Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed a Form 10-K for the 53-week fiscal year ended December 30, 2012. The company provides defense, security technology, engineering, manufacturing, systems integration, cybersecurity, unmanned systems, satellite communications, test and evaluation, and public safety solutions. Its two operating segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS).
U.S. Government contracts, including foreign military sales and subcontract work, represented approximately 65% of 2012 revenue, down from 74% in 2011. The company had approximately 4,300 employees and total backlog of approximately $1.3 billion, including $674.0 million of funded backlog.
Key Financial Metrics
| Metric | 2011 | 2012 | Change |
|---|---|---|---|
| Revenue | $713.9 million | $969.2 million | Up 35.8% |
| Gross profit | $191.2 million | $257.2 million | Up 34.5% |
| Gross margin | 26.8% | 26.5% | Down 0.3 percentage points |
| Operating income (loss) | $29.5 million | $(49.7) million | Declined $79.2 million |
| Net income (loss) | $(24.2) million | $(114.4) million | Loss increased $90.2 million |
| Loss from continuing operations | $(23.5) million | $(112.9) million | Loss increased $89.4 million |
| Diluted loss per share | $(0.88) | $(2.44) | Worsened $1.56 |
| Cash flow from continuing operations | $5.2 million | $52.3 million | Up $47.1 million |
| Cash and cash equivalents | $69.6 million | $49.0 million | Down $20.6 million |
| Total debt, including capital leases and premium | $655.9 million | $650.3 million | Down $5.6 million |
Revenue growth was driven principally by acquisitions. KGS revenue increased 30.2% to $783.2 million, while PSS revenue increased 65.8% to $186.0 million. Product sales increased 43.1% to $519.2 million, and service revenue increased 28.2% to $450.0 million.
Service gross margin declined from 25.7% to 22.0%, while product gross margin increased from 27.8% to 30.4%. SG&A increased to $193.1 million from $140.6 million, and research and development expense increased to $17.8 million from $8.6 million. Interest expense increased to $66.1 million from $51.1 million.
Fourth-quarter 2012 revenue was $263.6 million, gross profit was $68.0 million, operating loss from continuing operations was $80.3 million, and net loss was $90.0 million. The fourth-quarter loss included a $96.6 million impairment charge.
Material Changes Versus the Prior Comparable Period
- Revenue increased $255.3 million, primarily from acquisitions and organic growth in ballistic missile defense, range support, and learning and training businesses.
- Legacy government service revenue declined because of competitive pricing pressure, completion of acquired small-business contracts, government in-sourcing, and reduced orders and shipment timing.
- The company completed the $164.2 million acquisition of Composite Engineering, Inc. (CEI) on July 2, 2012. CEI contributed $68.2 million of revenue and $1.6 million of operating income in the reported period.
- CEI was funded with approximately $97.0 million of net equity proceeds, $40.0 million of revolving-credit borrowings, and other company resources. The revolving borrowings were repaid in September 2012.
- The company issued 20.0 million common shares in 2012, increasing shares outstanding and contributing to dilution.
- The company recorded a non-cash $82.0 million goodwill impairment in KGS and a $14.6 million intangible-asset impairment related primarily to reducing use of certain trade names. A further $1.5 million goodwill impairment was recorded in discontinued operations.
- Operating cash flow improved substantially despite the net loss, aided by non-cash impairment, depreciation and amortization, and working-capital changes.
- Backlog increased from approximately $1.1 billion at December 25, 2011 to $1.3 billion at December 30, 2012; funded backlog increased from $472.0 million to $674.0 million.
Guidance, Outlook, Commentary, Risks and Unusual Items
Management did not provide specific numerical revenue or earnings guidance in the filing. Management stated that it expects cash on hand, operating cash flow, and the revolving credit facility to be sufficient for at least the next 12 months, but cautioned that long-term growth may require additional capital.
Management believes defense, intelligence, homeland security modernization, unmanned aerial vehicles, cybersecurity, ballistic missile defense, satellite communications, space programs, and science and technology remain national priorities. However, the filing emphasizes substantial uncertainty from sequestration, continuing resolutions, the federal budget process, and the debt ceiling. The March 2013 sequestration order required estimated reductions of 7.8% in non-exempt defense discretionary funding and 5.0% in non-exempt non-defense discretionary funding for the remainder of fiscal 2013.
- The company had $625.0 million of 10% senior secured notes due June 1, 2017. The notes are secured by substantially all company and guarantor assets and contain restrictive covenants.
- The $110.0 million revolving facility had no outstanding borrowings at year-end, $15.7 million of letters of credit outstanding, and reported net borrowing-base availability of $89.4 million. The company was in compliance with its debt covenants.
- Contractual commitments totaled approximately $1.175 billion, including $630.7 million of debt obligations, $276.7 million of purchase orders, $161.2 million of operating leases, and $103.4 million of capital-lease commitments.
- The Department of Justice is investigating whether a subsidiary overstated labor and material costs on a Department of Defense contract before its acquisition. The company stated that accrued amounts were immaterial, but adverse resolution could involve False Claims Act penalties and treble damages.
- DCAA audits remain incomplete for fiscal 2006 and subsequent years. Adverse findings could result in cost disallowances, refunds, reduced billing rates, penalties, or restrictions on future government contracting.
- Goodwill was $596.5 million, approximately 46% of total assets, and long-lived intangible assets were $106.1 million. Further defense-budget reductions, lower valuations, weaker performance, or higher discount rates could result in additional impairment.
- The company had federal tax loss carryforwards of $344.7 million, but utilization is limited by ownership changes, including a May 2012 change. A full valuation allowance was maintained against most deferred tax assets.
- Certain non-core Integral businesses were classified as discontinued operations and were expected to be sold in 2013. Discontinued operations generated $18.5 million of revenue and a $1.5 million net loss in 2012.
- Management and Grant Thornton reported effective internal control over financial reporting, but the assessment and audit excluded CEI. CEI represented $166.9 million of assets and $68.2 million of 2012 revenue.
Important Facts for Investors to Verify
- Verify whether the company can sustain improved operating cash flow while servicing approximately $650.3 million of debt and funding working capital and capital expenditures.
- Assess the effect of sequestration, continuing resolutions, in-sourcing, contract delays, and federal procurement reductions on KGS revenue, margins, and backlog conversion.
- Review the sustainability of the reported backlog, particularly the approximately $635.0 million of unfunded backlog, which may be delayed, reduced, or canceled.
- Evaluate the integration and profitability of CEI and other recent acquisitions, including whether expected synergies and margin improvements are being realized.
- Monitor goodwill and intangible-asset carrying values for further impairment, especially within KGS.
- Review the status and potential exposure from DCAA audits, the Department of Justice investigation, and Integral-related indemnification matters.
- Reconcile the reported cash balance with restricted cash, foreign subsidiary cash, letters of credit, borrowing-base availability, and upcoming contractual commitments.
- Consider dilution from the 20.0 million-share 2012 equity offering, CEI acquisition shares, restricted stock units, and other equity awards.