KRATOS DEFENSE & SECURITY SOLUTIONS, INC. annual report, FY2016

Kratos Defense & Security Solutions, Inc. — FY2016 Form 10-K Summary

Reporting period: Fiscal year ended December 25, 2016, with 52 weeks. The filing was signed February 27, 2017. The provided filing includes unaudited fourth-quarter data but is an annual 10-K rather than a standalone quarterly filing.

Business context

Kratos is a mid-tier defense and security contractor focused on unmanned systems, satellite communications, microwave electronics, cyber security and warfare, missile defense, combat systems, training, and public safety and security. It operates through three reportable segments: Kratos Government Solutions (KGS), Unmanned Systems (US), and Public Safety & Security (PSS).

Approximately 60% of FY2016 revenue came from U.S. Government customers, including Foreign Military Sales.
Foreign customers contributed approximately $80.1 million, or 12% of revenue.
Approximately 83% of revenue came from fixed-price contracts, 12% from cost-plus-fee contracts, and 5% from time-and-materials contracts.
Total backlog was approximately $899.7 million, including $626.1 million of funded backlog, versus $913.8 million and $528.7 million, respectively, at the prior year-end.

Financial performance and key metrics

Metric	FY2016	FY2015	Change
Revenue	$668.7 million	$657.1 million	1.8% increase
Gross profit	$153.6 million	$161.8 million	5.1% decrease
Gross margin	23.0%	24.6%	Down 160 basis points
Operating income (loss)	$(18.6) million	$(4.5) million	Loss widened
Loss from continuing operations	$(60.4) million	$(33.2) million	Loss widened
Net income (loss)	$(60.5) million	$19.8 million	Prior year included disposal gain
Basic and diluted loss per share	$(0.99)	$0.34	Declined
Operating cash flow from continuing operations	$(12.4) million	$(29.7) million	Use of cash reduced
Capital expenditures	$9.2 million	$11.3 million	Decreased

Revenue growth reflected higher KGS revenue of $465.8 million, up 4.4%, and US revenue of $75.8 million, up 14.3%, partly offset by a 12.2% decline in PSS revenue to $127.1 million. Product sales increased 5.8% to $320.6 million, while service revenue decreased 1.7% to $348.1 million.

Year-end cash and cash equivalents were $69.1 million, compared with $28.5 million in FY2015. Working capital was $176.6 million, total assets were $948.6 million, and stockholders’ equity was $276.4 million. Accounts receivable, net, increased to $229.4 million from $206.8 million.

Debt and liquidity

Total debt, including discounts and issuance costs, was $432.0 million at year-end, compared with $445.1 million in FY2015.
Principal debt consisted primarily of $435.5 million of 7.00% Senior Secured Notes due May 15, 2019, plus other debt.
The Company repurchased and extinguished approximately $14.5 million of Notes during FY2016, generating a net gain of $0.2 million.
The $110.0 million revolving credit facility had no borrowings outstanding, $11.1 million of letters of credit outstanding, and reported net borrowing base availability of $56.0 million.
Management stated that available cash, operating cash flow, equity-offering proceeds, and credit-facility availability were expected to fund requirements for at least the next 12 months.
Contractual commitments totaled $720.8 million, including $437.3 million of debt principal, $76.3 million of estimated debt interest, $139.7 million of purchase orders, and $67.5 million of operating leases.

