Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed an unaudited Form 10-Q for the quarter and six months ended June 30, 2013. Kratos provides specialized defense, security, engineering, manufacturing, systems integration, unmanned systems, electronic warfare, cybersecurity, missile defense, and public-safety solutions. Its two segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS). Approximately 65% of six-month revenue came from the U.S. Government.
Financial Performance and Position
| Metric | Three Months Ended June 30, 2013 | Three Months Ended June 24, 2012 | Six Months Ended June 30, 2013 | Six Months Ended June 24, 2012 |
|---|---|---|---|---|
| Total revenue | $235.2 million | $219.8 million | $488.5 million | $429.3 million |
| Gross profit | $60.4 million | $57.7 million | $126.2 million | $115.1 million |
| Gross margin | 25.7% | 26.3% | 25.8% | 26.8% |
| Operating income | $8.9 million | $7.4 million | $20.3 million | $16.5 million |
| Net loss | $(9.6) million | $(17.2) million | $(19.9) million | $(20.2) million |
| Net loss per share | $(0.17) | $(0.41) | $(0.35) | $(0.54) |
| Operating cash flow from continuing operations | Not separately provided for the quarter | Not separately provided for the quarter | $8.4 million | $9.8 million |
- Six-month revenue increased 13.8%, primarily from the CEi acquisition, growth in cybersecurity and PSS transit programs, and higher product sales.
- Product sales increased to $262.3 million from $215.1 million, while service revenue increased to $226.2 million from $214.2 million.
- Six-month operating income improved despite lower gross margin. SG&A increased to $97.1 million, and research and development expense increased to $9.7 million.
- Cash and cash equivalents were $49.7 million at June 30, 2013, versus $49.0 million at December 30, 2012. Restricted cash was $5.2 million.
- Total assets were $1.222 billion and stockholders’ equity was $308.1 million at June 30, 2013. Accounts receivable were $253.6 million and inventoried costs were $85.3 million.
- Total debt, including debt premium and capital lease obligations, was approximately $647.5 million. The principal amount of the 10% Senior Secured Notes was $625.0 million, and the Herley-related term loan balance was $5.3 million.
- The company had no outstanding revolver borrowings, $14.2 million of letters of credit, and reported $69.3 million of net borrowing-base availability. It was in compliance with applicable debt covenants.
Material Changes Versus the Prior Comparable Period
- Second-quarter revenue rose $15.4 million, or 7.0%; six-month revenue rose $59.2 million, or 13.8%.
- KGS six-month revenue increased 12.0% to $386.2 million, driven substantially by CEi and cybersecurity growth. KGS service revenue declined 4.4%, while product sales increased 21.9%.
- PSS six-month revenue increased 20.9% to $102.3 million, including $11.6 million of additional revenue from large metropolitan transit authority programs.
- Gross margin declined because of product mix, including increased shipments of lower-margin specialized ground equipment and other products.
- Net losses narrowed in both the quarter and six-month period, partly reflecting improved operating income and a reduction in merger and acquisition expense. The six-month 2013 results included a $2.5 million merger and acquisition benefit, largely related to a liability reduction connected with former Integral directors and officers.
- Discontinued operations generated a six-month loss of $4.4 million versus $2.8 million in the prior period, including a $1.2 million impairment charge in 2013.
- Goodwill remained approximately $596.4 million. The company had previously recorded an $82.0 million KGS goodwill impairment in the fourth quarter of 2012, reflecting defense-market valuation and sequestration concerns.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
- Management did not provide specific numerical revenue or earnings guidance. It stated that cash on hand, revolver availability, and expected operating cash flow should fund working capital and other needs for at least the next 12 months.
- Management expects reduced fiscal 2013 budget levels and sequestration to produce lower awards on some programs, with potential effects on revenue, earnings, and cash flow. The fiscal 2014 defense-budget process remained uncertain.
- Backlog was approximately $1.1 billion at both June 30, 2013 and June 24, 2012; funded backlog increased to $558.0 million from $546.0 million. Backlog may be delayed, modified, or canceled, and government contracts may generally be terminated for convenience.
- Major risks include dependence on U.S. Government and defense spending, sequestration and budget delays, contract timing and cancellation, high leverage, acquisition integration, competition, cybersecurity incidents, regulatory matters, litigation, and potential cost disallowances following Defense Contract Audit Agency reviews.
- The Department of Justice was investigating whether a subsidiary overstated labor and material costs on a pre-acquisition Department of Defense contract. The company reported that related accruals were immaterial but warned that ultimate losses could exceed current accruals.
- The company assumed indemnification obligations related to former Integral officers and directors. The related SEC litigation was concluded after the appeal deadline expired July 1, 2013; a $3.1 million liability reduction was reflected as a second-quarter merger and acquisition benefit.
- Contract accounting uses percentage-of-completion methods and requires estimates of costs, schedules, incentives, and penalties. Changes in estimates may produce material cumulative catch-up adjustments.
- The company maintained a full valuation allowance against most U.S. federal, state, and certain foreign deferred tax assets. Future equity offerings or acquisitions could further restrict use of net operating losses under Section 382.
- Disclosure controls and procedures were concluded to be effective as of June 30, 2013, with no material change in internal control over financial reporting during the quarter.
Important Facts for Investors to Verify
- Whether sequestration, continuing resolutions, the fiscal 2014 budget process, and debt-ceiling developments reduce contract awards, funding, or payment timing.
- Whether product mix and CEi integration improve or further pressure gross margins and operating cash flow.
- Liquidity relative to approximately $647.5 million of debt, including the 2017 secured notes, interest expense of $32.5 million for the first six months, and applicable covenant requirements.
- The collectability and timing of the $253.6 million accounts receivable balance, including the $1.4 million Greek customer receivable.
- The resolution and potential exposure from DCAA reviews, the False Claims Act investigation, warranty obligations, and other litigation or acquisition-related contingencies.
- The conversion of approximately $1.1 billion of backlog into funded revenue, recognizing that unfunded backlog and government contracts remain subject to appropriation, cancellation, and scope changes.