Kratos Defense & Security Solutions, Inc. — Q3 2014 Form 10-Q Summary
Business context and reporting period
Kratos is a specialized security-technology contractor serving primarily U.S. national-security agencies. Its products and services include C5ISR, electronic warfare, radar, missile defense, unmanned systems, cybersecurity, satellite communications, weapons-system training, range operations, and public-safety security solutions.
The unaudited filing covers the 13-week quarter and 39-week year-to-date period ended September 28, 2014, compared with the periods ended September 29, 2013. Reportable segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS). Approximately 64% of third-quarter 2014 revenue and 59% of nine-month revenue came from the U.S. Government.
Key financial metrics
| Metric | Q3 2014 | Q3 2013 | 9M 2014 | 9M 2013 |
|---|---|---|---|---|
| Total revenue | $217.1 million | $226.4 million | $646.5 million | $714.9 million |
| Gross profit | $53.0 million | $52.3 million | $162.0 million | $178.5 million |
| Gross margin | 24.4% | 23.1% | 25.1% | 25.0% |
| Operating income | $1.2 million | $6.1 million | $9.2 million | $26.4 million |
| Net loss | $10.9 million | $9.9 million | $75.8 million | $29.8 million |
| Loss per share | $0.19 | $0.17 | $1.32 | $0.52 |
| Operating cash flow from continuing operations | Not provided quarterly | Not provided quarterly | $(18.2) million | $11.0 million |
- Q3 service revenue declined 10.8% to $97.1 million, while product sales increased 2.0% to $120.0 million.
- Q3 SG&A was $45.8 million, down from $47.8 million; research and development increased to $5.9 million from $4.8 million.
- Interest expense declined to $12.1 million in Q3 from $16.2 million. Nine-month interest expense was $42.2 million.
- Nine-month results included a $39.1 million loss on extinguishment of debt associated with the refinancing of the 10% Senior Secured Notes.
- Cash and cash equivalents were $16.2 million at September 28, 2014, down from $55.7 million at December 29, 2013. Total current assets were $376.7 million and current liabilities were $227.2 million.
- Accounts receivable were $255.1 million, inventoried costs were $80.4 million, and days sales outstanding increased from 103 days to 107 days.
- Total assets were $1.146 billion and stockholders’ equity was $231.0 million, down from $295.8 million at year-end 2013.
Debt and liquidity
- In May 2014, Kratos issued $625.0 million of 7.00% Senior Secured Notes due 2019 and used the proceeds, a $41.0 million revolving-credit draw, and cash to retire its $625.0 million 10% Senior Secured Notes due 2017.
- Total debt, including applicable debt obligations, increased from approximately $644.7 million at December 29, 2013 to $664.0 million at September 28, 2014, while the refinancing reduced the stated coupon and extended maturity.
- The new revolving credit facility has a maximum commitment of $110.0 million, potentially expandable to $135.0 million. At quarter-end, $41.0 million was drawn, $12.4 million was outstanding under letters of credit, and reported net borrowing-base availability was $43.3 million.
- Management stated that cash on hand, available credit, and expected operating cash flow should fund anticipated working-capital and other needs for at least the next 12 months. The company was in compliance with its debt covenants at September 28, 2014.
Material changes versus the prior comparable period
- Nine-month revenue decreased 9.6% to $646.5 million, primarily because of lower KGS revenue, delayed government awards, competitor protests, reduced defense-product shipments, completion of satellite-communications production programs, weakness in legacy government services, and lower aerial-target shipments.
- Q3 KGS revenue was essentially flat at $174.3 million, but PSS revenue fell 17.4% to $42.8 million because security-installation projects were completed or winding down and new awards were delayed.
- KGS operating income declined to $17.6 million for nine months from $23.8 million, while PSS shifted to a $0.1 million operating loss from $5.7 million of operating income.
- Gross margin improved modestly, reflecting favorable product mix and higher KGS margins, but PSS margins deteriorated because of project costs and an unfavorable revenue mix.
- Nine-month operating cash flow changed from $11.0 million provided to $18.2 million used, primarily because of lower operating income and working-capital investment in certain combatant-hardened-facility product lines.
- Backlog remained approximately $1.0 billion at both comparison dates; funded backlog declined from $543.0 million in 2013 to $533.0 million in 2014.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide a formal quantitative revenue or earnings forecast. Management described the defense outlook as somewhat improved following budget legislation, but continued to expect lower or delayed awards, greater competition, and increased protest activity. A fiscal 2015 continuing resolution funded the government through December 11, 2014, creating potential funding and timing uncertainty.
- Two PSS projects were completed or near completion. Kratos had submitted or was preparing change orders for customer-requested work but had not recorded the potential value of those claims in revenue.
- Q3 gross margins included $3.2 million of increased costs related to retrofit matters and a contract-conversion adjustment. Comparable 2013 product margins included approximately $5.4 million of aerial-target retrofit costs.
- The company recorded a $39.1 million debt-extinguishment loss, $1.7 million of restructuring and unused-office-space expense for nine months, and increased internal research and development spending.
- The Department of Justice was investigating whether a subsidiary overstated labor and material costs on a pre-acquisition Department of Defense contract. The company had accrued an amount it considered immaterial, but stated that an unfavorable resolution could materially affect cash flows or results.
- Key risks include federal budget reductions, contract delays or cancellations, government termination rights, competitor protests, customer concentration, debt leverage, covenant compliance, acquisition integration, cybersecurity incidents, litigation, and contract-estimate changes under percentage-of-completion accounting.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether government appropriations, continuing resolutions, protests, and delayed awards continue to pressure revenue and funded backlog.
- The pace of conversion of approximately $1.0 billion of backlog into revenue and cash, including the distinction between funded and unfunded backlog.
- Whether working-capital requirements and rising days sales outstanding improve sufficiently to restore positive operating cash flow.
- Available revolving-credit capacity, borrowing-base calculations, letters of credit, and ongoing compliance with the 7% Notes and credit-facility covenants.
- The ultimate exposure from Department of Justice and DCAA investigations, other contract disputes, warranties, and customer change-order claims.
- Whether PSS project losses and KGS contract-cost adjustments are isolated or indicate broader margin pressure.
- The effect of the registered exchange of all outstanding 7% Notes completed on October 16, 2014, and the continuing cash interest burden.