Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed this unaudited Form 10-Q for the 13-week quarter ended March 31, 2019, compared with the 13-week quarter ended April 1, 2018. Kratos provides defense technology, products, services, unmanned systems, space and satellite communications, microwave electronics, missile defense, cybersecurity, training systems and related national-security solutions. Operations are reported through Kratos Government Solutions (KGS) and Unmanned Systems (US).
On February 27, 2019, Kratos acquired an 80.1% interest in Florida Turbine Technologies, Inc. and FTT CORE, LLC for approximately $60.0 million, adding small jet-engine and turbomachinery capabilities to KGS.
Key Financial Metrics
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Total revenue | $160.4 million | $143.0 million | 12.2% increase |
| Service revenue | $62.6 million | $46.0 million | 36.1% increase |
| Product sales | $97.8 million | $97.0 million | 0.8% increase |
| Gross profit | $44.9 million | $40.8 million | 10.0% increase |
| Gross margin | 28.0% | 28.5% | Down 50 basis points |
| Operating income from continuing operations | $8.2 million | $7.0 million | 17.1% increase |
| Net income attributable to Kratos | $3.1 million | $(2.2) million | Improved $5.3 million |
| Diluted earnings per share | $0.03 | $(0.02) | Improved |
| Operating cash flow from continuing operations | $16.0 million | $6.5 million | Increase of $9.5 million |
| Capital expenditures | $4.0 million | $6.7 million | Decrease of $2.7 million |
Operating margin from continuing operations was approximately 5.1% in Q1 2019 versus 4.9% in Q1 2018. SG&A was $31.5 million, or 19.6% of revenue, compared with $29.8 million, or 20.8% of revenue. Research and development expense was $3.9 million, or 2.4% of revenue.
Cash and cash equivalents were $178.4 million at March 31, 2019, compared with $182.7 million at December 30, 2018. Total debt had a $294.4 million carrying amount, representing $300.0 million of 6.5% senior secured notes due 2025, net of unamortized issuance costs. The $90.0 million revolving credit facility had no borrowings, $5.7 million of letters of credit outstanding and $65.4 million of net borrowing-base availability.
Total assets were $1.17 billion and total stockholders’ equity was $552.9 million at March 31, 2019. The balance sheet included $38.1 million of operating lease right-of-use assets and $44.6 million of operating lease liabilities following adoption of ASC 842.
Material Changes Versus the Prior Comparable Period
- KGS revenue increased 8.9% to $125.5 million, including $4.2 million contributed by FTT. Service revenue increased substantially, while KGS product sales declined.
- US revenue increased 25.5% to $34.9 million, primarily from higher production of U.S. Air Force and U.S. Navy aerial targets.
- Service gross margin improved to 32.9% from 28.5%, but product gross margin declined to 24.8% from 28.6%. The overall gross margin declined because of product mix.
- KGS segment operating income increased to $11.4 million from $7.9 million. US segment operating income declined to $0.6 million from $0.8 million, primarily due to product mix.
- Unallocated corporate expense increased to $3.8 million from $1.7 million, including $1.2 million of FTT transaction expenses.
- Income tax expense of $0.9 million in Q1 2018 changed to a $1.5 million benefit in Q1 2019, primarily because the FTT acquisition enabled recognition of deferred tax assets and a $3.4 million valuation-allowance release. The benefit was partly offset by $1.6 million of uncertain tax-position liabilities.
- Loss from discontinued operations decreased to $0.6 million from $3.5 million. The prior-year loss included approximately $2.0 million of contract cost adjustments and $0.8 million of disposition-related expenses.
- Net cash used in continuing operations was $4.8 million, compared with net cash provided of $0.2 million in the prior-year period, after $17.6 million of acquisition cash payments and $4.0 million of capital expenditures.
Guidance, Outlook, Risks and Unusual Items
Management stated that cash on hand, operating cash generation and available revolver capacity should be sufficient for anticipated working-capital and other cash needs for at least the next 12 months. Fiscal 2019 capital expenditures are expected to be approximately $15 million to $18 million, including investments in aerial targets, tooling, an Oklahoma manufacturing facility and a secured US facility.
Backlog was approximately $620.2 million at March 31, 2019, of which $539.5 million was funded. Management expects to recognize approximately 57% of total remaining backlog in 2019, 23% by 2020 and the balance thereafter. Backlog remains subject to funding, schedule changes, cancellations and U.S. Government termination rights.
Kratos is highly dependent on government customers: U.S. Government revenue represented approximately $116.9 million, or 73% of total revenue, compared with 71% in the prior-year period. Key risks include changes or delays in defense appropriations, continuing resolutions or government shutdowns, bid protests, contract cancellations or modifications, DCAA audits and potential cost disallowances, cybersecurity incidents, competition, debt leverage and integration of acquisitions.
The company is disputing approximately $8.0 million relating to the closing working-capital adjustment from the sale of its Public Safety & Security Solutions business. It also reported an approximately $11.2 million dispute with an international US-segment customer concerning unbilled receivables and contractual flight requirements.
The FTT minority holders have annual put rights beginning in January 2024, generally based on 12 times trailing-twelve-month EBITDA; the multiple may increase to 14 times following specified events. Management estimated the related redemption amount at approximately $15.0 million as of March 31, 2019, although the actual amount may differ.
The company reported compliance with the covenants governing its senior notes and revolving credit facility, no credit-facility default and no material changes to previously disclosed risk factors. Management concluded that disclosure controls and procedures were effective as of March 31, 2019.
Important Facts for Investors to Verify
- Confirm the final purchase-price allocation, operating contribution and integration performance of FTT, including the provisional $29.3 million goodwill and $19.8 million acquired intangible assets.
- Monitor conversion of the $620.2 million backlog, particularly the $539.5 million funded portion and the timing of future government appropriations.
- Assess cash conversion and working-capital requirements, including the 136-day DSO and the $11.2 million international customer receivables dispute.
- Evaluate product-margin pressure, US-segment profitability and the effect of product mix on consolidated gross margin.
- Track liquidity relative to the $300.0 million senior notes, planned $15 million to $18 million of 2019 capital expenditures and acquisition-related deferred consideration.
- Follow resolution of the approximately $8.0 million PSS working-capital dispute and collection of remaining legacy-project proceeds.
- Review potential tax effects from uncertain tax positions, NOL limitations, the IRS examination and the FTT-related valuation-allowance release.