Kratos Defense & Security Solutions, Inc. — 2020 Q1 Form 10-Q Summary
Business context and reporting period
Kratos is a defense technology and government contractor focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity, training, rocket systems, missile defense, turbine technologies and C5ISR. The company operates through Kratos Government Solutions (KGS) and Unmanned Systems (US).
The filing covers the unaudited 13-week quarter ended March 29, 2020, compared with the 13-week quarter ended March 31, 2019. Approximately 73% of quarterly revenue came from the U.S. Government. The company had 106.96 million common shares outstanding as of May 1, 2020.
Financial performance and position
| Metric | Q1 2020 | Q1 2019 | Change |
|---|---|---|---|
| Total revenue | $168.9 million | $160.4 million | +5.3% |
| Service revenue | $63.6 million | $62.6 million | +1.6% |
| Product sales | $105.3 million | $97.8 million | +7.7% |
| Gross profit | $45.8 million | $44.9 million | +2.0% |
| Gross margin | 27.1% | 28.0% | -0.9 percentage points |
| Operating income | $4.7 million | $8.2 million | -$3.5 million |
| Income from continuing operations | $0.2 million | $3.7 million | -$3.5 million |
| Net income attributable to Kratos | $(0.2) million | $3.1 million | -$3.3 million |
| Diluted net income per share | Approximately $0.00 | $0.03 | Declined |
- KGS revenue increased 1.1% to $126.9 million; US revenue increased 20.3% to $42.0 million.
- Operating income margins were approximately 7.3% for KGS and 1.2% for US, compared with approximately 9.1% and 1.7%, respectively, in the prior-year quarter.
- SG&A increased to $34.9 million from $31.5 million, principally due to higher stock-based compensation and depreciation and amortization. Research and development increased to $5.7 million from $3.9 million.
- Interest expense, net was $5.4 million, and the company recognized a $1.4 million income tax benefit, primarily related to the TDI acquisition.
Cash flow, debt and liquidity
| Metric | March 29, 2020 | December 29, 2019 |
|---|---|---|
| Cash and cash equivalents | $158.6 million | $172.6 million |
| Long-term debt, carrying amount | $295.3 million | $295.1 million |
| 6.5% Senior Secured Notes principal | $300.0 million | $300.0 million |
| Revolver borrowings | None | None |
| Letters of credit | $5.7 million | Not clearly stated in the filing text |
| Net borrowing base availability | $64.8 million | Not clearly stated in the filing text |
- Operating cash flow from continuing operations was $4.0 million, down from $16.0 million. The decline reflected working-capital requirements and investments in the ballistic missile business.
- Investing cash outflow was $20.6 million, including $14.2 million for acquisitions and $6.4 million of capital expenditures.
- Capital expenditures for 2020 were expected to be approximately $25 million to $30 million, including approximately $20 million to $23 million for capital aerial targets and related support equipment.
- Total cash, cash equivalents and restricted cash declined by $14.0 million during the quarter to $158.6 million.
- Management stated that cash on hand, available credit and expected operating cash flow should fund working capital and other anticipated needs for at least the next 12 months.
Material changes versus the prior comparable period
- Revenue growth was driven primarily by US aerial target awards and tactical drone development, as well as contributions from the acquired Florida Turbine Technologies business. KGS growth was partly offset by lower training, satellite communications and legacy government services revenue.
- Gross margin declined because of less favorable service and segment mix, although product margins improved to 26.0% from 24.8%.
- Operating income fell as SG&A and R&D increased and gross margin compressed. Prior-year results also included $1.2 million of FTT transaction expenses, while current-quarter merger and acquisition expense was $0.4 million.
- The company acquired Technical Directions, Inc. on February 24, 2020, for approximately $10.5 million in cash. Its contribution to first-quarter results was not material.
- Backlog increased to approximately $646.8 million from $620.2 million; funded backlog increased to $549.8 million from $539.5 million. Management expected to recognize approximately 54% of remaining backlog in 2020 and an additional 22% by 2021.
- The company adopted the expected-credit-loss standard, ASC 326, effective December 30, 2019, with no material financial statement impact.
Guidance, outlook, risks and unusual items
- The company did not provide explicit revenue or earnings guidance in the filing text.
- Kratos continued operating as a critical-infrastructure company during the COVID-19 pandemic. Subsequent to quarter-end, it reported supply-chain disruptions, supplier-delivery delays, access difficulties at certain sites and customers, delays to demonstrations and exercises, and reduced demand from certain commercial aerospace and power customers.
- Management did not expect COVID-19 to have a material impact on results, cash flows or financial position at the filing date, but stated that the ultimate financial impact could not reasonably be estimated.
- Approximately $11.5 million of unbilled receivables remained outstanding on a large training program terminated for convenience by the customer. The company also disputed approximately $10.0 million of unbilled receivables with an international customer. Management concluded that no revenue or receivable adjustment was required at March 29, 2020.
- The company is involved in a dispute concerning the closing working-capital adjustment from the 2018 sale of its Public Safety & Security Solutions business; the amount in dispute was approximately $8 million. The company had collected approximately $5.6 million of retained working capital and expected to collect the balance during 2020, subject to final settlement.
- Government-contract audits by the Defense Contract Audit Agency may result in claims for disallowed, overstated or disputed costs. The company had not recorded a liability because the potential loss could not reasonably be estimated.
- Key ongoing risks include dependence on U.S. Government and Department of Defense funding, continuing resolutions or shutdowns, contract cancellations and modifications, bid protests, supplier and subcontractor performance, cybersecurity incidents, product defects, competition, debt leverage, acquisition integration and pandemic-related disruption.
- The company was in compliance with the covenants governing its senior secured notes and revolving credit facility, and reported no credit-agreement default as of March 29, 2020.
Important facts for investors to verify
- Whether COVID-19-related supply-chain, customer-access and commercial-demand issues materially affect subsequent-quarter revenue, margins and cash flow.
- Collection timing and ultimate recoverability of the $11.5 million terminated-program receivable and the $10.0 million disputed international receivable.
- Progress and final settlement of the approximately $8 million PSS working-capital dispute.
- Conversion of the $646.8 million backlog, including the $549.8 million funded portion, into revenue and cash.
- Ability to fund planned $25 million to $30 million of 2020 capital expenditures while maintaining compliance with debt covenants.
- Future performance of the US segment and whether increased lower-margin development work pressures segment profitability.
- Potential cash obligations associated with the redeemable minority interest in FTT beginning in 2024 and the related purchase rights beginning in 2025.