of 2018, subject to regulatory and other approvals.
Kratos had no borrowings under its $90.0 million revolving credit facility, $9.6 million of outstanding letters of credit, and reported $59.0 million of net borrowing-base availability. The company stated that it was in compliance with its credit facility and note covenants and expects cash on hand, available credit, and operating cash flow to fund needs for at least the next 12 months.
Key risks include dependence on U.S. Government and Department of Defense spending, appropriations and potential shutdowns; contract delays, cancellations, bid protests, and lowest-price technically acceptable awards; execution and estimate risk on long-term contracts; leverage and covenant compliance; cybersecurity and information-system disruptions; litigation and DCAA cost audits; competition; and uncertainty regarding the pending divestiture. U.S. Government revenue represented approximately 71% of Q1 2018 revenue.
Most important facts for investors to verify
- Whether the Public Safety & Security divestiture closed on the expected terms and whether approximately $70 million of net proceeds were received.
- The recurring effect of ASC 606 on revenue timing, backlog, contract assets, contract liabilities, and operating income.
- Conversion of the $551.8 million backlog, including the $495.4 million funded portion, into revenue and cash flow.
- Execution of Unmanned Systems production programs, including SSAT/177, LCASD, and UTAP-22 initiatives, against projected spending and margin expectations.
- Accounts receivable and unbilled receivable trends, including the increase in days sales outstanding from 116 days at year-end 2017 to 133 days at April 1, 2018.
- Compliance with debt covenants, availability under the revolving facility, and the company’s ability to service approximately $300.5 million of principal debt.
- Potential financial exposure from DCAA audits, contract cost claims, litigation, and the identified discontinued-operation project adjustments.