KRATOS DEFENSE & SECURITY SOLUTIONS, INC. annual report, FY2017

Business Context and Reporting Period

Kratos Defense & Security Solutions, Inc. is a technology-focused defense contractor serving the U.S. Department of Defense, allied governments, intelligence agencies, public-sector customers and commercial customers. Its principal areas include unmanned systems, satellite communications, microwave electronics, cybersecurity, missile defense, training systems and public safety/security.

This Form 10-K covers the 53-week fiscal year ended December 31, 2017, with comparisons to the 52-week fiscal years ended December 25, 2016 and December 27, 2015. The company operated through three reportable segments: Kratos Government Solutions (KGS), Unmanned Systems (US), and Public Safety & Security (PSS).

Key Financial Metrics

Metric	2017	2016	Change
Revenue	$751.9 million	$668.7 million	+12.4%
Gross profit	$197.3 million	$153.6 million	+28.5%
Gross margin	26.2%	23.0%	+320 bps
Operating income (loss)	$(5.8) million	$(18.6) million	Improved $12.8 million
Net income (loss)	$(42.7) million	$(60.5) million	Improved $17.8 million
Loss per diluted share	$(0.48)	$(0.99)	Improved $0.51
Cash used in operating activities	$(27.0) million	$(12.4) million	Use increased $14.6 million
Capital expenditures	$26.5 million	$9.2 million	+188.0%
Cash and equivalents	$129.6 million	$69.1 million	+$60.5 million
Total debt, net of issuance costs	$294.3 million	$432.0 million	-$137.7 million

Product sales increased 26.5% to $405.5 million and represented 53.9% of revenue, compared with 47.9% in 2016. Service revenue decreased 0.5% to $346.4 million. Selling, general and administrative expense was $160.6 million, or 21.4% of revenue, and internally funded research and development increased to $17.8 million, or 2.4% of revenue.

KGS revenue: $480.3 million, up 3.1%; operating income was $1.7 million versus $17.3 million.
US revenue: $121.7 million, up 60.6%; operating loss narrowed to $3.0 million from $27.7 million.
PSS revenue: $149.9 million, up 17.9%; operating income was $3.8 million versus a $3.0 million loss.
Customer concentration: U.S. Government revenue was $452.8 million, or 60% of total revenue. No individual contract represented more than 5% of revenue.
Contract mix: approximately 88% fixed-price, 8% cost-plus-fee and 4% time-and-materials.
Backlog: approximately $730.4 million at December 31, 2017, including $531.1 million funded, versus total backlog of $899.7 million and funded backlog of $626.1 million at the prior year-end.

Material Changes Versus the Prior Comparable Period

Revenue growth was led by unmanned combat and aerial target systems, including the start of low-rate initial production for the Navy’s SSAT/177 program, higher KGS product shipments and increased PSS security-system integration work.
Gross margin improved because of product mix, US production ramp-up, cost reductions and the absence of the $18.7 million LCASD cost-share loss accrual recorded in 2016.
The company recorded a $24.2 million non-cash goodwill impairment charge in the fourth quarter related to the DRSS reporting unit. Management attributed the impairment to commoditization and increased price competition in legacy government services, including losses on two sizable contract opportunities.
The company recorded a $17.3 million loss on extinguishment of debt, including a $15.2 million charge in the fourth quarter, as it redeemed the remaining 7% Senior Secured Notes.
In November 2017, the company issued $300.0 million of 6.5% Senior Secured Notes due 2025 and used the proceeds, together with equity-offering proceeds and cash, to retire the remaining 7% Notes.
The company sold approximately 28.0 million common shares in 2017 for net proceeds of approximately $269.1 million. Shares outstanding increased to 103.3 million at year-end from 73.9 million.
Operating cash flow remained negative, primarily because of working-capital requirements, increased receivables, internally funded development and interest payments. Days sales outstanding increased to 121 days from 115 days.

Fourth-Quarter Results

Fourth-quarter 2017 revenue was $202.2 million, compared with $182.1 million in the fourth quarter of 2016. Gross profit was $56.7 million versus $46.6 million. Operating loss was $13.2 million, compared with operating income of $4.6 million, reflecting the goodwill impairment and debt-extinguishment charge. Net loss was $22.2 million, or $0.21 per diluted share, compared with a $4.3 million loss, or $0.07 per diluted share, in the prior-year quarter.

