Kratos Defense & Security Solutions, Inc. — Q1 2015 Form 10-Q Summary
Reporting period: Three months ended March 29, 2015, compared with the three months ended March 30, 2014. The interim financial statements are unaudited. Kratos provides defense, national security, unmanned systems, cybersecurity, public safety, and security products and services, with the U.S. Government as its principal customer.
Key Financial Metrics
| Metric | Q1 2015 | Q1 2014 | Change |
|---|---|---|---|
| Total revenue | $182.5 million | $200.1 million | Down 8.8% |
| Service revenue | $87.4 million | $100.6 million | Down 13.1% |
| Product sales | $95.1 million | $99.5 million | Down 4.4% |
| Gross profit | $46.9 million | $52.6 million | Down $5.7 million |
| Gross margin | 25.7% | 26.3% | Down 60 basis points |
| Operating income (loss) | $(1.5) million | $3.3 million | Down $4.8 million |
| Net loss | $(16.3) million | $(15.0) million | Loss increased $1.3 million |
| Loss per diluted share | $(0.28) | $(0.26) | Loss increased $0.02 |
| Operating cash flow from continuing operations | $(2.9) million | $1.7 million | Down $4.6 million |
| Capital expenditures | $2.2 million | $3.1 million | Down $0.9 million |
Balance Sheet, Debt, and Liquidity
- Cash and cash equivalents were $34.4 million at March 29, 2015, compared with $34.7 million at December 28, 2014. Restricted cash declined from $5.4 million to $1.6 million.
- Total assets were $1.123 billion and total liabilities were $911.1 million. Stockholders’ equity declined to $211.5 million from $224.3 million, primarily reflecting the quarterly comprehensive loss.
- Principal long-term debt was approximately $669.5 million, including $625.0 million of 7.00% Senior Secured Notes due 2019, a $41.0 million revolving credit borrowing, and a $3.5 million Israeli term loan. The balance sheet separately reports $622.0 million of long-term debt and $41.0 million under the line of credit.
- The $110.0 million revolving credit facility had $41.0 million outstanding, $13.1 million of letters of credit, and $38.4 million of net borrowing-base availability.
- Kratos was in compliance with the Senior Secured Notes, revolving credit facility, and Israeli term-loan covenants at March 29, 2015.
- Management stated that cash on hand, available credit, and expected operating cash flow should fund anticipated working capital and other cash needs for at least the next 12 months, but warned that weaker operating conditions could affect liquidity and covenant compliance.
Material Changes Versus Q1 2014
- Revenue declined $17.6 million, primarily because of lower defense product shipments, delayed orders and awards, and the challenging federal government and Department of Defense funding environment.
- Kratos Government Solutions revenue increased 0.8% to $132.5 million, supported by simulation and training and technical government services, partly offset by lower legacy government services revenue.
- Public Safety & Security revenue decreased 23.1% to $37.6 million following the company’s decision to selectively bid on larger projects and the completion or wind-down of certain security installation projects.
- Unmanned Systems revenue decreased 37.1% to $12.4 million, principally because of delayed follow-on and new international contract awards and lower aerial-target shipments.
- Gross margin decreased to 25.7%. Service margin fell to 24.5% because of an unfavorable revenue mix, while product margin improved to 26.8%.
- Unmanned Systems operating loss increased to $4.1 million from $1.8 million. KGS operating income declined to $4.7 million from $5.9 million, and Public Safety & Security operating income declined to $0.1 million from $1.0 million.
- SG&A declined modestly to $42.6 million, but increased as a percentage of revenue to 23.3%. Restructuring expense increased to $1.0 million, including approximately $0.9 million of employee termination costs.
- Net interest expense declined to $12.2 million from $16.1 million following the May 2014 refinancing of the 10% Senior Secured Notes with 7% Senior Secured Notes.
- Days sales outstanding increased from 104 days at December 28, 2014 to 119 days at March 29, 2015, reflecting delayed contractual milestones and government funding delays.
- Backlog was approximately $1.1 billion at both comparison dates; funded backlog increased to approximately $650.0 million from $538.0 million.
Outlook, Risks, and Unusual Items
- The company did not provide specific quantitative revenue or earnings guidance in the filing.
- Management cited potential effects from federal and DoD spending reductions, delayed or canceled awards, bid protests, contract scope or timing changes, customer concentration, competition, and the possible return of sequestration beginning October 1, 2015 if no FY 2016 budget agreement is reached.
- Additional risks include high debt leverage, cybersecurity incidents, integration and cost-reduction execution, divestiture activities, regulatory action, litigation, and potential covenant pressure if revenues or operating cash flow weaken.
- Revenue recognition for many contracts uses percentage-of-completion methods and depends on estimates of costs, schedules, performance, incentives, and penalties. Changes in estimates may produce material cumulative catch-up adjustments.
- The company is subject to Defense Contract Audit Agency reviews and potential claims concerning disallowed, overstated, or disputed costs. Routine litigation accruals were not material, but management noted that unfavorable contingency outcomes could materially affect a future period.
- The company adopted ASU 2014-08 on discontinued operations; management stated that the adoption had no material impact. It had not yet selected a transition method or determined the impact of the forthcoming revenue-recognition standard, ASU 2014-09.
- The company maintains a full valuation allowance against most U.S. federal, state, and certain foreign deferred tax assets. Federal net operating loss utilization is subject to Section 382 limitations resulting from prior ownership changes.
- Disclosure controls and procedures were assessed as effective as of March 29, 2015, with no material change in internal control over financial reporting.
Investor Verification Items
- Verify whether delayed government funding, contract awards, and shipment milestones continue to pressure revenue, accounts receivable, and days sales outstanding.
- Monitor Unmanned Systems losses and the effect of product mix, international awards, and production volumes on consolidated margins.
- Assess cash generation relative to approximately $669.5 million of debt principal, scheduled interest, revolving-credit requirements, and covenant thresholds.
- Confirm available borrowing capacity and compliance with the revolving facility’s 1.15:1 minimum fixed-charge coverage ratio and other debt covenants.
- Evaluate the sustainability of the approximately $1.1 billion backlog, including the funded portion, cancellation risk, contract options, and timing of conversion to revenue.
- Review DCAA audits, government cost claims, litigation, warranties, and other contingencies for potential material cash or earnings effects.
- Reconcile the filing’s debt classifications and carrying amounts, including the $622.0 million long-term debt balance, $41.0 million revolving borrowing, and reported total principal.