Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed its Form 10-K for the 52-week fiscal year ended December 25, 2011. The company provides national-security products, engineering, manufacturing, systems integration, cybersecurity, satellite communications, unmanned-system, missile-defense, training, range-support, and public-safety solutions.
Operations are organized into Kratos Government Solutions (KGS) and Public Safety & Security (PSS). U.S. Government customers accounted for 74% of 2011 revenue, compared with 87% in 2010. The company had approximately 4,000 employees and total backlog of approximately $1.1 billion, including $472 million of funded backlog.
Financial Performance and Position
| Metric | 2011 | 2010 | Change |
|---|---|---|---|
| Revenue | $723.1 million | $408.5 million | 77.0% increase |
| Gross profit | $192.2 million | $84.3 million | 128.0% increase |
| Gross margin | 26.6% | 20.6% | Up 600 basis points |
| Operating income | $28.2 million | $23.1 million | 22.1% increase |
| Operating margin | 3.9% | 5.7% | Declined |
| Net income (loss) | $(24.2) million | $14.5 million | Returned to a loss |
| Diluted loss per share | $(0.88) | $0.86 income | Declined |
| Cash flow from continuing operations | $2.9 million | $28.3 million | Declined |
KGS revenue increased 64.1% to $610.9 million, while PSS revenue increased 209.1% to $112.2 million. Acquisitions contributed $384.3 million of the total year-over-year revenue increase. Product revenue increased to $369.5 million, or 51.1% of revenue, from $123.7 million, or 30.3%, primarily because of the Herley and Integral acquisitions. Service revenue was $353.6 million.
Net loss was driven substantially by $51.1 million of net interest expense, $38.0 million of amortization of purchased intangibles, and $12.5 million of merger and acquisition expenses. SG&A increased to $142.5 million, or 19.7% of revenue, from $57.3 million, or 14.0%, in 2010. The filing reports no 2011 goodwill impairment charge, but identifies significant future impairment sensitivity.
Fourth-quarter revenue was $218.2 million, gross profit was $59.2 million, operating income was $8.1 million, and net loss was $8.6 million, or $0.25 per diluted share. Fourth-quarter results included $13.5 million of purchased-intangible amortization and $1.2 million of acquisition-related expenses.
Liquidity, Debt, and Capital Resources
- Cash and cash equivalents were $69.8 million at year-end, compared with $10.8 million in 2010.
- Working capital increased to $207.2 million from $65.8 million.
- Total debt and capital lease obligations were approximately $655.9 million, including $22.8 million of unamortized debt premium.
- The company had $625.0 million principal amount of 10% senior secured notes due June 2017. The notes are secured by substantially all company and guarantor assets.
- The amended revolving credit facility was $90.0 million, with no borrowings outstanding and $21.3 million of letters of credit outstanding, resulting in reported net availability of $68.7 million.
- Cash paid for acquisitions was $391.1 million, capital expenditures were $7.5 million, and net cash provided by financing activities was $452.4 million.
- Interest paid increased to $46.2 million from $15.4 million in 2010 because of acquisition-related debt issuance.
Management stated that cash on hand, operating cash flow, and the revolving facility were expected to meet requirements for at least the next 12 months. The company was in compliance with its debt covenants at year-end, including the revolver's minimum fixed-charge coverage covenant.
Material Changes Versus the Prior Comparable Period
- Revenue growth was primarily acquisition-driven. Herley, Integral, and SecureInfo were acquired in 2011 for aggregate transaction values of approximately $272.5 million, $241.1 million, and $20.3 million, respectively.
- Herley and Integral expanded higher-margin defense electronics, electronic warfare, satellite, and communications capabilities. SecureInfo added cybersecurity operations.
- The company issued $285.0 million and $115.0 million of 10% senior secured notes in 2011 and issued approximately 4.9 million shares for $61.1 million of net proceeds.
- The company issued approximately 10.4 million shares as part of the Integral acquisition and repurchased 2.0 million shares for $10.9 million in December 2011.
- Gross margin improved because of greater product revenue and improved service mix, but operating margin declined because of acquisition-related costs, increased amortization, higher corporate costs, and increased SG&A.
- Operating cash flow fell sharply because of higher interest and transaction payments and working-capital investment. Excluding transaction expenses, operating cash flow was $30.7 million in 2011 versus $31.4 million in 2010.
- Total assets increased to $1.216 billion from $535.7 million, including goodwill of $573.5 million and intangible assets of $124.6 million. Goodwill represented approximately 47% of total assets.
- The KGS reporting unit's estimated fair value exceeded carrying value by only approximately 3.5% at year-end, creating material sensitivity to defense-budget reductions, market conditions, and forecast changes.
Guidance, Outlook, Risks, and Unusual Items
The filing does not provide formal numerical revenue or earnings guidance. Management expected continued demand in cybersecurity, unmanned systems, ballistic missile defense, space, modernization, maintenance, and science-and-technology programs, while pursuing organic growth, margin improvement, and additional acquisitions.
- The Budget Control Act, anticipated sequestration, proposed reductions in defense spending, continuing resolutions, appropriations delays, contract protests, and government insourcing could reduce or delay awards, funding, revenue, and cash flow.
- Backlog is not a guarantee of future revenue. Government contracts may be terminated for convenience, reduced, delayed, or not fully funded. Approximately $592 million of year-end backlog was unfunded.
- Leverage is significant. Debt service, restrictive covenants, fixed interest costs, and potential refinancing requirements could constrain acquisitions, capital spending, and liquidity.
- Goodwill and intangible assets are substantial. A deterioration in KGS performance or valuation could result in material impairment charges.
- Revenue and margin recognition depends on estimates of costs to complete long-term contracts. Contract modifications, delays, cancellations, or adverse cost estimates could materially affect reported results.
- DCAA audits of incurred costs for fiscal 2005 and later years had not been completed. Future audit adjustments could reduce revenue or profitability.
- The company assumed indemnification obligations related to former Integral officers and directors. Integral's directors-and-officers insurance limits were exhausted in December 2011, and Kratos was advancing potentially indemnifiable costs.
- Contingent acquisition payments totaled $7.6 million at year-end, including expected payments related to SecureInfo and DEI. A January 2012 acquisition of selected Ingersoll Rand assets cost approximately $20.0 million; the final working-capital adjustment and purchase-price allocation were not yet determined.
- Management and Grant Thornton reported effective internal control over financial reporting, but the assessment and audit excluded the 2011 acquisitions of Herley, Integral, and SecureInfo, which represented 53.9% of consolidated assets and 34.5% of consolidated revenue in the auditor's scope disclosure.
Investor Verification Priorities
- Verify the sustainability of acquisition-driven revenue and the integration, margins, and cash generation of Herley, Integral, and SecureInfo.
- Reconcile reported operating cash flow with earnings, working-capital growth, acquisition spending, and recurring interest requirements.
- Review the $625 million of 10% notes, revolver availability, covenant headroom, maturity schedule, and refinancing risk.
- Assess the funded versus unfunded backlog and the sensitivity of awards to defense-budget reductions and sequestration.
- Evaluate goodwill impairment risk, particularly the approximately 3.5% KGS fair-value cushion.
- Review DCAA audit exposure, government cost claims, warranties, environmental matters, and Integral-related indemnification obligations.
- Confirm the final purchase accounting and working-capital adjustment for the January 2012 Ingersoll Rand asset acquisition.