Kratos Defense & Security Solutions, Inc. — Q3 2016 Form 10-Q
Reporting period: Unaudited 13-week quarter and nine months ended September 25, 2016, compared with September 27, 2015. Kratos is a mid-tier defense contractor serving the U.S. Department of Defense, national security agencies, and commercial and government customers through Kratos Government Solutions, Unmanned Systems, and Public Safety & Security.
Key Financial Metrics
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Total revenue | $165.4 million | $161.7 million | $486.6 million | $479.6 million |
| Gross profit | $25.9 million | $40.4 million | $107.0 million | $119.6 million |
| Gross margin | 15.7% | 25.0% | 22.0% | 24.9% |
| Operating income (loss), continuing operations | $(13.0) million | $1.6 million | $(23.2) million | $(6.0) million |
| Net income (loss) | $(23.6) million | $55.1 million | $(56.2) million | $23.8 million |
| Diluted loss per share | $(0.39) | $0.92 | $(0.94) | $0.40 |
| Operating cash flow from continuing operations | Not provided for quarter | Not provided for quarter | $(8.7) million | $(23.4) million |
- Q3 revenue increased 2.3%, while nine-month revenue increased 1.5%. Product sales grew 5.2% in Q3 and 5.8% year to date; service revenue was essentially flat in Q3 and declined 2.1% year to date.
- Q3 product gross margin fell to 4.3% from 24.8%; nine-month product margin fell to 16.8% from 25.3%. The primary driver was an $18.7 million loss accrual on the LCASD cost-share contract.
- SG&A was $35.5 million in Q3 and $109.6 million for nine months, compared with $34.9 million and $112.6 million, respectively. R&D was $3.2 million in Q3 and $10.1 million year to date.
- Cash and cash equivalents were $20.5 million at September 25, 2016, down from $28.5 million at December 27, 2015. Total assets were $875.9 million and stockholders’ equity was $204.1 million.
- Total debt carrying value was $446.0 million, including $450.0 million principal outstanding on the 7.00% Senior Secured Notes due 2019 and approximately $2.0 million on an Israeli term loan. No revolver borrowings were outstanding.
- The $110.0 million revolving credit facility had $11.2 million of letters of credit outstanding and reported net borrowing-base availability of $44.8 million. The Company stated that it was in compliance with debt covenants and had no event of default.
Material Changes Versus the Prior Comparable Period
- Kratos Government Solutions revenue increased 3.8% in Q3 and 5.6% for nine months, supported by satellite communications, microwave products, ballistic missile targets, and training.
- Public Safety & Security revenue increased 3.6% in Q3 but declined 10.6% year to date as the Company wound down certain security installation projects and focused on smaller, higher-margin work.
- Unmanned Systems revenue declined 8.0% in Q3 and was flat year to date. Its operating loss widened to $20.4 million in Q3 and $27.6 million for nine months, primarily because of the LCASD contract loss accrual.
- Nine-month unused office, restructuring, and other expenses rose to $10.5 million from $1.3 million, including a $7.8 million charge for a facility closure and exit from lower-margin product lines and a $1.9 million litigation settlement charge.
- The prior-year periods included a $80.3 million gain on the sale of the Herley entities, producing $50.8 million and $50.0 million of discontinued-operations income in Q3 and nine months of 2015, respectively. The 2016 periods had no comparable gain.
- Backlog declined to approximately $900.9 million from $960.7 million, although funded backlog increased to $582.4 million from $551.5 million.
Guidance, Outlook, Risks, and Unusual Items
- No formal numerical revenue or earnings guidance is provided in the filing. Management stated that cash on hand, available revolver capacity, and expected operating cash flow should fund anticipated needs for at least the next 12 months.
- Under a $40.8 million LCASD cost-share award, the government is providing $7.3 million and Kratos expects to invest approximately $33.5 million over 30 months. Approximately $14.2 million of the investment is expected to be capitalized, while $26.0 million is estimated as non-capitalizable contract cost. The Company recorded an $18.7 million provision for contract loss and had a remaining accrual of $16.6 million at quarter-end. Estimates may change as the work progresses.
- Management expects capital expenditures to increase over the next 24 to 30 months, including approximately $14.2 million related to LCASD air vehicles, tooling, and launch equipment.
- Days sales outstanding increased to 114 days from 106 days at year-end, reflecting delayed billing milestones, advanced billings, and delays in government funding and payments.
- Key risks include reductions or delays in federal and DoD spending, contract cancellations or scope changes, bid protests, customer concentration, contract losses and cost overruns, debt leverage, cybersecurity incidents, litigation, regulatory and DCAA audits, and competition.
- U.S. Government revenue represented approximately 58% of Q3 revenue and 60% of nine-month revenue. The Company also disclosed continuing indemnification obligations related to the Herley sale, including up to $34.0 million for specified pre-existing environmental conditions, although management does not expect payment.
- Management concluded that disclosure controls and procedures were effective as of September 25, 2016, and reported no material change in internal control over financial reporting.
Investor Verification Checklist
- Verify the updated total expected cost, remaining accrual, capitalization, and ultimate profitability of the LCASD contract.
- Assess whether the $900.9 million backlog, including $582.4 million funded backlog, converts to revenue at the expected timing and margin.
- Monitor cash burn, accounts receivable collection, the 114-day DSO, and availability under the revolving credit facility.
- Review the maturity, refinancing requirements, covenants, and market value of the $450.0 million Senior Secured Notes due 2019.
- Evaluate the effect of the PSS strategic shift, facility closures, restructuring actions, and litigation settlement on recurring margins.
- Track DCAA and other government contract audits, tax matters, and remaining Herley-related indemnification exposure.