Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed its Form 10-K for the 52-week fiscal year ended December 29, 2013. The company provides C5ISR products, engineering, manufacturing, systems integration, test and evaluation, cybersecurity, unmanned systems, missile-defense services, training, and critical-infrastructure security. Its reportable segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS).
U.S. Government customers accounted for approximately 64% of 2013 revenue, compared with 65% in 2012. The company had approximately 3,800 employees, total backlog of approximately $1.1 billion, and funded backlog of $541.0 million at year-end.
Key Financial Metrics
| Metric | 2013 | 2012 | Change |
|---|---|---|---|
| Revenue | $950.6 million | $969.2 million | (1.9%) |
| Gross profit | $240.0 million | $257.2 million | (6.7%) |
| Gross margin | 25.2% | 26.5% | Down 130 bps |
| Operating income from continuing operations | $31.8 million | $(49.7) million | Improved |
| Loss from continuing operations | $(31.9) million | $(112.9) million | Improved |
| Net loss | $(37.2) million | $(114.4) million | Improved |
| Net loss per share | $(0.65) | $(2.44) | Improved |
| Operating cash flow from continuing operations | $22.6 million | $52.3 million | Down $29.7 million |
Product sales were $507.0 million and service revenue was $443.6 million. Service gross margin improved to 24.4% from 22.0%, while product gross margin declined to 26.0% from 30.4%. SG&A was essentially flat at $193.0 million, but R&D increased to $21.4 million from $17.8 million.
Year-end cash and cash equivalents were $55.7 million, including $16.0 million held by foreign subsidiaries. Working capital was $179.3 million and total assets were $1.217 billion. Total debt, including capital leases and unamortized debt premium, was approximately $644.7 million; the $625.0 million of 10% senior secured notes mature in 2017. The revolver had no borrowings, $10.7 million of letters of credit outstanding, and $79.9 million of net borrowing-base availability. Management stated that available capital and operating cash flow were expected to fund requirements for at least the next 12 months.
Capital expenditures were $16.6 million. Cash paid for interest was $63.8 million, substantially exceeding operating cash flow. Contractual commitments totaled approximately $1.134 billion, including $629.8 million of debt principal, $213.7 million of estimated interest, $219.1 million of purchase orders, and $70.9 million of operating leases.
Fourth-Quarter 2013 Results
| Metric | Fourth quarter 2013 |
|---|---|
| Revenue | $235.7 million |
| Gross profit | $61.5 million |
| Operating income from continuing operations | $5.4 million |
| Net loss | $(7.4) million |
| Basic and diluted loss per share | $(0.12) |
Material Changes Versus the Prior Comparable Period
- KGS revenue declined 5.4% to $740.9 million, driven by lower legacy government service revenue, completion of certain satellite-communications production programs, delayed awards and shipments, and budget-related uncertainty.
- PSS revenue increased 12.7% to $209.7 million, primarily from demand for security and surveillance systems in transportation and utility markets.
- Revenue was affected by approximately $28.0 million of delayed awards and shipments, particularly in ground equipment, ballistic missile targets, and electronic-warfare products.
- Gross margin declined because of product mix and approximately $7.6 million of contract design retrofit costs following an unsuccessful aerial-target flight test.
- Operating results benefited from the absence of the $96.6 million goodwill and intangible-asset impairment recorded in 2012, as well as cost reductions and acquisition-related benefits.
- Operating cash flow fell to $22.6 million from $52.3 million, despite lower inventories and improved accounts-receivable cash conversion; accounts payable and other working-capital movements were less favorable.
- Total backlog declined from approximately $1.3 billion at the end of 2012 to $1.1 billion at the end of 2013, while funded backlog declined from $674.0 million to $541.0 million.
- Goodwill remained substantial at $596.4 million, approximately 49% of total assets. The company recorded no 2013 impairment but identified future impairment risk if defense funding, projected cash flows, market valuation, or discount rates deteriorate.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
Management stated that legislation enacted after year-end improved the near-term defense-industry outlook by offsetting a significant portion of sequestration cuts. However, it still expected lower or delayed awards on some programs, with potential negative effects on revenue, earnings, and cash flow. No quantified revenue or earnings guidance was provided in the filing.
- Defense-budget reductions, sequestration, continuing resolutions, delayed appropriations, government insourcing, contract cancellations, and non-renewal of options could reduce revenue and backlog realization.
- The company operates with significant leverage and must satisfy restrictive debt covenants, including a minimum fixed-charge coverage ratio under its revolver. A deterioration in operating performance could limit liquidity or trigger defaults.
- Most government contracts may be terminated for convenience, and backlog—particularly the $522.0 million unfunded portion—is not a guarantee of future revenue.
- Fixed-price contracts represented approximately 80% of 2013 revenue, increasing exposure to cost overruns, technical failures, schedule delays, and contract modifications.
- The Department of Justice is investigating whether a subsidiary overstated labor and material costs on a Department of Defense contract before Kratos acquired it. DCAA audits remain incomplete for fiscal 2006 and later years; adverse findings could result in refunds, penalties, reduced billing rates, or contract restrictions.
- The company reported cybersecurity attacks in the past and remains exposed to security breaches, classified-information risks, product defects, warranty claims, supply-chain disruptions, environmental liabilities, and procurement-law violations.
- Discontinued operations generated $3.7 million of revenue and a $5.3 million net loss in 2013. The company also recorded a $1.2 million impairment charge related to certain disposed operations.
- Management reported effective disclosure controls and internal control over financial reporting, and the independent auditor issued an unqualified opinion.
Important Facts for Investors to Verify
- Reconcile the company’s ability to service approximately $644.7 million of debt against $22.6 million of 2013 operating cash flow and $63.8 million of cash interest paid.
- Review the maturity and refinancing plan for the $625.0 million senior secured notes due in 2017.
- Assess the quality and expected timing of the $1.1 billion backlog, particularly the $522.0 million unfunded component.
- Monitor defense appropriations, sequestration implementation, contract awards, customer insourcing, and government procurement decisions.
- Evaluate whether the 2013 gross-margin decline and aerial-target retrofit costs are isolated or indicate broader execution and product-quality issues.
- Track the DOJ investigation, outstanding DCAA audits, potential False Claims Act exposure, and any related accrual changes.
- Test the sensitivity of the $596.4 million goodwill balance to lower forecasts, higher discount rates, or further declines in defense-market valuations.
- Review the company’s full valuation allowance on deferred tax assets, limitations on net operating loss utilization, and $15.8 million of unrecognized tax benefits.