Liquidity, Debt and Commitments

Cash and cash equivalents were $129.6 million, including $10.7 million held by foreign subsidiaries. Working capital was $282.4 million.
The amended revolving credit facility has a $90.0 million commitment, with no borrowings outstanding and $9.5 million of letters of credit outstanding at year-end. Net borrowing-base availability was $65.8 million.
Total principal debt was approximately $300.8 million, consisting primarily of the $300.0 million 6.5% Notes due November 2025 and $0.8 million of other term debt. The company reported compliance with applicable debt covenants and no credit-facility default.
Contractual commitments totaled $722.8 million, including $300.8 million of debt, $156.0 million of estimated interest, $138.2 million of purchase orders and $127.8 million of operating leases.
Management stated that cash on hand, expected operating cash flow and available revolver capacity should fund anticipated working-capital and capital requirements for at least the next 12 months, while noting that additional capital could be required to support large future tactical-drone production awards.

Guidance, Outlook, Commentary and Risks

The filing does not provide formal revenue, earnings or margin guidance. Management expects to continue investing in proprietary technology and intellectual property, particularly unmanned systems, satellite communications, microwave electronics, cybersecurity and training systems. The company expects opportunities to improve operating margins by leveraging corporate infrastructure, increasing product production and pursuing operational efficiencies.

The February 2018 Bipartisan Budget Act increased projected defense spending and raised the near-term defense funding outlook. However, management cautioned that continuing resolutions, government shutdowns, debt-ceiling debates, program cancellations, stop-work orders, delayed payments and changing defense priorities could affect awards and contract execution.

Dependence on the U.S. Government, which represented 60% of 2017 revenue, exposes the company to appropriations, procurement delays, bid protests, contract terminations and budget changes.
High fixed-price contract exposure creates risk from cost overruns, supplier performance, technical problems and inaccurate estimates of costs to complete.
Goodwill totaled $461.2 million, or approximately 45% of total assets, and further impairment remains possible if forecasts, contract awards or market conditions deteriorate.
The company faces substantial leverage, interest obligations, covenant restrictions and potential refinancing risk despite the 2017 debt reduction.
Cybersecurity incidents, classified-information requirements, export controls, government audits, DCAA cost claims, environmental matters and litigation could adversely affect results.
Revenue recognition depends significantly on percentage-of-completion estimates and contract-cost assumptions. The adoption of the new revenue standard on January 1, 2018 was expected to increase revenue and operating income by less than $2 million each on a cumulative basis.
On February 28, 2018, the company announced an agreement to sell the PSS business for approximately $69 million in cash, with estimated net proceeds of approximately $70 million. The transaction was subject to customary closing and regulatory conditions, and PSS was expected to be presented as discontinued operations in future filings.

Most Important Facts for Investors to Verify

Whether unmanned-systems awards, including SSAT/177, tactical drone and UCAS programs, convert into sustained production revenue and positive segment cash flow.
Whether the lower backlog balance, particularly the decline in funded backlog, translates into slower revenue or delivery timing.
Whether the company can maintain positive operating cash flow while funding receivables, inventory, capital expenditures and internal development.
The final accounting and cash impact of the PSS divestiture, including working-capital adjustments, transaction costs and the recasting of prior periods.
Compliance with the 6.5% Notes and revolving-credit covenants, available liquidity and the ability to refinance or repay the $300.0 million maturity in 2025.
Potential additional goodwill or intangible-asset impairment, especially in DRSS and the US reporting unit.
Outcomes of DCAA and other government audits, including any disallowed costs, refunds, penalties or effects on contract eligibility.
The finalization of provisional accounting for the 2017 Tax Act and the company’s ability to utilize federal and state net operating loss carryforwards.

Audit and Controls

Deloitte & Touche LLP issued an unqualified opinion on the consolidated financial statements and internal control over financial reporting. Management reported that disclosure controls and internal control over financial reporting were effective as of December 31, 2017, with no unresolved staff comments.