Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. is a government contractor focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity, rocket and hypersonic systems, missile defense, turbine technologies, C5ISR, and training. The company operates through Kratos Government Solutions (KGS) and Unmanned Systems (US).
This unaudited Form 10-Q covers the 13-week quarter and 26-week year-to-date periods ended June 27, 2021, compared with the corresponding periods ended June 28, 2020.
Financial Performance and Key Metrics
| Metric | Q2 2021 | Q2 2020 | Six Months 2021 | Six Months 2020 |
|---|---|---|---|---|
| Total revenue | $205.1 million | $170.4 million | $399.3 million | $339.3 million |
| Gross profit | $52.0 million | $46.0 million | $103.0 million | $91.8 million |
| Gross margin | 25.4% | 27.0% | 25.8% | 27.1% |
| Operating income | $3.3 million | $2.9 million | $8.2 million | $7.6 million |
| Income from continuing operations | $1.2 million | $(0.6) million | $3.1 million | $(0.4) million |
| Net income attributable to Kratos | $1.1 million | $(0.7) million | $3.0 million | $(0.9) million |
| Diluted EPS | $0.01 | $(0.01) | $0.02 | $(0.01) |
- Product sales were $147.1 million in the quarter and $284.0 million year to date, representing 71.7% and 71.1% of revenue, respectively. Service revenue declined to $58.0 million in the quarter and $115.3 million year to date.
- Quarterly KGS revenue increased 12.8% to $144.8 million, while US revenue increased 43.6% to $60.3 million. Year-to-date KGS revenue increased 10.9% to $283.1 million and US revenue increased 38.3% to $116.2 million.
- Operating income included SG&A of $38.2 million for the quarter and $76.1 million year to date, R&D expense of $10.2 million and $18.2 million, and merger and acquisition expense of $0.1 million and $0.3 million, respectively.
- Interest expense was $5.7 million in the quarter and $11.6 million year to date.
- Cash provided by operating activities from continuing operations was $22.0 million year to date, compared with $10.8 million in the prior-year period. Capital expenditures were $20.5 million and acquisition-related cash payments were $6.2 million.
- Cash and cash equivalents were $369.3 million at June 27, 2021, compared with $380.8 million at December 27, 2020. Total assets were $1.562 billion and stockholders’ equity was $935.9 million.
- Long-term debt carrying value was $301.9 million, consisting primarily of $300.0 million of 6.5% senior secured notes due 2025. No revolver borrowings were outstanding; letters of credit totaled $5.9 million and net borrowing base availability was $64.4 million.
Material Changes Versus the Prior Comparable Period
- Revenue increased 20.4% in the quarter and 17.7% year to date, driven primarily by higher product sales, increased US segment production, and the contribution from the ASC Signal acquisition.
- ASC Signal contributed approximately $11.8 million of quarterly revenue and $20.4 million of year-to-date revenue. TDI and 5-D Systems also contributed approximately $2.1 million in the quarter and $3.7 million year to date.
- Gross margin declined 160 basis points in the quarter and 130 basis points year to date. Management attributed the decline principally to a less favorable product and program mix, including increased activity on developmental programs.
- US segment operating income increased to $4.1 million in the quarter and $8.3 million year to date, from $1.0 million and $1.5 million, respectively. KGS operating income declined to $5.9 million in the quarter and $13.0 million year to date, primarily due to mix.
- R&D increased materially, reflecting investment in space and satellite communications and efforts to achieve first-to-market and designed-in positions.
- Backlog increased to approximately $865.6 million from $683.4 million at June 28, 2020; funded backlog was $630.6 million versus $569.6 million. Approximately 39% of remaining backlog was expected to be recognized in 2021 and 27% in 2022.
- Cash declined by $11.5 million from year-end, compared with a $224.6 million increase in the prior-year period, when the company received $240.5 million of net proceeds from an equity offering.
Guidance, Outlook, Commentary, Risks and Unusual Items
- Management stated that cash on hand, expected operating cash flow, and available revolver capacity should fund anticipated working capital and other cash needs for at least the next 12 months.
- Management expected 2021 capital expenditures of approximately $33 million to $37 million, including approximately $20 million to $25 million for capital aerial targets and related support equipment.
- The company’s remaining performance obligations were approximately $865.6 million, with recognition expected over 2021, 2022, and later periods. Backlog timing remains subject to funding, contract modifications, cancellations, and customer scheduling.
- Management identified substantial dependence on U.S. Government and Department of Defense spending. U.S. Government revenue represented 71% of quarterly revenue and 72% of year-to-date revenue.
- Risks include defense budget reductions, continuing resolutions or government shutdowns, contract delays or cancellations, bid protests, subcontractor and supplier performance, execution risk on fixed-price contracts, competition, leverage, acquisitions and integration, cybersecurity incidents, and COVID-19-related operating and supply-chain disruptions.
- Approximately $11.5 million of unbilled receivables related to a customer-terminated training program remained outstanding. Kratos also disputed approximately $10.0 million of unbilled receivables with an international customer; the customer asserted counterclaims. Management recorded no adjustment to the related revenue or receivables.
- The company continued to dispute approximately $8 million of the closing working-capital adjustment related to the 2018 sale of its Public Safety & Security Solutions business. The ultimate resolution was not recorded as of June 27, 2021.
- Department of Defense contracts remain subject to DCAA audits and potential claims regarding disallowed, overstated, or disputed costs. The company had not recorded a liability because a loss range could not reasonably be estimated.
- The company intended to repay approximately $5.1 million of Israel term loans in the third quarter of 2021. A separate approximately $0.5 million 5-D Systems PPP loan was forgiven in July 2021.
- Management concluded that disclosure controls and procedures were effective as of June 27, 2021, and reported no material change in internal control over financial reporting.
Important Facts for Investors to Verify
- Whether revenue growth and backlog conversion continue to offset lower service revenue and pressure on gross margins.
- The profitability and cash-flow contribution of developmental unmanned systems and other major production programs.
- The timing and collectability of the $11.5 million training-program receivable and $10.0 million international-customer receivable dispute.
- Resolution of the approximately $8 million divestiture-related working-capital dispute.
- Future U.S. Government appropriations, continuing-resolution exposure, program funding, and customer concentration.
- Execution of planned 2021 capital expenditures and their effect on liquidity and operating cash flow.
- Compliance with debt covenants and refinancing or repayment requirements for the $300 million senior secured notes due 2025.