Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. is a national security technology contractor serving U.S. government, foreign government, commercial and public safety customers. Its principal offerings include C5ISR, electronic warfare, radar and missile systems, satellite communications, unmanned systems, cybersecurity, weapons training and critical infrastructure security.
This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2012. The 2012 nine-month period comprised 40 weeks versus 39 weeks in the comparable 2011 period. The company operated through Kratos Government Solutions (KGS) and Public Safety & Security (PSS).
Financial Highlights
| Metric | Q3 2012 | Q3 2011 | 9M 2012 | 9M 2011 |
|---|---|---|---|---|
| Total revenue | $276.3 million | $206.6 million | $705.6 million | $500.5 million |
| Gross profit | $74.1 million | $59.0 million | $189.2 million | $131.8 million |
| Gross margin | 26.8% | 28.6% | 26.8% | 26.3% |
| Operating income | $14.1 million | $9.7 million | $30.6 million | $19.8 million |
| Operating margin | 5.1% | 4.7% | 4.3% | 4.0% |
| Net loss | $4.2 million | $6.9 million | $24.4 million | $15.6 million |
| Net loss per share | $0.07 | $0.22 | $0.56 | $0.62 |
Q3 revenue increased 33.7%, led by KGS revenue growth of 28.3% and PSS growth of 63.0%. Nine-month revenue increased 41.0%, with KGS revenue of $568.2 million and PSS revenue of $137.4 million. U.S. Government revenue represented 59% of Q3 revenue and 63% of nine-month revenue.
Interest expense was $17.6 million in Q3 and $49.9 million for nine months, compared with $15.0 million and $34.8 million, respectively, in the prior-year periods. SG&A increased to $54.5 million in Q3 and $140.9 million for nine months, primarily due to acquired businesses. Research and development expense increased to $4.5 million in Q3 and $12.9 million for nine months.
Cash Flow, Balance Sheet, Debt and Liquidity
- Cash provided by operating activities from continuing operations was $35.1 million for the nine months ended September 30, 2012, compared with $12.6 million in the prior-year period.
- Investing cash usage was $160.9 million, including $149.4 million for acquisitions and $12.0 million of capital expenditures.
- Financing activities provided $91.6 million, including $97.0 million of net equity proceeds and $40.0 million of revolver borrowings, partly offset by $40.8 million of debt repayments.
- Cash and cash equivalents declined to $37.6 million from $69.6 million at December 25, 2011. Restricted cash was $5.6 million.
- Accounts receivable increased to $281.4 million and inventoried costs increased to $99.9 million, contributing to working-capital needs.
- Outstanding 10% Senior Secured Notes due 2017 had principal of $625.0 million. Total debt, including the debt premium and other obligations as described by management, was reported at approximately $651.7 million.
- The $110.0 million revolving credit facility had no outstanding borrowings, $13.0 million of letters of credit and $88.9 million of net borrowing-base availability at September 30, 2012. The company reported compliance with its debt covenants.
- Management believes cash on hand, operating cash flow and revolver availability will fund anticipated needs for at least the next 12 months.
Material Changes Versus the Prior Comparable Period
- Revenue growth was driven substantially by acquisitions, including CEI, Integral, Herley, SecureInfo and the Critical Infrastructure Business, along with organic growth in selected programs.
- Q3 gross margin declined to 26.8% from 28.6%, principally because of lower service margins and the mix of the acquired Critical Infrastructure Business. Nine-month gross margin improved modestly because of stronger product margins from CEI, Integral and Herley.
- Legacy government service businesses experienced weakness, increased competition and continued U.S. Government employee insourcing. Timing of orders and shipments also reduced revenue in certain ground equipment and weapons-sustainment businesses.
- Interest expense increased materially because of debt issued to fund the Herley and Integral acquisitions.
- Common shares outstanding increased from 32.4 million at December 25, 2011 to approximately 56.6 million at September 30, 2012, primarily reflecting the May 2012 issuance of 20.0 million shares and 4.0 million shares issued for the CEI acquisition.
- Goodwill increased to $678.5 million from $571.6 million, primarily from acquisitions. Intangible assets increased to $132.2 million.
Guidance, Outlook, Risks and Unusual Items
The filing does not provide formal quantitative revenue or earnings guidance. Management expects defense, intelligence and homeland security modernization and maintenance to remain national priorities, but cautions that the Budget Control Act, sequestration and continuing-resolution funding may delay or reduce procurement. The company reported backlog of approximately $1.3 billion at September 30, 2012, including $692.0 million of funded backlog, but notes that contracts may be delayed, modified or terminated by the U.S. Government.
- In July 2012, Kratos acquired Composite Engineering, Inc. for approximately $163.5 million, including $135.0 million of cash and 4.0 million shares. CEI contributed $34.7 million of Q3 revenue and $1.7 million of operating income.
- Businesses associated with antennas, satellite-based products and fly-away terminals were classified as held for sale. A $1.5 million goodwill impairment charge was recorded in the second quarter of 2012, and discontinued operations generated a nine-month loss of $2.6 million.
- The KGS reporting unit exceeded carrying value by only 7.4% in the impairment analysis. Management stated that adverse market conditions or further defense-industry deterioration could result in future goodwill impairment.
- Purchase price allocations for CEI, SecureInfo and the Critical Infrastructure Business remained provisional and could change, including for intangible assets, inventory, property and equipment, contingent liabilities and deferred taxes.
- Potential future DEI contingent consideration was described as ranging from $1.0 million to $4.0 million in the notes, while the MD&A presents a range of $2.0 million to $4.5 million; the filing attributes possible reductions to uncollected cash receipts. This discrepancy should be reconciled.
- The company has assumed indemnification obligations related to former Integral officers in an SEC-related civil action; insurance limits were exhausted and the company was advancing eligible costs. Trial was scheduled for December 2012.
- Federal NOL utilization is limited following ownership changes, including the May 2012 equity issuance. Future equity offerings or acquisitions could further restrict tax attributes.
- Additional risks include high leverage, customer concentration, contract-estimate changes, acquisition integration, cybersecurity incidents, natural disasters, foreign exchange exposure and potential government budget reductions.
Important Facts for Investors to Verify
- Reconcile the differing DEI contingent-consideration ranges disclosed in the notes and MD&A.
- Assess whether the 7.4% KGS goodwill valuation cushion remains adequate given sequestration and defense-budget uncertainty.
- Evaluate cash conversion, including the growth in accounts receivable and inventoried costs relative to operating cash flow.
- Review the sustainability of margins after integration of the Critical Infrastructure Business and the effect of lower-margin service revenue.
- Confirm debt covenant compliance, revolver borrowing-base availability and the company’s ability to service 10% senior secured notes due 2017.
- Determine the final purchase accounting for CEI and other recent acquisitions and any resulting impact on goodwill, intangible assets, taxes or earnings.
- Monitor the disposition of discontinued businesses and the outcome and costs of the Integral-related litigation.