KRATOS DEFENSE & SECURITY SOLUTIONS, INC. annual report, FY2018

Kratos Defense & Security Solutions, Inc. — FY2018 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, cyber security/warfare, missile defense, training systems and related national-security products and services. The filing covers the 52-week fiscal year ended December 30, 2018; the comparable prior year ended December 31, 2017 and included 53 weeks. Continuing operations comprise Kratos Government Solutions (KGS) and Unmanned Systems (US).

Approximately 2,600 employees and operations at 42 locations.
U.S. Government-related contracts, including foreign military sales, represented 72% of 2018 revenue, compared with 75% in 2017.
International revenue was $114.3 million, or 19% of total revenue, compared with $84.7 million, or 14%, in 2017.
Public Safety & Security was sold on June 11, 2018 and is presented as discontinued operations.

Financial performance and key metrics

($ in millions, except per-share data)	2018	2017	Change
Revenue	$618.0	$603.3	2.4%
Gross profit	$169.7	$157.6	7.7%
Gross margin	27.5%	26.1%	+140 bps
Operating income from continuing operations	$30.5	$(12.0)	Improved
Income from continuing operations	$4.1	$(46.9)	Improved
Net income (loss)	$(3.5)	$(42.7)	Improved
Diluted net loss per share	$(0.03)	$(0.48)	Improved
Cash flow from continuing operations	$18.1	$(26.9)	Improved
Capital expenditures	$22.6	$26.1	$(3.5)

KGS revenue was $485.1 million, up 0.7%; US revenue was $132.9 million, up 9.2%.
Product sales increased 2.9% to $417.3 million; service revenue increased 1.5% to $200.7 million.
SG&A declined to $119.8 million from $127.3 million, and IR&D declined to $15.6 million from $17.8 million.
Interest expense declined to $20.8 million from $28.6 million, primarily following the 2017 refinancing.
Discontinued operations generated a $7.6 million loss in 2018, including operating losses, transaction expenses and other adjustments.

Liquidity, debt and balance sheet

Cash and cash equivalents were $182.7 million at December 30, 2018, compared with $130.5 million at December 31, 2017. Approximately $66 million of 2018 cash reflected net proceeds from the PSS divestiture.
Total assets were $1.010 billion, working capital was $330.0 million and stockholders’ equity was $519.3 million.
Debt was $294.2 million net of issuance costs, consisting primarily of $300 million of 6.5% Senior Secured Notes due November 2025. The notes carry significant restrictive covenants and are secured by substantially all company and guarantor assets.
The $90 million revolving credit facility had no borrowings outstanding; $9.7 million of letters of credit were outstanding and net borrowing-base availability was $51.4 million. The company reported compliance with applicable debt covenants and no event of default.
Contractual commitments totaled $686.1 million, including $300.0 million of debt principal, $136.5 million of estimated interest, $132.4 million of purchase orders and $117.2 million of operating leases.
Days sales outstanding increased to 140 days from 128 days. The company was disputing approximately $11.2 million of unbilled receivables with an international customer.

Material changes versus the prior comparable period

Revenue growth was modest, but profitability improved materially due to higher-margin revenue mix, cost reductions, lower amortization and increased manufacturing leverage.
The 2017 $24.2 million goodwill impairment charge in the DRSS reporting unit did not recur in 2018.
The 2017 $17.3 million loss on extinguishment of debt did not recur. The refinancing reduced the principal balance and coupon rate from the former 7% notes to the $300 million 6.5% notes.
ASC 606 was adopted on January 1, 2018 using the modified retrospective method. The adoption increased 2018 revenue by approximately $30.0 million, cost of revenue by $21.9 million and operating income by $8.1 million; opening equity declined by $0.2 million.
Total backlog was $620.7 million at year-end, up from an ASC 606-comparable $519.9 million at year-end 2017. Funded backlog was $537.2 million versus $457.3 million. Management expected 66.7% of total backlog to be recognized in 2019 and 13.7% in 2020.
PSS generated $44.2 million of revenue before its June 2018 divestiture, compared with $149.9 million in 2017. Expected aggregate net proceeds were approximately $70 million, but approximately $8 million was subject to a closing working-capital dispute with the buyer.

Guidance, outlook, commentary and risks

Management believes cash on hand, operating cash flow and available revolver capacity are sufficient for anticipated working-capital and other needs for at least the next 12 months. It cautioned that larger tactical-drone production awards could require additional working capital or financing.
Management expects growth from unmanned aerial systems, space and satellite communications, microwave electronics, training and other technology-focused defense programs. The company highlighted 2018 awards for aerial targets, Firejet systems, Gremlins and other unmanned platforms.
Key risks include U.S. defense-budget uncertainty, continuing resolutions, government shutdowns, debt-ceiling and sequestration-related pressures, program delays or cancellations, bid protests and government contract termination rights.
Additional risks include fixed-price contract execution, supplier and subcontractor performance, cybersecurity and classified-information incidents, export and ITAR compliance, DCAA audits and potential cost disallowances, international exposure, competition from larger contractors and the need to maintain security clearances.
Goodwill was $425.7 million, approximately 42% of total assets. Future impairment could result if operating performance, defense funding, new unmanned-system awards or international expansion fail to meet assumptions.
The company recognized $3.8 million of restructuring and other expense in 2018, including approximately $2.8 million of litigation settlement and legal costs and $1.0 million of employee termination costs.
On February 27, 2019, after year-end, Kratos completed the acquisition of 80.1% of FTT Core, LLC and Florida Turbine Technologies, Inc. for $60 million, consisting of $33 million cash and approximately $27 million of Kratos stock.

Most important facts for investors to verify

Reconcile 2018 growth and margin expansion excluding the $30 million ASC 606 revenue acceleration and assess the sustainability of contract estimates.
Monitor conversion, funding and timing of the $620.7 million backlog, particularly the $537.2 million funded portion.
Track collection and resolution of the $11.2 million international unbilled-receivable dispute and the approximately $8 million PSS working-capital dispute.
Evaluate liquidity against the $300 million 2025 notes, interest obligations, purchase orders, lease commitments and possible working-capital needs from tactical-drone production.
Assess the performance and award timing of key unmanned-system programs, including SSAT, BQM-167A, LCASD/Valkyrie, Mako and Gremlins.
Review DCAA audits, uncertain tax positions, cybersecurity matters, contract claims and the assumptions supporting the $425.7 million goodwill balance.
Confirm the financial and operational effects of the February 2019 Florida Turbine Technologies acquisition.