Kratos Defense & Security Solutions, Inc. — FY2014 Form 10-K
Reporting period: Fiscal year ended December 28, 2014, comprising 52 weeks. The filing was dated March 13, 2015. Fourth-quarter data are included in the annual filing. Kratos operates in Kratos Government Solutions (KGS), Unmanned Systems (US), and Public Safety & Security (PSS); the US segment was separated from KGS in the fourth quarter, with prior periods recast.
Business Context
Kratos provides specialized defense and security technology, engineering, manufacturing, systems integration, testing, cybersecurity, satellite communications, electronic warfare, missile defense, unmanned systems, training, range operations, and critical-infrastructure security. U.S. Government customers represented 59% of 2014 revenue, down from 64% in 2013. The company had approximately 3,600 employees and served domestic, international government, and commercial customers.
Key Financial Metrics
| Metric | FY2014 | FY2013 | Change |
|---|---|---|---|
| Revenue | $868.0 million | $950.6 million | Down 8.7% |
| Gross profit | $218.2 million | $240.0 million | Down $21.8 million |
| Gross margin | 25.1% | 25.2% | Down 0.1 percentage point |
| Operating income | $19.9 million | $31.8 million | Down $11.9 million |
| Net loss | $78.0 million | $37.2 million | Loss increased $40.8 million |
| Loss per share | $1.35 | $0.65 | Loss increased $0.70 |
| Operating cash flow | $7.7 million | $22.6 million | Down $14.9 million |
| Capital expenditures | $14.2 million | $16.6 million | Down $2.4 million |
Service revenue declined to $390.8 million from $443.6 million, while product sales declined to $477.2 million from $507.0 million. Product revenue represented 55.0% of total revenue, compared with 53.3% in 2013. Service gross margin fell to 22.1% from 24.4%, while product gross margin increased to 27.7% from 26.0%.
Fourth Quarter
| Metric | Q4 FY2014 | Q4 FY2013 |
|---|---|---|
| Revenue | $221.5 million | $235.7 million |
| Gross profit | $56.2 million | $61.5 million |
| Operating income | $10.7 million | $5.4 million |
| Net loss | $2.2 million | $7.4 million |
| Loss per share | $0.04 | $0.12 |
Balance Sheet, Liquidity, and Debt
- Cash and cash equivalents were $34.7 million at year-end, down from $55.7 million; $12.0 million was held by foreign subsidiaries.
- Working capital was $148.8 million, down from $179.3 million.
- Total assets were $1.139 billion and stockholders’ equity was $224.3 million, down from $295.8 million.
- Total indebtedness was approximately $664.1 million, including $5.8 million of unamortized original issue discount and $0.1 million of capital lease obligations.
- In May 2014, Kratos refinanced $625.0 million of 10% Senior Secured Notes due 2017 with $625.0 million of 7.00% Senior Secured Notes due 2019. The refinancing reduced annual interest expense but generated a $39.1 million loss on extinguishment of debt.
- The company had $41.0 million outstanding under a new $110.0 million revolving credit facility, $13.6 million of outstanding letters of credit, and $45.1 million of net borrowing-base availability at year-end.
- Management stated that available capital resources and operating cash flow were expected to meet working-capital and capital-expenditure needs for at least the next 12 months. Debt and credit-facility covenants were in compliance at year-end.
Material Changes Versus Prior Period
- Revenue decreased $82.6 million, primarily because of contract delays and bid protests, reduced defense-product shipments, delayed government awards, completion of major satellite-communications production programs, weakness in legacy government services, and delayed international unmanned-systems orders.
- KGS revenue fell 4.7% to $590.1 million; US revenue fell 33.0% to $81.5 million; PSS revenue fell 6.3% to $196.4 million.
- Operating income declined despite lower SG&A, as reduced revenue and weaker service margins offset cost reductions.
- SG&A decreased to $173.4 million from $193.0 million, primarily because of lower amortization of acquired intangibles and cost-reduction actions. Excluding amortization, SG&A increased as a percentage of revenue.
- Research and development expense increased to $23.0 million from $21.4 million, focused on unmanned systems, electronic products, and satellite communications.
- PSS operating income changed from $8.3 million of income to a $4.4 million loss, partly due to costs on two large projects and pending customer change-order negotiations.
- US operating loss improved from $16.9 million to $9.6 million, although 2014 included approximately $3.1 million of costs associated with aerial-platform retrofits and a contract conversion adjustment.
- Backlog remained approximately $1.1 billion, but funded backlog increased to $662.0 million from $541.0 million. Approximately $437.0 million was unfunded at year-end.
Outlook, Risks, and Unusual Items
Management expected continued pressure from defense-budget constraints, sequestration risk, delayed awards, bid protests, procurement changes, and increased competition. The FY2015 defense appropriation provided $554.2 billion in base and overseas-contingency funding, including a $496.1 billion base budget. Management identified cyber, unmanned systems, satellite communications, missile defense, and electronic warfare as important future funding priorities, but stated that the timing and level of government awards remained uncertain.
- Debt and refinancing: The $39.1 million debt-extinguishment loss materially increased the 2014 net loss, although refinancing reduced the stated coupon from 10% to 7% and extended maturity to 2019.
- Goodwill and impairment risk: Goodwill was $596.4 million, approximately 52% of total assets. No 2014 impairment was recorded, but management identified potential future impairment risk if forecasts, government funding, unmanned-system development, or follow-on orders do not materialize.
- Government audits and claims: DCAA audits were examining certain previously accepted practices. A DOJ investigation concerning alleged pre-acquisition overstated labor and material costs was settled in December 2014; the written settlement became effective in January 2015 and was paid in February 2015. The difference from the recorded reserve was immaterial.
- Contract estimates: Revenue is recognized under multiple contract types, including percentage-of-completion methods. Changes in estimated costs, schedules, customer modifications, or cancellations could materially affect revenue and margins.
- Strategic alternatives: The board engaged an investment bank to review the company’s businesses and competitive positioning, including possible divestitures. No specific transaction was announced in the filing.
- Liquidity risks: The company depends on operating cash flow and revolving-credit availability while carrying substantial debt and significant contractual commitments. Total commitments and recorded liabilities were approximately $1.056 billion, including $666.8 million of debt due in 2018–2019, estimated interest of $191.7 million, purchase orders of $109.9 million, and operating leases of $84.8 million.
Most Important Facts for Investors to Verify
- Whether revenue declines and delayed awards stabilize, particularly in KGS, US, and PSS.
- Conversion of the $1.1 billion backlog into revenue and cash flow, including the realizability of $437.0 million of unfunded backlog.
- Operating cash flow, borrowing-base availability, covenant compliance, and the company’s ability to refinance or repay the 2019 secured notes.
- Whether PSS project change orders are recovered and whether related costs create further margin pressure.
- Performance and customer acceptance of UCAS, SSAT, and other unmanned-systems programs supporting the goodwill valuation.
- Results of ongoing DCAA audits and any additional government cost adjustments, refunds, penalties, or claims.
- Potential divestitures, restructuring actions, associated write-offs, and their effect on revenue, earnings, taxes, and debt reduction.
- Future utilization of federal and state net operating losses, which were subject to ownership-change limitations and substantial valuation allowances.