Kratos Defense & Security Solutions, Inc. — Q1 2012 Form 10-Q Summary
Business context and reporting period
Kratos provides national-security technology, engineering, manufacturing, systems integration, cybersecurity, electronic warfare, satellite communications, unmanned systems, missile-defense, training, and public-safety solutions. The company operates through Kratos Government Solutions (KGS) and Public Safety & Security (PSS).
The filing covers the unaudited 13-week quarter ended March 25, 2012, compared with the 13-week quarter ended March 27, 2011. Results include significant contributions from the acquisitions of Herley, Integral Systems, SecureInfo, and the Critical Infrastructure Business.
Financial performance and liquidity
| Metric | Q1 2011 | Q1 2012 | Change |
|---|---|---|---|
| Total revenue | $122.8 million | $215.0 million | +75.1% |
| Gross profit | $27.4 million | $57.9 million | +111.3% |
| Gross margin | 22.3% | 26.9% | +460 bps |
| Operating income | $1.4 million | $8.2 million | + $6.8 million |
| Operating margin | 1.1% | 3.8% | +270 bps |
| Loss from continuing operations | $(3.8) million | $(3.2) million | Improved |
| Net loss | $(3.5) million | $(3.0) million | Improved |
| Net loss per share | $(0.17) | $(0.09) | Improved |
| Operating cash flow from continuing operations | $(3.2) million | $29.5 million | Improved by $32.7 million |
- KGS revenue increased from $97.4 million to $174.4 million, while PSS revenue increased from $25.4 million to $40.6 million.
- Product sales increased to $109.8 million from $43.0 million; product margin rose to 31.4% from 18.4%. Service revenue increased to $105.2 million, but service margin declined to 22.2% from 24.4%.
- SG&A increased to $45.0 million from $19.6 million, primarily due to acquired businesses; SG&A as a percentage of revenue increased to 20.9% from 16.0%.
- Interest expense increased to $16.1 million from $6.7 million due primarily to debt issued to finance the Herley and Integral acquisitions.
- Cash and cash equivalents were $74.8 million at March 25, 2012, compared with $69.8 million at December 25, 2011.
- Total assets were $1.237 billion and stockholders’ equity was $310.7 million at quarter-end. Accounts receivable were $259.6 million and inventoried costs were $87.4 million.
- Capital expenditures were $2.7 million. Investing cash outflows were $23.8 million, including $20.0 million for the Critical Infrastructure Business and $1.5 million of contingent acquisition consideration.
Debt and liquidity
- The company had $625.0 million principal amount of 10% Senior Secured Notes due 2017 outstanding, plus a $6.5 million Israeli term loan. Total debt including the unamortized note premium was approximately $654.5 million according to management’s discussion.
- The $90.0 million revolving credit facility had no borrowings and $16.4 million of outstanding letters of credit, resulting in $73.6 million of net availability.
- Management stated that cash on hand, operating cash flow, and available revolver capacity should be sufficient to meet anticipated cash needs for at least the next 12 months.
- The company reported compliance with the note, revolver, and Israeli term-loan covenants as of March 25, 2012.
Material changes and unusual items
- Revenue growth was driven primarily by acquisitions, including $100.5 million of combined KGS revenue from SecureInfo, Integral, and Herley, and $13.8 million of revenue from the acquired Critical Infrastructure Business.
- Gross-margin expansion reflected the higher-margin product businesses acquired with Integral and Herley. PSS margin declined because of business mix and integration-related cost-reduction actions that were not yet fully implemented.
- Merger and acquisition expenses declined to $0.9 million from $5.8 million.
- Depreciation and amortization increased to $13.7 million from $4.8 million, including $10.5 million of intangible-asset amortization.
- The company recorded a $4.2 million income-tax benefit on a $7.4 million pretax loss from continuing operations. The company maintains a full valuation allowance against most deferred tax assets.
- The Critical Infrastructure Business purchase price remained subject to a working-capital adjustment. Kratos reported a deficiency against the required $17.0 million working-capital level, but no adjustment had been recorded because the seller had not yet objected or reached agreement.
- Acquisition-related purchase-price allocations for several transactions remained provisional and could change, including allocations for intangible assets, inventory, property and equipment, deferred taxes, and goodwill.
Backlog, outlook, commentary, and risks
- Total backlog increased to approximately $1.1 billion from approximately $800 million year over year; approximately $500 million was funded in 2012 compared with $400 million in 2011. Backlog may be delayed, reduced, or canceled, and unfunded backlog depends on future appropriations.
- Management expects modernization, maintenance, cybersecurity, unmanned systems, ballistic missile defense, space, and science-and-technology programs to remain national-security priorities. The filing does not provide formal quantitative revenue or earnings guidance.
- The Budget Control Act and potential sequestration could materially reduce defense and non-defense spending beginning in 2013, potentially affecting contract awards, funding, and customer demand.
- Approximately 67% of Q1 2012 revenue came from the U.S. Government, compared with 77% in Q1 2011, creating exposure to federal budget decisions, appropriations, contract delays, cancellations, and customer insourcing.
- Key risks include substantial leverage and interest expense, covenant compliance, acquisition integration, contract-estimate changes under percentage-of-completion accounting, competition and margin pressure, cybersecurity incidents, litigation and indemnification obligations related to former Integral officers, and collectability of receivables.
- Management stated that it was not aware of legal proceedings expected to have a material adverse effect and reported effective disclosure controls with no material changes in internal control over financial reporting.
Important facts for investors to verify
- Whether acquisition-driven revenue growth translates into sustainable organic growth and improved consolidated margins.
- The working-capital adjustment and final purchase-price allocation for the Critical Infrastructure Business and other recent acquisitions.
- Cash conversion, receivables growth, inventory requirements, and the sustainability of the $29.5 million quarterly operating cash inflow.
- Debt-service capacity, future interest expense, covenant headroom, and the company’s ability to refinance or reduce the $625.0 million note principal due in 2017.
- The effects of sequestration, appropriations changes, contract timing, customer insourcing, and potential reductions in defense spending.
- Whether the $1.1 billion backlog is funded, executable, and realizable on the timing assumed by management.
- Potential contingent acquisition payments, indemnification costs, tax-position changes, and other legal or contractual liabilities.