Material changes versus FY2015

Revenue increased modestly, but gross profit and operating results deteriorated because of unfavorable product mix and unusual contract and restructuring charges.
US segment operating loss increased to $27.7 million from $16.2 million, primarily because of an $18.7 million loss accrual on the Air Force Research Laboratory Low-Cost Attritable Strike UAS Demonstration cost-share contract.
PSS revenue declined as the Company emphasized smaller, higher-margin projects and selectively pursued larger security-integration projects. The segment also recorded approximately $4.1 million of unexpected cost growth and a $1.9 million contract-dispute settlement charge.
KGS included a $9.2 million charge related to the closure of a manufacturing facility, exit from lower-margin product lines, and related restructuring.
Product gross margin declined to 19.1% from 24.5%, while service gross margin improved to 26.5% from 24.8%.
SG&A declined to $146.3 million from $150.7 million, and internal research and development expense declined to $13.9 million from $16.2 million.
The Company completed a public offering of approximately 13.4 million shares at $6.00 per share, receiving $76.2 million of net proceeds. Approximately $14.1 million was used for debt repurchase and $5.1 million for a satellite signal monitoring and intelligence technology investment.
FY2015 net income benefited from an $80.8 million pretax gain on the sale of the Herley Entities. FY2016 had no comparable disposal gain.

Fourth-quarter and unusual items

FY2016 fourth-quarter revenue was $182.1 million, gross profit was $46.6 million, operating income was $4.6 million, loss from continuing operations was $4.4 million, and net loss was $4.3 million. Fourth-quarter results included a $1.4 million restructuring charge related to the modular systems facility closure.

The Company recorded an $18.7 million LCASD loss accrual, $10.1 million of unused-office-space and restructuring expense for the year, and $1.9 million related to a PSS contract-dispute settlement. Contract-loss accruals included in accrued expenses totaled $17.7 million at year-end, compared with $3.5 million at the prior year-end.

Outlook, management commentary, and risks

Management planned continued investment in unmanned systems, satellite communications, microwave electronics, cyber security, training systems, autonomy, artificial intelligence, robotics, directed energy, hypersonic systems, and related national-security technologies. The Company expects to use its backlog, customer relationships, proprietary technology, and designed-in positions to support future growth and believes corporate infrastructure can be leveraged as revenue expands.

Management did not provide a clear quantitative revenue, earnings, or cash-flow guidance range in the provided filing.
Key risks include U.S. Government budget reductions, continuing resolutions, sequestration, delayed appropriations, bid protests, contract cancellations, and government termination rights.
Fixed-price contracts create exposure to cost overruns, schedule delays, supplier failures, and inaccurate estimates of costs to complete.
High leverage and the 2019 Notes maturity create refinancing and debt-service risk. Debt agreements impose financial and operational covenants.
Goodwill was $485.4 million, approximately 51% of total assets, and impairment testing depended on assumptions regarding future revenue, unmanned-system program success, international expansion, discount rates, and government funding.
DCAA audits and other government reviews could result in cost disallowances, billing-rate reductions, refunds, penalties, or contract restrictions. The Company had submitted incurred-cost claims through 2015, while audits for later periods remained unresolved.
Cybersecurity, classified-program compliance, export controls, facility security clearances, environmental matters, litigation, supplier concentration, and the ability to recruit cleared technical personnel remain material operating risks.
The Company paid $1.9 million to 5-D Systems during FY2016 for engineering services. A senior Unmanned Systems executive owned 33.3% of that supplier; future transactions were to be reviewed by the Audit Committee and board.

Most important facts for investors to verify

Whether the $18.7 million LCASD accrual fully captures expected contract costs and whether additional losses or cash requirements arise.
Whether US segment programs, including high-performance unmanned systems and the Sub-Sonic Aerial Target, achieve expected technical milestones, follow-on awards, and production opportunities.
Whether funded backlog converts to revenue on schedule and whether unfunded backlog is appropriated, authorized, canceled, or modified.
Whether the Company can refinance or repay the $435.5 million Notes due in 2019 without materially adverse dilution or financing terms.
Whether operating cash flow turns positive after interest expense, working-capital investment, research and development, and capital expenditures.
Whether goodwill and long-lived assets remain recoverable if defense budgets, contract awards, market multiples, or operating forecasts weaken.
Whether DCAA audits, tax contingencies, litigation, environmental indemnities, or other government-contract matters create liabilities beyond recorded amounts.
Whether the equity offering and strategic investments generate sufficient growth to offset dilution and the Company’s continuing net losses.