Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. is a defense technology company serving national security, aerospace, space, satellite communications, cybersecurity, hypersonic, missile defense, rocket, training, and unmanned systems markets. It reports two segments: Kratos Government Solutions (KGS) and Unmanned Systems (US).
This unaudited Form 10-Q covers the 14-week quarter and 40-week year-to-date period ended October 1, 2023, compared with 13-week and 39-week periods ended September 25, 2022. Results are therefore affected by the additional reporting week.
Key Financial Metrics
| Metric | Three Months Ended October 1, 2023 | Year-to-Date October 1, 2023 | Prior Comparable Period |
|---|---|---|---|
| Total revenue | $274.6 million | $763.3 million | $228.6 million / $649.0 million |
| Revenue growth | 20.1% | 17.6% | — |
| Gross profit | $73.4 million | $196.7 million | $54.9 million / $164.6 million |
| Gross margin | 26.7% | 25.8% | 24.0% / 25.4% |
| Operating income | $12.2 million | $19.4 million | $(3.6) million / $(6.7) million |
| Income from continuing operations | $3.0 million | $(3.4) million | $(8.0) million / $(29.0) million |
| Net loss attributable to Kratos | $(1.6) million | $(11.3) million | $(8.0) million / $(28.6) million |
| Loss per diluted share | $(0.01) | $(0.09) | $(0.06) / $(0.23) |
| Operating cash flow from continuing operations | Not separately provided for the quarter | $(2.2) million | $(32.3) million |
Service revenue was $106.5 million for the quarter and $301.8 million year to date; product sales were $168.1 million and $461.5 million, respectively. KGS generated $217.9 million of quarterly revenue and $606.5 million year to date, while US generated $56.7 million and $156.8 million.
At October 1, 2023, cash and cash equivalents were $42.2 million, down from $81.3 million at December 25, 2022. Total debt principal was $243.7 million, consisting primarily of $193.7 million of Term Loan A and $50.0 million drawn on the revolving facility. Approximately $150.0 million of revolver capacity remained, before $13.7 million of outstanding letters of credit. The company was in compliance with its debt covenants.
Current assets were $604.4 million and current liabilities were $263.0 million. Unbilled receivables were $223.7 million, inventoried costs were $150.1 million, and net contract assets were $144.3 million.
Material Changes Versus the Prior Comparable Period
- Quarterly revenue increased $46.0 million, or 20.1%, driven by higher KGS activity and increased target-drone production in US.
- Year-to-date revenue increased $114.3 million, or 17.6%. KGS grew 23.8%, while US declined 1.4% because of timing of tactical-drone contract awards.
- Quarterly gross margin expanded 270 basis points to 26.7%, primarily from improved product margins and business mix. Year-to-date gross margin increased 40 basis points to 25.8%.
- Operating results improved substantially, with quarterly operating income of $12.2 million versus a $3.6 million loss and year-to-date operating income of $19.4 million versus a $6.7 million loss.
- SG&A increased in dollars but declined as a percentage of revenue to 18.5% for the quarter and 19.1% year to date, compared with 21.2% and 21.0%, respectively.
- Year-to-date restructuring and other expense declined to $0.9 million from $6.4 million, primarily because the prior-year period included a $5.5 million litigation settlement charge.
- Year-to-date other expense declined to $15.9 million from $26.9 million, reflecting the absence of the prior-year $13.0 million loss on debt extinguishment. This benefit was partly offset by higher interest expense from increased rates.
- Operating cash use improved to $2.2 million from $32.3 million, but working-capital investment remained significant, including $23.7 million used for inventory purchases and $32.6 million of net receivable growth.
Backlog, Outlook, Risks, and Unusual Items
Total backlog was approximately $1.165 billion at October 1, 2023, including $850.9 million of funded backlog, compared with $1.0689 billion and $696.1 million, respectively, at September 25, 2022. Management expects approximately 20% of remaining performance obligations to be recognized in fiscal 2023, 47% in fiscal 2024, and the balance thereafter. Backlog may be affected by funding, contract modifications, cancellations, customer termination rights, and execution performance.
The filing does not provide formal consolidated earnings or revenue guidance. Management expects 2023 capital expenditures to remain significant, including approximately $20 million to $25 million for the US business. The company is producing additional Valkyrie unmanned aircraft ahead of government contract awards, creating execution and demand risk.
Management expects cash on hand, available borrowing capacity, and operating cash flow to fund working-capital and other requirements for at least the next 12 months. Liquidity remains sensitive to government funding, customer payment timing, inventory needs, contract milestones, and interest rates.
- Government funding uncertainty includes continuing-resolution restrictions, potential shutdowns, budget delays, defense spending changes, and possible cancellation or postponement of programs. Approximately 69% of year-to-date revenue came from the U.S. Government.
- Supply-chain disruption, inflation, higher material and labor costs, and shortages of skilled and security-cleared personnel are adversely affecting execution, margins, and forecasts.
- Interest expense increased due to higher rates. An interest-rate swap with a $195.0 million initial notional amount fixes the one-month SOFR component of Term Loan A at 3.721% through May 2026.
- Approximately $4.8 million of unbilled receivables from a 2019 government contract termination remains subject to negotiation and settlement.
- DCAA audits may result in disputed or disallowed costs; the company has not accrued a liability because the potential loss cannot currently be reasonably estimated.
- The redeemable noncontrolling interest increased to $19.3 million. Minority holders of KTT Core have an annual put right beginning in January 2024, with the purchase price based on specified EBITDA multiples.
- On October 3, 2023, after the reporting date, Kratos agreed to acquire Sierra Technical Services, issuing shares valued at $12.8 million and potentially issuing additional shares valued at up to $14.5 million under holdback and earn-out provisions. Purchase accounting was incomplete at filing.
Investor Verification Items
- Verify whether revenue growth and gross-margin improvement continue after adjusting for the additional reporting week and favorable product mix.
- Monitor conversion of the $1.165 billion backlog, particularly the $314.1 million of unfunded backlog and government appropriation timing.
- Assess cash conversion, receivable and inventory growth, contract billing milestones, and the company’s ability to return to positive operating cash flow.
- Review debt maturities, interest-rate exposure, revolver availability, covenant compliance, and the substantial 2027 debt maturity concentration.
- Evaluate execution, demand, and funding risks related to Valkyrie production and other unmanned-systems investments made ahead of contract awards.
- Track the January 2024 KTT Core minority-interest put right and its potential cash or equity funding requirements.
- Review the final purchase accounting, dilution, earn-out obligations, and operating contribution from the Sierra Technical Services acquisition.