Kratos Defense & Security Solutions, Inc. — 2019 Q2 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, missile defense, training systems, cybersecurity and related national-security programs. The filing covers the 13-week quarter and six months ended June 30, 2019, compared with July 1, 2018. The company operates through Kratos Government Solutions (KGS) and Unmanned Systems (US).
Key financial metrics
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Total revenue | $187.9 million | $151.2 million | $348.3 million | $294.2 million |
| Gross profit | $48.1 million | $39.3 million | $93.0 million | $80.1 million |
| Gross margin | 25.6% | 26.0% | 26.7% | 27.2% |
| Operating income from continuing operations | $9.0 million | $2.6 million | $17.2 million | $9.6 million |
| Net income attributable to Kratos | $3.9 million | $(7.7) million | $7.0 million | $(9.9) million |
| Diluted earnings per share | $0.04 | $(0.07) | $0.06 | $(0.10) |
| Operating cash flow from continuing operations | Not separately provided for the quarter | Not separately provided | $20.0 million | $1.4 million |
Q2 service revenue increased 56.8% to $73.7 million, while product sales increased 9.6% to $114.2 million. KGS revenue rose 25.8% to $145.4 million, and US revenue rose 19.4% to $42.5 million. U.S. Government sales represented 71% of total Q2 revenue and 72% of six-month revenue.
At June 30, 2019, cash and cash equivalents were $176.2 million, versus $182.7 million at December 30, 2018. Total assets were $1.174 billion and total liabilities were $598.7 million. Long-term debt had a $300.0 million principal balance and a $294.6 million carrying value. The company had no revolver borrowings, $5.7 million of outstanding letters of credit and $64.8 million of net borrowing-base availability.
Material changes versus the prior comparable period
- Revenue growth was driven by the February 2019 acquisition of Florida Turbine Technologies (FTT), higher activity in training, satellite communications, modular systems and ballistic-missile targets, and increased US aerial-target production.
- FTT contributed $17.2 million of revenue and $1.6 million of operating income in Q2, and $21.4 million of revenue and $1.7 million of operating income for the six months.
- Gross margin declined because product margins fell to 21.9% in Q2 from 24.5% and to 23.3% for the six months from 26.4%, primarily due to product mix. Service margins improved.
- SG&A increased in dollars but declined as a percentage of revenue to 17.9% in Q2 from 19.9%, and to 18.7% for the six months from 20.4%, reflecting operating leverage and prior cost reductions.
- Operating income improved despite $0.6 million of Q2 and $1.8 million of six-month merger and acquisition expenses. Prior-year restructuring expense included a $2.3 million litigation settlement and related legal costs.
- Cash flow from continuing operations increased to $20.0 million from $1.4 million, but investing cash use was $27.4 million, including $17.6 million for acquisitions and $9.8 million of capital expenditures.
- Backlog increased to $620.3 million from $501.9 million at the prior comparable date; funded backlog was $545.4 million versus $451.9 million.
Guidance, outlook, commentary and risks
Management expects to recognize approximately 41% of remaining performance obligations in 2019, an additional 34% by 2020 and the balance thereafter. Expected 2019 capital expenditures are approximately $15 million to $18 million, including investments in aerial targets, manufacturing capacity and secured facilities. Management stated that cash on hand, operating cash flow and available credit should fund anticipated needs for at least the next 12 months.
The filing does not provide formal revenue or earnings guidance. Management noted uncertainty surrounding defense appropriations, continuing resolutions, government shutdowns, debt-ceiling issues, program delays or cancellations, bid protests, contract performance, subcontractor and supplier execution, competition, cybersecurity and the growth of unmanned-systems markets.
The PSS divestiture remains subject to a dispute with the buyer over an approximately $8 million closing working-capital adjustment. Discontinued operations included a $3.6 million gain from releasing an indemnification liability, partially offset by legacy-project and legal costs. The company expects approximately $70 million of aggregate net cash proceeds from the transaction before the final working-capital settlement, but the ultimate proceeds remain uncertain.
Other matters requiring attention include an approximately $11.2 million dispute with an international US-segment customer over unbilled receivables, ongoing DCAA audits and potential government cost claims for which the company has not recorded a liability, and the redeemable minority interest associated with FTT. Beginning in 2024, FTT minority holders may exercise annual put rights based on a 12-times trailing EBITDA valuation; certain events could increase the multiple to 14 times.
Important facts for investors to verify
- Whether revenue growth and backlog conversion continue after the FTT acquisition contribution annualizes.
- Whether product margins recover from the Q2 decline and whether US-segment execution improves.
- The resolution and cash impact of the PSS working-capital dispute.
- The collectability and timing of the disputed $11.2 million international unbilled receivable.
- Progress and final cost of planned 2019 capital investments.
- Compliance with the 6.5% senior secured notes and revolving-credit covenants as cash needs and working capital fluctuate.
- Outcomes of DCAA audits, tax examinations and other legal or regulatory contingencies.
- Future defense appropriations, continuing-resolution exposure and potential government shutdown effects.