Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed this unaudited Form 10-Q for the 13-week quarter and 39-week year-to-date period ended September 25, 2011, compared with September 26, 2010. Kratos provides national-security technology, engineering, manufacturing, systems integration, cybersecurity, electronic warfare, satellite communications, missile and weapons support, modeling and simulation, and public-safety security solutions. Its principal segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS).
Results substantially reflect acquisitions of Herley Industries, Integral Systems, Henry Bros. Electronics, DEI Services, Southside Container & Trailer, and Gichner Holdings. Integral was acquired July 27, 2011; Herley was acquired in March 2011.
Financial Performance and Position
| Metric | Q3 2011 | Q3 2010 | 9M 2011 | 9M 2010 |
|---|---|---|---|---|
| Total revenue | $211.0 million | $119.9 million | $504.9 million | $287.7 million |
| Gross profit | $60.2 million | $24.4 million | $133.0 million | $59.5 million |
| Gross margin | 28.5% | 20.4% | 26.3% | 20.7% |
| Operating income | $10.0 million | $8.4 million | $20.1 million | $16.5 million |
| Operating margin | 4.7% | 7.0% | 4.0% | 5.7% |
| Net income (loss) | $(6.9) million | $3.2 million | $(15.6) million | $14.1 million |
| Diluted EPS | $(0.22) | $0.19 | $(0.62) | $0.86 |
| Operating cash flow from continuing operations | Not separately provided | Not separately provided | $7.7 million | $24.7 million |
Product sales increased to $113.4 million in the quarter and $252.2 million year to date, while service revenue was $97.6 million and $252.7 million, respectively. SG&A rose to $43.2 million in the quarter and $96.5 million year to date, including substantially higher amortization from acquisitions. Interest expense increased to $15.0 million in the quarter and $34.8 million year to date.
At September 25, 2011, cash and cash equivalents were $109.4 million, restricted cash was $1.0 million, working capital was $237.9 million, and total assets were $1.24 billion. Accounts receivable increased to $248.7 million and inventoried costs to $79.8 million. Days sales outstanding increased to approximately 100 days from 75 days at December 26, 2010, with management attributing the increase primarily to contract-payment timing and the Integral acquisition.
Long-term debt principal was $631.0 million, with a $23.9 million debt premium and carrying value of $654.9 million. The company also assumed approximately $7.0 million outstanding under a Herley foreign term loan. Its 10% senior secured notes mature in 2017. The amended senior secured revolving credit facility has a $65.0 million capacity, with approximately $47.4 million available at September 25, 2011. Management reported compliance with applicable debt covenants.
Material Changes Versus the Prior Comparable Period
- Revenue increased 76.0% in the quarter and 75.5% year to date, driven primarily by acquisitions. KGS revenue rose 62.1% in the quarter and 60.0% year to date; PSS revenue rose 234.0% and 242.6%, respectively.
- Gross margins improved materially, reflecting the higher-margin acquired businesses, especially Integral, Herley, and DEI.
- Despite higher gross profit, operating margin declined because SG&A, acquisition expenses, research and development, and amortization increased significantly.
- The company moved from net income to net loss. Higher interest expense from acquisition-related debt was the principal factor, compounded by $11.3 million of year-to-date merger and acquisition expenses.
- Operating cash flow declined to $7.7 million from $24.7 million. Excluding $20.9 million of acquisition-related costs paid, management stated that operating cash flow would have been $28.6 million.
- Investing cash use increased to $375.8 million, including $373.8 million for acquisitions. Financing provided $467.0 million, primarily from $400.0 million of additional senior secured notes and $61.1 million of equity proceeds.
- Backlog increased to approximately $1.034 billion from $660 million, including $548 million of funded backlog compared with $285 million in the prior-year period.
- Common shares outstanding increased to approximately 34.4 million from 18.6 million, reflecting the February equity offering, shares issued for the Integral acquisition, and other equity activity.
Outlook, Risks, Contingencies, and Unusual Items
Management did not provide formal quantitative revenue or earnings guidance in the filing. Management stated that cash on hand, operating cash flow, and available revolver capacity should be sufficient to meet cash needs for at least the next 12 months, while noting that future acquisitions could require additional debt or equity financing.
- The Budget Control Act and continuing resolutions created significant uncertainty regarding defense appropriations, procurement timing, contract funding, cancellations, and potential sequestration-related reductions beginning in 2013.
- Approximately 74% of year-to-date revenue came from the U.S. Government, including foreign military sales, creating substantial customer and budget-concentration risk.
- Leverage increased sharply following the Herley and Integral acquisitions. Higher interest obligations, restrictive covenants, borrowing-base requirements, and potential cross-defaults could constrain liquidity and strategic flexibility.
- Goodwill increased to $547.5 million, including $321.3 million of acquisition additions. Management concluded that no interim impairment was indicated but planned to reassess goodwill in the fourth quarter in light of market capitalization and defense-budget risks.
- Acquisition purchase-price allocations remained provisional, including valuations of intangible assets, inventory, property and equipment, and deferred taxes. Future adjustments could affect goodwill and reported earnings.
- Potential future contingent consideration included up to $8.0 million for DEI and up to $3.5 million for SCT, subject to performance and other conditions.
- Kratos assumed indemnification obligations related to former Integral officers involved in SEC civil actions. The company may need to advance costs exceeding available insurance coverage.
- Warranty liabilities and deferred warranty revenue totaled $3.1 million at September 25, 2011. The company also disclosed ordinary-course legal, environmental, employment, tax, and commercial contingencies.
- Cybersecurity incidents, information-system disruptions, contract-performance issues, competition, customer insourcing, and delays in government funding were identified as material risks.
Important Facts for Investors to Verify
- Reconcile the reported debt amounts, including the $631.0 million principal balance, $23.9 million premium, assumed term debt, and management’s separate reference to approximately $657.3 million of total indebtedness.
- Assess whether acquisition-driven revenue and gross-margin improvements can persist after acquisition accounting effects, amortization, integration costs, and elevated SG&A are normalized.
- Monitor operating cash conversion, accounts receivable aging, and the increase in DSO to approximately 100 days.
- Review funded versus unfunded backlog and determine how much backlog is exposed to continuing resolutions, appropriations reductions, termination rights, or customer delays.
- Evaluate covenant headroom and the company’s ability to service 10% senior secured notes while funding working capital and contingent acquisition obligations.
- Track fourth-quarter goodwill impairment testing and any revisions to the provisional purchase-price allocations.
- Verify the status and potential cost of the assumed Integral indemnification obligations and other acquisition-related contingencies.