Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed an unaudited Form 10-Q for the 13-week and 26-week periods ended June 28, 2015. Kratos provides specialized national-security products, services, engineering, manufacturing, systems integration and testing, primarily for U.S. Government customers, across Kratos Government Solutions, Unmanned Systems, and Public Safety & Security.
Prior-period results were recast to present Herley Industries and certain subsidiaries as discontinued operations following the May 31, 2015 agreement to sell the U.S. and U.K. electronics businesses to Ultra Electronics. The transaction was expected to close in the third fiscal quarter of 2015.
Key Financial Metrics
| Metric | Three Months Ended June 28, 2015 | Six Months Ended June 28, 2015 | Comparable Prior Period |
|---|---|---|---|
| Total revenue | $160.5 million | $317.4 million | $204.2 million and $378.0 million |
| Gross profit | $40.9 million | $79.2 million | $48.1 million and $91.9 million |
| Gross margin | 25.5% | 25.0% | 23.6% and 24.3% |
| Operating income (loss) from continuing operations | $(3.7) million | $(7.6) million | $2.3 million and $2.7 million |
| Net loss | $(15.0) million | $(31.3) million | $(49.9) million and $(64.9) million |
| Net loss per share | $(0.25) | $(0.54) | $(0.87) and $(1.13) |
| Operating cash flow from continuing operations | Not separately reported | $(15.1) million | $(6.6) million |
Service revenue was $88.8 million in the quarter and $176.1 million year to date. Product sales were $71.7 million in the quarter and $141.3 million year to date. SG&A expense was $40.3 million in the quarter and $77.7 million year to date; research and development expense was $4.3 million and $8.2 million, respectively.
At June 28, 2015, cash and cash equivalents were $22.2 million, compared with $33.5 million at December 28, 2014. Total assets were $1.103 billion and stockholders’ equity was $198.7 million. Principal long-term debt was approximately $669.2 million, including $625.0 million of 7% Senior Secured Notes, $41.0 million outstanding under the revolving credit facility, and $3.3 million of Israeli term debt. Credit-facility availability was approximately $32.9 million after $12.0 million of outstanding letters of credit.
Backlog was approximately $953.5 million at June 28, 2015, including $554.2 million of funded backlog, compared with total backlog of $955.3 million and funded backlog of $474.0 million at June 29, 2014. U.S. Government revenue represented 62% of quarterly revenue and 61% of year-to-date revenue.
Material Changes Versus the Prior Comparable Period
- Quarterly revenue declined $43.7 million, or 21.4%, and six-month revenue declined $60.6 million, or 16.0%.
- Public Safety & Security revenue declined 44.3% in the quarter and 35.1% year to date, reflecting completion or wind-down of installation projects, a prior-year $13.0 million one-time equipment shipment, and a shift toward selectively bidding on smaller, higher-margin projects.
- Kratos Government Solutions revenue declined 12.7% in the quarter and 6.1% year to date, primarily because of reduced specialized ground-equipment shipments and delays in federal and Department of Defense awards.
- Unmanned Systems revenue was essentially flat in the quarter but declined 19.2% year to date because of delayed international aerial-target awards. Six-month segment operating margin declined to 19.1% from 25.3%, primarily because of product mix and increased costs on international aerial-target projects.
- Gross margin improved to 25.5% in the quarter and 25.0% year to date, primarily due to product and segment mix, cost-reduction actions, and a shift in the Public Safety & Security business toward higher-margin work.
- Operating results deteriorated despite the higher gross margin because revenue fell while SG&A remained comparatively high. Quarterly operating loss was $3.7 million versus operating income of $2.3 million; year-to-date operating loss was $7.6 million versus income of $2.7 million.
- Net loss improved substantially because the prior-year periods included a $39.1 million loss on extinguishment of debt related to the 2014 refinancing. Interest expense also declined following the refinancing from 10% notes to 7% notes due 2019.
- Cash used in continuing operations increased to $15.1 million from $6.6 million, while days sales outstanding increased from 104 days at December 28, 2014 to 116 days at June 28, 2015.
Outlook, Unusual Items, Risks and Contingencies
- The pending Herley sale contemplated $260.0 million of cash consideration, subject to a $2.0 million escrow, up to $5.0 million for taxes, and an estimated $6.0 million working-capital reduction. Management estimated approximately $236.0 million of net cash proceeds after approximately $23.0 million of transaction costs, including estimated taxes.
- Following closing, management intended to repurchase approximately $175.0 million to $200.0 million of the 7% Senior Secured Notes and repay the $41.0 million outstanding under the credit facility. The credit agreement required repayment of all outstanding revolving borrowings upon the Herley sale and required at least a $175.0 million note repurchase.
- Management stated that cash on hand, expected operating cash flow, and available credit were sufficient for anticipated needs for at least the next 12 months. However, liquidity was pressured by negative operating cash flow, declining revenue, higher receivable days, substantial leverage, and reliance on government funding.
- Defense spending reductions, sequestration, continuing-resolution uncertainty, delayed or canceled awards, bid protests, contract changes, customer concentration, competition, cybersecurity incidents, and execution of cost-reduction and divestiture plans were identified as material risks.
- The company was in compliance with the Senior Secured Notes and credit-agreement covenants at June 28, 2015. The filing warned that further deterioration in operations or cash flow could create covenant-compliance and liquidity risks.
- DCAA and DCMA audits may result in claims for unallowable, overstated, or disputed government-contract costs. On July 28, 2015, after the reporting period, the company received a DCMA determination letter concerning alleged unallowable costs for one subsidiary for fiscal year 2007. The company was evaluating the matter, believed it had a defensible position, and had not recorded a liability because the potential loss could not reasonably be estimated.
- The company maintained a full valuation allowance against most U.S. federal, state, and certain foreign deferred tax assets. The Herley transaction was expected to generate taxable gain and use a portion of the company’s net operating losses.
- Management identified no material change in internal control over financial reporting and concluded that disclosure controls were effective at a reasonable assurance level.
Investor Verification Priorities
- Verify whether and when the Herley transaction closed, the final purchase-price adjustments, taxes, transaction costs, and actual net proceeds.
- Verify the subsequent repayment of the $41.0 million credit-facility balance and any repurchase of the 7% Senior Secured Notes.
- Reconcile post-transaction revenue, margins, backlog, and earnings after removing Herley and related allocated costs.
- Monitor accounts receivable, days sales outstanding, operating cash flow, and working-capital requirements.
- Assess covenant compliance, borrowing-base availability, letters of credit, and required debt repayments.
- Review outcomes of DCAA and DCMA audits, litigation, warranty obligations, and other unrecorded contingencies.
- Evaluate exposure to U.S. Government funding changes, contract delays, customer concentration, and international program cost overruns.