Kratos Defense & Security Solutions, Inc. — Q3 2020 Form 10-Q
Business context and reporting period
Kratos is a defense technology and government contractor focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity, rocket and hypersonic systems, missile defense, turbine technologies and C5ISR. The filing covers the unaudited 13-week quarter and 39-week year-to-date period ended September 27, 2020, compared with September 29, 2019.
The company operates through Kratos Government Solutions (KGS) and Unmanned Systems (US). U.S. Government revenue represented 72% of quarterly revenue and 74% of year-to-date revenue.
Key financial metrics
| Metric | Q3 2020 | Q3 2019 | 9M 2020 | 9M 2019 |
|---|---|---|---|---|
| Total revenue | $202.0 million | $184.1 million | $541.3 million | $532.4 million |
| Gross profit | $57.1 million | $48.6 million | $148.9 million | $141.6 million |
| Gross margin | 28.3% | 26.4% | 27.5% | 26.6% |
| Operating income | $12.7 million | $11.5 million | $20.3 million | $28.7 million |
| Net income attributable to Kratos | $2.4 million | $2.5 million | $1.5 million | $9.5 million |
| Diluted earnings per share | $0.02 | $0.02 | $0.01 | $0.09 |
| Operating cash flow from continuing operations | Not provided for quarter | Not provided for quarter | $19.1 million | $30.2 million |
Quarterly revenue increased 9.7%, driven by an 18.6% increase in product sales, partially offset by a 4.5% decline in service revenue. Year-to-date revenue increased 1.7%, while operating income declined 29.3% and attributable net income declined substantially, primarily reflecting higher SG&A, research and development costs, and lower discontinued-operations results.
Quarterly product margin increased to 29.8% from 24.7%, while service margin declined to 25.3% from 29.1%. Year-to-date product margin increased to 27.9% from 23.8%, while service margin declined to 26.9% from 31.0%.
Liquidity, cash flow and capital structure
- Cash and cash equivalents were $374.7 million at September 27, 2020, versus $172.6 million at December 29, 2019. Cash, cash equivalents and restricted cash totaled $375.4 million.
- Year-to-date cash increased $202.8 million, primarily because of $240.4 million of net proceeds from a June equity offering of 15.525 million shares.
- Year-to-date investing cash use was $66.8 million, including $43.9 million for acquisitions and $23.0 million of capital expenditures.
- Long-term debt carrying value was $300.3 million, including $300.0 million of 6.5% senior secured notes due 2025 and approximately $4.8 million of Israeli term loans. Principal debt totaled $304.8 million.
- The $90.0 million revolving credit facility had no borrowings, $6.1 million of letters of credit outstanding and $69.1 million of net borrowing-base availability. The company reported compliance with debt covenants.
- Management stated that cash on hand, available revolver capacity and expected operating cash flow should fund anticipated working capital and other cash needs for at least the next 12 months.
Material changes versus the prior comparable period
- Q3 revenue growth was led by ASC Signal, which contributed $10.2 million, organic growth in defense and rocket support, microwave products and C5ISR, and increased US production activity.
- Year-to-date KGS revenue declined $5.5 million, primarily because of completed or rescoped training and international contracts, satellite infrastructure project completion and COVID-19 effects. US revenue increased $14.4 million.
- ASC Signal was acquired on June 30, 2020 for approximately $35 million in cash and contributed $10.2 million of Q3 revenue and $0.7 million of operating income. TDI and OPM were also acquired during 2020; their results were not material.
- SG&A increased to $36.3 million in Q3 and $107.2 million year to date, partly because stock-based compensation rose to $5.0 million in Q3 and $14.5 million year to date.
- Research and development increased to $7.7 million in Q3 and $19.4 million year to date, reflecting continued investment in space, satellite and other advanced technologies.
- The prior-year nine-month results included $2.4 million of income from discontinued operations, including a $3.6 million indemnification-liability release. The 2020 period recorded a $0.8 million loss from discontinued operations.
- Common shares outstanding increased to approximately 122.8 million at September 27, 2020 from 106.6 million at December 29, 2019, primarily reflecting the equity offering.
Outlook, commentary, risks and unusual items
- Total backlog was approximately $873.1 million at September 27, 2020, including $579.3 million funded, compared with $608.7 million total and $518.7 million funded at September 29, 2019. Management expects to recognize approximately 22% of remaining backlog in 2020, an additional 35% by 2021 and the balance thereafter.
- Management expects 2020 capital expenditures of approximately $18 million to $23 million, including approximately $13 million to $16 million for capital aerial targets and related support equipment.
- The filing does not provide a formal revenue or earnings guidance range. Backlog conversion is subject to funding, contract timing, cancellations and scope changes.
- COVID-19 caused supply-chain and delivery delays, restricted access to facilities and customers, delayed drone and rocket demonstrations and exercises, and reduced demand from certain commercial aerospace, power and satellite communications customers. Management did not expect a material impact at the filing date but stated that the ultimate financial effect could not be reasonably estimated.
- A continuing federal budget resolution began October 1, 2020. Prolonged continuing resolutions or a government shutdown could delay, cancel or restrict defense programs, new starts, production increases and customer payments.
- Approximately $11.5 million of unbilled receivables relates to a customer termination-for-convenience settlement, and approximately $10.0 million relates to a dispute with an international US-segment customer. Management determined that no revenue or receivable adjustment was required, but collection could be delayed.
- The company remains in a dispute over approximately $8 million of the closing working-capital adjustment related to the sale of its Public Safety & Security Solutions business. It has collected approximately $6.8 million of retained working capital and expects the remaining amount to be collected after legacy projects are completed.
- DCAA audits may result in claims for disallowed, overstated or disputed government-contract costs. The company has not recorded a liability because the potential loss cannot reasonably be estimated.
- The redeemable minority interest associated with the FTT acquisition may become payable beginning in January 2024 through the sellers’ put right; the company may purchase the interest beginning in January 2025. No carrying-value adjustment was required at quarter end.
Investor verification checklist
- Verify whether backlog, funded backlog and expected conversion are translating into revenue and cash flow, particularly amid continuing-resolution and COVID-19 risks.
- Monitor collection and resolution of the $11.5 million termination-related receivable and the $10.0 million international customer dispute.
- Assess the sustainability of improved product margins against declining service margins and higher SG&A and R&D spending.
- Evaluate leverage, the 6.5% notes due 2025, revolver availability and the company’s potential use of its large cash balance for acquisitions or debt actions.
- Track integration and performance of ASC Signal and other acquisitions, along with remaining FTT minority-interest obligations.
- Review the effects of share issuance and stock-based compensation on per-share results and shareholder dilution.
- Monitor DCAA audits, government-contract compliance, federal appropriations and the Public Safety & Security working-capital dispute.