Kratos Defense & Security Solutions, Inc. — Q3 2019 Form 10-Q Summary
Business context and reporting period
Kratos is a defense technology and government contractor focused on unmanned systems, space and satellite communications, microwave electronics, missile defense, training systems, cyber-related solutions, C5ISR and other national-security programs. The filing covers the 13-week quarter and 39-week year-to-date periods ended September 29, 2019, compared with September 30, 2018. The results are unaudited.
The company operates through Kratos Government Solutions (KGS) and Unmanned Systems (US). On February 27, 2019, Kratos acquired an 80.1% interest in Florida Turbine Technologies, Inc. and FTT Core for approximately $60.0 million. FTT contributed $16.3 million of third-quarter revenue and $37.7 million of nine-month revenue.
Financial performance and liquidity
| Metric | Q3 2019 | Q3 2018 | Change |
|---|---|---|---|
| Total revenue | $184.1 million | $159.4 million | Up 15.5% |
| Gross profit | $48.6 million | $44.1 million | Up $4.5 million |
| Gross margin | 26.4% | 27.7% | Down 130 bps |
| Operating income | $11.5 million | $10.1 million | Up $1.4 million |
| Net income attributable to Kratos | $2.5 million | $1.7 million | Up $0.8 million |
| Diluted earnings per share | $0.02 | $0.02 | No change |
| Metric | Nine months 2019 | Nine months 2018 | Change |
|---|---|---|---|
| Total revenue | $532.4 million | $453.6 million | Up 17.4% |
| Gross profit | $141.6 million | $124.2 million | Up $17.4 million |
| Gross margin | 26.6% | 27.4% | Down 80 bps |
| Operating income | $28.7 million | $19.7 million | Up $9.0 million |
| Income from continuing operations | $7.6 million | $(1.1) million | Improved $8.7 million |
| Net income attributable to Kratos | $9.5 million | $(8.2) million | Improved $17.7 million |
| Diluted earnings per share | $0.09 | $(0.08) | Improved $0.17 |
- Revenue mix: Nine-month service revenue increased 40.0% to $207.1 million, while product sales increased 6.4% to $325.3 million. KGS revenue increased 14.7% to $409.3 million and US revenue increased 27.3% to $123.1 million.
- Cash flow: Nine-month operating cash flow from continuing operations was $30.2 million, compared with $15.4 million in the prior-year period. Investing cash flow was $(35.2) million, including $17.6 million for acquisitions and $17.9 million of capital expenditures. Total cash, cash equivalents and restricted cash declined to $181.0 million from $183.0 million at the beginning of the year.
- Balance sheet: Cash was $181.0 million at September 29, 2019. Total assets were $1.178 billion and total liabilities were $596.1 million. Goodwill was $458.1 million, including the goodwill recorded from the FTT acquisition.
- Debt and liquidity: The company had $300.0 million principal amount of 6.5% senior secured notes due 2025, carried at $294.8 million net of unamortized issuance costs. No revolving credit borrowings were outstanding; $5.7 million of letters of credit reduced net borrowing base availability to $54.2 million. The company stated that cash, available credit and expected operating cash flow should fund anticipated needs for at least the next 12 months.
- Backlog: Total backlog was approximately $608.7 million, including $518.7 million funded, compared with $571.7 million total and $528.1 million funded at September 30, 2018. Management expected to recognize approximately 27% of remaining backlog in 2019 and an additional 41% by 2020.
Material changes versus the prior comparable period
- Revenue growth was driven by the FTT acquisition, increased satellite communications, modular systems, training systems, ballistic missile target activity and higher US aerial-target production.
- Quarterly gross margin declined because of less favorable service revenue mix, particularly in space and satellite communications, training solutions and FTT. Nine-month product margins also declined because of product mix.
- SG&A increased in absolute dollars to $97.7 million year to date but declined as a percentage of revenue to 18.4% from 19.7%, reflecting revenue leverage and cost-reduction actions.
- Restructuring and other expense declined to $0.3 million year to date from $3.5 million, which included a $2.3 million litigation settlement and related costs in 2018.
- Discontinued operations contributed $2.4 million of income year to date versus a $7.1 million loss in 2018. The 2019 amount included a $3.6 million gain from releasing an indemnification liability.
- The company adopted ASC 842 lease accounting on December 31, 2018. At September 29, 2019, it reported $44.8 million of operating lease right-of-use assets and $50.4 million of operating lease liabilities, plus finance lease liabilities of approximately $39.2 million.
Guidance, outlook, risks and unusual items
- The company did not provide a formal revenue or earnings forecast in the filing. It projected fiscal 2019 capital expenditures of approximately $14 million to $16 million, including investments in aerial targets, support equipment, tooling and new facilities.
- The U.S. government was operating under a continuing resolution through November 21, 2019. A prolonged continuing resolution or government shutdown could delay awards, restrict new program starts, disrupt performance and delay customer payments.
- Approximately 71% of nine-month revenue came from the U.S. Government, creating exposure to appropriations, defense-budget changes, contract cancellations, bid protests and changes in program scope or timing.
- The company was disputing approximately $11.2 million of unbilled receivables with an international US-segment customer concerning flight requirements and contractual milestones.
- The sale of the former Public Safety & Security Solutions business remained subject to an approximately $8.0 million dispute over the closing net working capital adjustment. Management expected approximately $70.0 million of aggregate net cash proceeds, excluding the effect of final settlement.
- Government contracts are subject to Defense Contract Audit Agency review. The company had not recorded a liability for unresolved potential cost claims because it could not reasonably estimate the range of loss.
- The FTT minority holders have a put right beginning in January 2024, generally priced using 12 times trailing twelve-month EBITDA; certain events can accelerate the put and increase the multiple to 14 times. The company has a corresponding purchase right beginning in January 2025.
- Other principal risks include contract execution and cost estimates, supplier and subcontractor performance, cybersecurity, product defects, competition, debt leverage, acquisition integration and the possibility of additional tax limitations or liabilities. Management stated that debt and revolving-credit covenants were satisfied and no default had occurred.
Important facts for investors to verify
- Whether revenue growth and backlog conversion continue after the one-time comparative impact of the FTT acquisition.
- Whether service and product gross margins recover from the year-over-year declines.
- The collectability and timing of the $11.2 million disputed unbilled receivable and other contract assets totaling $176.2 million.
- The final resolution and cash impact of the approximately $8.0 million PSS working-capital dispute.
- The effect of continuing resolutions, government shutdowns, appropriations changes and contract funding on backlog conversion.
- The future cash obligation associated with the FTT minority-interest put right and the company’s ability to manage its $300.0 million debt maturity in 2025.
- The company’s continuing ability to generate operating cash flow while funding acquisitions, capital expenditures, inventory and contract-related working capital.