Kratos Defense & Security Solutions, Inc. — Q3 2018 Form 10-Q Summary
Business context and reporting period
Kratos is a defense technology and government contractor serving U.S. and allied national-security customers through two continuing segments: Kratos Government Solutions (KGS) and Unmanned Systems (US). The filing covers the 13-week quarter and 39-week year-to-date period ended September 30, 2018; comparable 2017 periods covered 14 and 40 weeks, respectively. Results have been recast to present the Public Safety & Security business as discontinued operations following its sale on June 11, 2018.
Financial performance and liquidity
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Total revenue | $159.4 million | $157.1 million | $453.6 million | $437.0 million |
| Gross profit | $44.1 million | $37.2 million | $124.2 million | $110.8 million |
| Gross margin | 27.7% | 23.7% | 27.4% | 25.4% |
| Operating income from continuing operations | $10.1 million | $0.1 million | $19.7 million | $3.0 million |
| Income (loss) from continuing operations | $1.4 million | $(5.9) million | $(1.1) million | $(22.9) million |
| Net income (loss) | $1.7 million | $(4.3) million | $(8.2) million | $(20.5) million |
| Operating cash flow from continuing operations | Not separately provided | Not separately provided | $15.4 million | $(16.9) million |
Q3 service revenue increased 15.3% to $54.9 million, while product sales decreased 4.6% to $104.5 million. KGS revenue rose 9.2% to $126.1 million, partly offset by a 20.0% decline in US revenue to $33.3 million. U.S. Government revenue represented 76% of Q3 revenue and 72% of nine-month revenue.
SG&A declined to $29.5 million in Q3 and $89.4 million year to date, compared with $32.9 million and $94.8 million in the prior comparable periods. Net interest expense was $5.0 million in Q3 and $15.8 million year to date, benefiting from the November 2017 refinancing. The nine-month tax provision was $4.4 million, including a $3.3 million discrete expense related to uncertain tax positions.
Cash and cash equivalents were $187.2 million at September 30, 2018, up from $130.5 million at December 31, 2017. Nine-month investing cash flow was $46.2 million, including approximately $66.7 million of net proceeds from the PSS sale, offset by $17.9 million of capital expenditures. Management expected 2018 capital expenditures of approximately $22 million to $25 million and internal non-capital product-development spending of $5 million to $7 million.
Total debt principal was $300.0 million, consisting of 6.5% Senior Secured Notes due 2025; carrying value was $294.0 million. The revolving credit facility had no borrowings, $5.3 million of letters of credit outstanding, and $57.4 million of net borrowing-base availability. The company reported compliance with its debt covenants and stated that available cash, revolver capacity, and operating cash flow should fund anticipated needs for at least the next 12 months.
Material changes versus the prior comparable period
- Revenue increased 1.5% in Q3 and 3.8% year to date, while gross margin improved by 4.0 and 2.0 percentage points, respectively.
- Operating income from continuing operations increased substantially, supported by improved mix, cost reductions, and lower SG&A.
- Nine-month operating cash flow from continuing operations improved from a $16.9 million use to $15.4 million provided.
- ASC 606 was adopted on January 1, 2018 using the modified retrospective method. It increased reported Q3 revenue by $5.3 million and nine-month revenue by $21.0 million, with corresponding cost increases of $3.8 million and $15.5 million. Opening equity decreased by $0.2 million.
- The PSS business was sold for a stated purchase price of $69 million in cash. The company expected approximately $70 million of net cash proceeds, subject to working-capital adjustments and transaction-related amounts, and expected the transaction to be approximately break-even after all proceeds were collected.
- Nine-month discontinued operations produced a $7.1 million loss, including $2.7 million of transaction expenses and operating losses through disposition.
- The company recorded $3.5 million of restructuring and other expense year to date, including approximately $2.8 million for a pending legal settlement and related legal costs and approximately $0.7 million of employee termination costs.
Guidance, outlook, commentary, and risks
At September 30, 2018, remaining performance obligations were approximately $571.7 million, of which $528.1 million was funded. Management expected to recognize approximately 23.3% in 2018, an additional 42.6% by 2020, and the balance thereafter. The filing also states that ASC 606 reduced reported backlog by approximately $176.7 million; the comparable backlog under ASC 606 at October 1, 2017 was approximately $569.8 million.
Management cited increased defense appropriations for fiscal 2018 and 2019 but noted continuing uncertainty over federal budgets, the debt ceiling, continuing resolutions, and potential government shutdowns. Key risks include reductions or delays in U.S. Department of Defense and foreign military spending, bid protests, contract cancellations or scope changes, customer concentration, LPTA pricing pressure, execution and estimate-at-completion risk, debt leverage, cybersecurity incidents, litigation, government contract audits, and competition.
The company’s contracts are subject to Defense Contract Audit Agency review. The filing states that potential disallowed or disputed costs cannot currently be reasonably estimated and no liability was recorded for those matters. The IRS and New York State were examining specified prior-year tax returns, and the outcomes had not been determined.
Important facts for investors to verify
- Whether revenue and margin improvements persist after the timing effects and acceleration associated with ASC 606.
- The collection and final amount of approximately $7 million of PSS net working capital and the ultimate net proceeds from the divestiture.
- Progress in converting the $571.7 million remaining-performance-obligation balance into funded and recognized revenue.
- Cash conversion and working-capital requirements, particularly the increase in days sales outstanding from 116 days at year-end 2017 to 129 days at September 30, 2018.
- Compliance with the 6.5% Notes and revolving-credit covenants and the permitted use of PSS sale proceeds under the debt documents.
- Potential exposure from DCAA audits, tax examinations, uncertain tax positions, and the pending $2.3 million legal settlement.
- Execution and returns on planned unmanned-systems investment, including the 2018 capital-expenditure and internal-development programs.