KRATOS DEFENSE & SECURITY SOLUTIONS, INC. quarterly report, Q1 FY2017

Kratos Defense & Security Solutions, Inc. — Q1 2017 Form 10-Q

Reporting period: Three months ended March 26, 2017, compared with the 13-week period ended March 27, 2016. Interim financial statements are unaudited. Kratos is a defense technology and government contractor focused on unmanned systems, satellite communications, microwave electronics, cyber, missile defense, security and related products and services.

Financial performance and position

Metric	Q1 2017	Q1 2016	Change
Total revenue	$167.8 million	$153.0 million	Up 9.7%
Gross profit	$45.1 million	$35.9 million	Up $9.2 million
Gross margin	26.9%	23.5%	Up 340 bps
Operating income from continuing operations	$1.7 million	$(10.2) million	Improved $11.9 million
Net loss	$(10.0) million	$(22.2) million	Improved $12.2 million
Loss per diluted share	$(0.13)	$(0.37)	Improved
Cash used in operating activities	$(8.7) million	$(11.5) million	Improved $2.8 million

Service revenue increased 2.9% to $85.0 million; product sales increased 17.6% to $82.8 million.
SG&A was $38.7 million, or 23.1% of revenue, compared with $37.7 million, or 24.6%, in the prior-year quarter.
Research and development expense increased to $4.4 million from $2.9 million.
Interest expense was $8.2 million. A $2.1 million loss on extinguishment of debt reduced pretax results.
Cash and cash equivalents were $73.4 million at March 26, 2017, compared with $69.1 million at December 25, 2016. Total assets were $961.6 million and stockholders’ equity was $351.4 million.
Accounts receivable were $227.9 million and inventoried costs were $64.8 million at quarter-end. Days sales outstanding increased to 124 days from 115 days at year-end.

Segments and material changes

Kratos Government Solutions: Revenue increased 6.3% to $115.4 million, and segment operating income improved to $9.6 million from a $1.8 million loss. Product growth reflected recent satellite communications and training solutions awards, while service revenue declined.
Public Safety & Security: Revenue increased 21.9% to $36.8 million, driven by security-system and communications-equipment integration for a mass-transit deployment. Segment operating loss narrowed to $0.2 million from $2.7 million.
Unmanned Systems: Revenue increased 9.9% to $15.6 million, but operating loss widened to $5.0 million from $4.2 million. Margin declined to 9.0% from 12.7% because of product mix and higher development costs for new aerial-target platforms.
Gross-margin improvement primarily reflected product mix and the absence of significant Q1 2016 restructuring, inventory impairment and litigation charges. Q1 2016 included $3.0 million of inventory impairment, $1.9 million of litigation settlement expense and other termination costs.
U.S. Government revenue was $96.3 million, or 57% of total revenue, compared with $95.4 million, or 62%, in Q1 2016.
Backlog was approximately $878.3 million at March 26, 2017, including $616.2 million of funded backlog, compared with total backlog of $909.1 million and funded backlog of $553.9 million at March 27, 2016.

Debt, liquidity and cash flow

Total long-term debt carrying value, including current portion, declined to $370.3 million from $432.0 million at December 25, 2016. The company repurchased and extinguished $62.7 million principal amount of its 7.00% Senior Secured Notes due 2019, using $64.0 million of cash, and recognized a $2.1 million loss.
Principal outstanding on the Notes was $372.8 million at quarter-end. The company also had a $1.5 million Israeli term loan.
The $110.0 million revolving credit facility had no borrowings, $10.1 million of letters of credit outstanding and $57.4 million of net borrowing-base availability.
Financing cash flow was $18.4 million, including $81.9 million of net proceeds from an equity offering of approximately 11.9 million shares, partially offset by debt retirement. Shares outstanding increased to 86.4 million from 73.9 million at year-end.
Capital expenditures were $5.2 million. Management expected fiscal 2017 capital expenditures of approximately $18.0 million to $23.0 million and non-capital internal development spending of $7.0 million to $10.0 million for the LCASD program.
Management stated that cash on hand, available revolver capacity and expected operating cash flow should be sufficient for anticipated needs for at least the next 12 months.

Outlook, risks and unusual items

The filing provides no formal revenue or earnings guidance. Management expects significant 2017 capital investment in the unmanned-systems business and continued LCASD development spending.
Key risks include changes or delays in U.S. Government and Department of Defense funding, continuing resolutions or government shutdowns, debt leverage, contract cancellations or scope changes, bid protests, competition, cybersecurity incidents, regulatory action, litigation and execution of integration, cost-reduction and divestiture strategies.
The company noted that the federal debt ceiling had been reached in March 2017 and that failure to raise it could delay government payments while the company remains obligated to perform certain contracts.
Defense Contract Audit Agency reviews may result in disputed or unallowable costs; the company has not recorded a liability for matters where a loss cannot reasonably be estimated.
The company maintains a full valuation allowance against most U.S. federal, state and certain foreign deferred tax assets. Unrecognized tax benefits were $18.6 million at December 25, 2016 and remained unchanged during the quarter.
On May 1, 2017, after quarter-end, the company entered into a 10-year lease for approximately 26,192 square feet of new San Diego headquarters space. Initial base rent is approximately $817,200 per year, escalating approximately 3% annually.
Management reported compliance with debt covenants, no credit-facility event of default, effective disclosure controls and no material changes to previously disclosed risk factors.

Investor verification points

Verify whether improved operating performance is sustainable after excluding the unusually high Q1 2016 restructuring, impairment and litigation charges.
Monitor cash conversion, receivables, inventory growth and the 124-day days-sales-outstanding level.
Assess the company’s ability to fund planned 2017 capital expenditures and LCASD development while continuing to reduce or refinance the 2019 Notes.
Evaluate Unmanned Systems losses, development costs and margin trends.
Track U.S. Government appropriations, continuing-resolution and debt-ceiling developments because 57% of quarterly revenue came from the U.S. Government.
Reconcile backlog conversion and funding: total backlog declined year over year even though funded backlog increased.