Kratos Defense & Security Solutions, Inc. — Q3 2017 Form 10-Q Summary
Business Context and Reporting Period
Kratos is a technology and intellectual-property-focused defense contractor serving the U.S. Department of Defense, intelligence and national security agencies, homeland security customers, and selected commercial customers. Its reportable segments are Kratos Government Solutions, Public Safety & Security, and Unmanned Systems.
The filing covers the 14-week quarter and 40-week year-to-date period ended October 1, 2017, compared with 13-week and 39-week periods ended September 25, 2016. The interim financial statements are unaudited.
Financial Performance and Position
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Total revenue | $196.2 million | $165.4 million | $549.7 million | $486.6 million |
| Gross profit | $48.1 million | $25.9 million | $140.6 million | $107.0 million |
| Gross margin | 24.5% | 15.7% | 25.6% | 22.0% |
| Operating income (loss) | $3.1 million | $(13.0) million | $7.4 million | $(23.2) million |
| Net loss | $(4.3) million | $(23.6) million | $(20.5) million | $(56.2) million |
| Net loss per share | $(0.05) | $(0.39) | $(0.24) | $(0.94) |
| Operating cash flow from continuing operations | Not separately provided for the quarter | $(16.7) million | $(8.7) million |
- Q3 revenue increased 18.6%, driven primarily by a 40.0% increase in product sales to $109.5 million; service revenue declined 0.6% to $86.7 million.
- Nine-month revenue increased 13.0%. Product sales rose 25.3% to $286.4 million, while service revenue increased 2.1% to $263.3 million.
- Q3 SG&A was $40.7 million and R&D was $4.2 million. Nine-month SG&A was $120.0 million and R&D was $12.7 million.
- Cash and cash equivalents were $239.2 million at October 1, 2017, versus $69.1 million at December 25, 2016. The increase primarily reflects equity issuance proceeds.
- Total assets were $1.143 billion and stockholders’ equity was $531.9 million at October 1, 2017, compared with $948.6 million and $276.4 million, respectively, at December 25, 2016.
Segments and Material Changes
- Kratos Government Solutions: Q3 revenue increased 2.3% to $115.4 million; nine-month revenue increased 4.4% to $356.4 million. Product sales growth more than offset continued contraction in legacy government services.
- Public Safety & Security: Q3 revenue increased 14.3% to $39.2 million; nine-month revenue increased 20.0% to $113.9 million, supported by a large mass-transit security deployment and a healthcare access-control project.
- Unmanned Systems: Q3 revenue increased 127.3% to $41.6 million; nine-month revenue increased 57.9% to $79.4 million, reflecting higher shipments and production of unmanned aerial systems, including low-rate initial production of the SSAT program.
- Q3 gross margin improved substantially because the prior-year quarter included an $18.7 million loss accrual on the LCASD unmanned aerial system demonstration contract. Nine-month product margin increased to 23.4% from 16.8% for the same reason and due to a more favorable product mix.
- Prior-year nine-month results also included $7.8 million of restructuring charges related to a manufacturing-facility closure and product-line exits and a $1.9 million litigation settlement charge. Current-year restructuring and other charges were $0.5 million for the nine months.
- U.S. Government revenue represented 60% of Q3 revenue and 59% of nine-month revenue, creating significant customer and funding concentration.
Cash Flow, Debt, Liquidity, and Capital Allocation
- Nine-month operating cash flow from continuing operations was negative $16.7 million, including working-capital needs associated with growth, approximately $7.4 million of inventory buildup, and approximately $6.1 million of internal development investment related to the Valkyrie program.
- Nine-month investing cash flow from continuing operations was negative $17.9 million, including $19.0 million of capital expenditures in the consolidated cash-flow statement. Approximately $11.6 million of capital expenditures were in Unmanned Systems.
- Financing cash flow was positive $204.7 million, primarily reflecting $268.0 million of common-stock issuance proceeds, partially offset by $64.0 million used to retire approximately $62.7 million of senior notes.
- Long-term debt carrying value declined to $370.7 million from $432.0 million at December 25, 2016. Principal debt at October 1, 2017 included $372.8 million of 7.00% senior secured notes due 2019 and approximately $1.0 million of an Israeli term loan.
- The $110.0 million revolving credit facility had no borrowings, $9.2 million of letters of credit, and $68.7 million of net borrowing-base availability at October 1, 2017. The Company reported compliance with its debt covenants and no events of default.
- Management stated that cash on hand, available revolver capacity, and expected operating cash flow should fund anticipated working-capital and other cash needs for at least the next 12 months.
Guidance, Outlook, Risks, and Unusual Items
- Management expected fiscal 2017 capital expenditures of approximately $18.0 million to $23.0 million, primarily for capital aerial targets and related equipment for the Valkyrie and Mako platforms.
- Management expected fiscal 2017 non-capital internal product-development spending of approximately $7.0 million to $10.0 million, including Valkyrie-related development.
- Backlog was approximately $798.9 million at October 1, 2017, down from $900.9 million at September 25, 2016. Funded backlog was $586.2 million. The filing cautions that backlog may be delayed, canceled, or adjusted and that government contracts may be terminated for convenience.
- The federal government was operating under a continuing resolution expiring December 8, 2017. Failure to enact appropriations or another continuing resolution could cause a shutdown, stop-work orders, delayed payments, program cancellations, or reduced contract activity.
- Principal disclosed risks include changes or cutbacks in DoD spending, bid protests, contract timing and cancellation, regulatory and litigation exposure, debt leverage and refinancing, integration or divestiture execution, cybersecurity incidents, competition, and dependence on government customers.
- The Company planned to adopt the new revenue-recognition standard on January 1, 2018 using the modified-retrospective method. It expected an increase in revenue of less than $3 million, an increase in operating income of less than $2 million, and no material ongoing effect on results or cash flows.
- New long-term lease commitments were entered into for corporate headquarters in San Diego and facilities in Colorado Springs. The Colorado Springs leases may involve initial annual base rent of up to approximately $1.9 million for the new building, in addition to other occupancy costs.
Most Important Facts for Investors to Verify
- Whether revenue growth, particularly in Unmanned Systems and product sales, converts into sustained positive operating cash flow rather than continued working-capital consumption.
- The timing and funding of the $798.9 million backlog, including the $212.7 million of unfunded backlog implied by the disclosed funded amount.
- Execution, margins, and cash requirements for the Valkyrie, Mako, SSAT, and other unmanned-system programs.
- Ability to refinance or repay the approximately $372.8 million of senior secured notes due 2019 and maintain covenant compliance.
- Effects of federal appropriations, continuing resolutions, potential government shutdowns, and the Company’s 59%–60% U.S. Government revenue concentration.
- Impact of the 2018 revenue-standard adoption, including the disclosed cumulative adjustment and any changes to contract timing or performance obligations.
- Exposure to DCAA/DCMA cost audits, uncertain tax positions, litigation, cybersecurity events, and other contingencies for which the ultimate loss may differ from recorded amounts.