Kratos Defense & Security Solutions, Inc. — Q1 2016 Form 10-Q Summary
Business context and reporting period
Kratos is a mid-tier defense contractor focused on unmanned systems, satellite communications, microwave electronics, missile defense, cyber security and public safety/security solutions. The filing covers the 13 weeks ended March 27, 2016, compared with the 13 weeks ended March 29, 2015. Continuing operations comprise Kratos Government Solutions, Unmanned Systems and Public Safety & Security. Herley Industries and related entities were sold on August 21, 2015 and are presented as discontinued operations.
Key financial metrics
| Metric | Q1 2016 | Q1 2015 | Change |
|---|---|---|---|
| Total revenue | $153.0 million | $157.1 million | Down 2.6% |
| Service revenue | $82.6 million | $87.3 million | Down 5.4% |
| Product sales | $70.4 million | $69.8 million | Up 0.9% |
| Gross profit | $35.9 million | $38.3 million | Down $2.4 million |
| Gross margin | 23.5% | 24.4% | Down 0.9 percentage points |
| Operating loss from continuing operations | $(10.2) million | $(3.9) million | Loss increased |
| Net loss | $(22.2) million | $(16.2) million | Loss increased |
| Loss per diluted share | $(0.37) | $(0.28) | Worsened |
| Cash flow from continuing operations | $(11.5) million | $(2.8) million | Higher cash use |
- Service gross margin increased to 27.0% from 24.4%, while product gross margin declined to 19.3% from 24.4%.
- SG&A was $37.7 million versus $37.4 million; R&D declined to $2.9 million from $3.9 million.
- Unused office space, restructuring and other expense was $5.5 million, including a $3.0 million inventory impairment, a $1.9 million PSS litigation settlement charge and employee termination costs.
- Cash and cash equivalents were $20.1 million at March 27, 2016, down from $28.5 million at December 27, 2015. Accounts receivable were $208.8 million and inventoried costs were $52.6 million.
- Total debt principal was $452.5 million, including $450.0 million of 7.00% Senior Secured Notes due 2019 and $2.5 million of an Israeli term loan. Carrying-value debt was $445.4 million.
- The $110.0 million revolving credit facility had no borrowings, $10.1 million of letters of credit outstanding and reported net borrowing-base availability of $52.8 million.
- Backlog was approximately $909.1 million, including $553.9 million funded, compared with $980.4 million and $578.3 million, respectively, in the prior-year period.
Material changes versus the prior comparable period
- Revenue declined primarily because PSS revenue fell $7.3 million as certain security installation projects wound down and the company focused on smaller, higher-margin projects. KGS revenue increased $1.4 million, while Unmanned Systems revenue increased $1.8 million.
- Operating performance deteriorated as lower revenue and unfavorable product mix reduced gross profit, while restructuring, inventory impairment and litigation charges increased.
- Net loss from discontinued operations was zero in Q1 2016 versus a $1.7 million loss in Q1 2015 because the Herley operations had been sold.
- Operating cash use increased substantially. Management reported days sales outstanding of 124 days, up from 106 days at December 27, 2015, citing delayed billing milestones, advanced billings and government funding delays.
- U.S. Government revenue was $95.4 million, or 62% of total revenue, versus $95.0 million, or 60%, in the prior-year quarter.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide quantitative revenue or earnings guidance. 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.
- Management expected to complete the manufacturing-facility closure and related restructuring in Q2 2016, with additional charges possible.
- The company had approximately $2.0 million to $4.0 million of remaining proceeds from the Herley disposition that it intended to invest in replacement collateral within the required 360-day period.
- All reported debt and credit-facility covenants were in compliance at March 27, 2016, and no credit-facility default had occurred.
- Key risks include U.S. government and DoD budget reductions, contract delays or cancellations, bid protests, customer concentration, backlog funding and timing, high leverage, litigation and government cost audits, cybersecurity incidents, competition and execution of restructuring and divestiture strategies.
- The company recorded a $3.6 million income-tax provision despite a pretax loss, including a $1.7 million increase in uncertain tax positions and a full valuation allowance against most U.S. deferred tax assets.
- The company adopted ASU 2015-01 during the quarter with no material impact; the filing states that the impact of other pending accounting standards had not yet been determined.
Most important facts for investors to verify
- Whether the PSS revenue decline and the unfavorable product mix in product sales are temporary or reflect a sustained change in demand and profitability.
- Progress and final cost of the manufacturing-facility closure, product-line exits and related restructuring charges.
- Collection of accounts receivable and the reduction of the 124-day DSO, particularly given government funding and billing-milestone delays.
- Liquidity under continued operating cash outflows, including the $450.0 million Notes due 2019 and revolver borrowing-base availability.
- Backlog conversion, funding status and exposure to U.S. Government contract cancellations or scope changes.
- Potential outcomes of DCAA/DCMA cost audits, litigation matters and the indemnification obligations related to the Herley sale.