Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. is a defense and national security technology company focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity, missile defense, hypersonics, propulsion, C5ISR systems and training solutions. The company reports two segments: Kratos Government Solutions (KGS) and Unmanned Systems (US).
This unaudited Form 10-Q covers the 13-week quarter and 26-week year-to-date period ended June 25, 2023, compared with the periods ended June 26, 2022.
Key Financial Metrics
| Metric | Q2 2023 | Q2 2022 | Six Months 2023 | Six Months 2022 |
|---|---|---|---|---|
| Total revenue | $256.9 million | $224.2 million | $488.7 million | $420.4 million |
| Gross profit | $63.9 million | $57.8 million | $123.3 million | $109.7 million |
| Gross margin | 24.9% | 25.8% | 25.2% | 26.1% |
| Operating income (loss) | $6.7 million | $(1.9) million | $7.2 million | $(3.1) million |
| Net loss attributable to Kratos | $(2.7) million | $(4.7) million | $(9.7) million | $(20.6) million |
| Loss per share | $(0.02) | $(0.04) | $(0.08) | $(0.16) |
| Operating cash flow from continuing operations | Not separately provided | Not separately provided | $(2.1) million | $(29.5) million |
Q2 service revenue increased 31.6% to $103.7 million, while product sales increased 5.4% to $153.2 million. Six-month service revenue increased 33.1% to $195.3 million, and product sales increased 7.2% to $293.4 million.
KGS generated Q2 revenue of $204.8 million, up 22.1%, and operating income of $11.6 million. US revenue declined 7.6% to $52.1 million, but the segment returned to operating profitability of $1.2 million versus a $5.0 million loss in the prior-year quarter.
At June 25, 2023, cash and cash equivalents were $48.2 million, compared with $81.3 million at December 25, 2022. Total debt was $238.0 million before unamortized debt issuance costs, including $195.0 million of Term Loan A and $43.0 million drawn on the revolving facility. Approximately $157.0 million of revolving capacity remained, less $13.6 million of outstanding letters of credit. The reported current-period interest rate was 7.5%.
Total assets were $1.56 billion and stockholders’ equity was $945.6 million at June 25, 2023. Inventoried costs increased to $145.9 million from $125.5 million at year-end, while net contract assets were $148.9 million.
Material Changes Versus the Prior Comparable Period
- Revenue increased $32.7 million, or 14.6%, in Q2 and $68.3 million, or 16.2%, for the six-month period.
- KGS growth reflected the SRI Engineering Division acquisition, increased C5ISR, turbine technologies, microwave electronics, defense and rocket support activity, and stronger space and satellite communications revenue.
- US revenue declined primarily because of the timing of tactical-drone program awards.
- Gross margin declined by 0.9 percentage points in Q2 and 0.9 percentage points year to date, principally because of less favorable service and segment revenue mix. Product margins improved, but service margins decreased.
- Operating results improved from losses in the prior-year periods to operating income in 2023. The comparison benefited from the absence of the $5.5 million litigation settlement charge recorded in 2022.
- Six-month net loss attributable to Kratos improved by $10.9 million. The prior-year period included a $13.0 million loss on extinguishment of debt; 2023 interest expense increased because of higher interest rates.
- Operating cash use improved to $2.1 million from $29.5 million, although working capital remained a significant cash use. Inventory purchases used approximately $20.0 million of cash.
- Cash declined by $33.1 million during the first six months. Financing cash outflows included debt repayments, partially offset by a $34.0 million revolving-facility draw.
Guidance, Outlook, Commentary and Risks
Management did not provide specific consolidated revenue or earnings guidance in the filing. It expects 2023 capital expenditures to remain significant, including approximately $20 million to $25 million in the US business. The company expects $10 million to $15 million of that amount to fund production of Valkyries ahead of government contract awards.
Backlog was approximately $1.16 billion at June 25, 2023, including $863.9 million of funded backlog, versus $1.05 billion and $713.6 million, respectively, at June 26, 2022. Management expects approximately 39% of remaining performance obligations to be recognized in fiscal 2023, 32% in fiscal 2024 and the balance thereafter. Backlog may be affected by funding decisions, cancellations, contract modifications and timing of awards.
Management stated that cash on hand, available credit and expected operating cash flow should fund anticipated needs for at least the next 12 months. However, liquidity is sensitive to customer collections, inventory investment, contract milestones, program timing and covenant compliance.
- Federal budget uncertainty, continuing resolutions, potential spending reductions, appropriations delays and changes in Department of Defense priorities could delay, reduce or cancel contracts.
- Supply-chain disruption, inflation, higher labor costs and difficulty hiring and retaining cleared technical personnel have pressured execution, margins and forecasts.
- Higher interest rates increased interest expense. A new interest-rate swap effective May 1, 2023 fixes the Term Loan A one-month SOFR component at 3.721% through May 1, 2026, subject to the swap terms.
- Government contract audits, including Defense Contract Audit Agency reviews, could result in disputed or disallowed costs; the filing states that no liability has been recorded because potential losses cannot reasonably be estimated.
- A $4.8 million unbilled receivable remains subject to negotiation and settlement following termination for convenience of a large training-solutions program.
- The redeemable 9.95% minority interest in KTT Core had a carrying value of $14.7 million. The minority holders’ annual put right begins in January 2024 and could require a future purchase based on a specified EBITDA multiple.
- Other principal risks include cybersecurity incidents, CMMC compliance, customer and subcontractor performance, bid protests, litigation, acquisition integration, competition, international exposure and developments related to Ukraine.
Important Facts for Investors to Verify
- Whether revenue growth and backlog conversion continue, particularly in KGS, space and satellite communications, and unmanned systems.
- Whether gross-margin pressure from service mix, inflation, supply constraints and labor costs improves or persists.
- Cash conversion, accounts receivable and unbilled receivables, including the $4.8 million disputed balance and the 120-day DSO.
- Liquidity and leverage, including the $238.0 million of gross debt, interest-rate exposure, mandatory amortization and revolving-facility availability.
- Funding and customer-award timing for Valkyrie production and other unmanned-systems investments.
- Potential effects of government budget actions, contract audits, terminations, bid protests and other contingencies.
- The timing and potential cost of the KTT Core minority-interest put right beginning in January 2024.