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Aug. 4, 2022, 4:27 p.m. EDT

10-Q: KRATOS DEFENSE & SECURITY SOLUTIONS, INC.

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(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

This Quarterly Report on Form 10-Q (this "Quarterly Report") contains "forward-looking statements" relating to our future financial performance, the market for our services and our expansion plans and opportunities. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," or "continue," the negative of such terms or other comparable terminology. These forward-looking statements reflect our current beliefs, expectations and projections, are based on assumptions, and are subject to known and unknown risks and uncertainties that could cause our actual results or achievements to differ materially from any future results or achievements expressed in or implied by our forward-looking statements. Many of these factors are beyond our ability to control or predict. As a result, you should not place undue reliance on forward-looking statements. Important risks and uncertainties that could cause our actual results or achievements to differ materially from the results or achievements reflected in our forward-looking statements include, but are not limited to: changes or cutbacks in spending or the appropriation of funding by the Federal Government, including the DoD, which could cause delays, cancellations or reductions of key government contracts; bid protests; changes in the scope or timing of our projects; the timing, rescheduling or cancellation of significant customer contracts and agreements; failure by our subcontractors or suppliers to perform their contractual obligations; our failure to meet performance obligations; if the unmanned systems markets do not experience significant growth, or it the products we have developed or will develop do not become programs of record; if we cannot expand our customer base or if our products do not achieve broad acceptance which could impact our ability to achieve our anticipated level of growth; consolidation by or the loss of key customers; risks of adverse regulatory action or litigation; risks associated with debt leverage; failure to successfully achieve our acquisition, integration, cost reduction or divestiture strategies; risks related to security breaches, cybersecurity attacks or other significant disruptions of our information systems; risks related to the new DoD CMMC requirement recently issued by the Pentagon; risks associated with pandemics, epidemics or other public health emergencies, such as the outbreak of coronavirus disease 2019 (" COVID-19"); risks related to unknown defects or errors in our products; and competition in the marketplace, which could reduce revenues and profit margins, as well as the additional risks and uncertainties described in this Quarterly Report on Form 10-Q, in "Item 1A-Risk Factors" of our Annual Report on Form 10-K for the fiscal year ended December 26, 2021 filed with the U.S. Securities and Exchange Commission (the "SEC") on February 22, 2022 (the "Form 10-K"), and in other reports that we have filed with the SEC. These forward-looking statements reflect our views and assumptions only as of the date such forward-looking statements are made. Except as required by law, we assume no responsibility for updating any forward-looking statements, whether as a result of new information, future events or otherwise.

All references to "us," "we," "our," the "Company" and "Kratos" refer to Kratos Defense & Security Solutions, Inc., a Delaware corporation, and its subsidiaries.

Overview

Kratos is a government contractor at the forefront of the DoD's recapitalization of strategic weapon systems to address peer and near peer threats and the DoD's related Rapid Innovation Initiatives. Kratos is a leading technology, intellectual property, proprietary product and system company focused on the U.S. and its allies' national security. Kratos is a recognized industry leader in the rapid development, demonstration and fielding of disruptive, transformative and high technology systems and products at an affordable cost. At Kratos, affordability is a technology. Kratos' primary focus areas are unmanned systems, space and satellite communications, microwave electronics, cybersecurity/warfare, rocket, hypersonic and missile defense systems, turbine technologies, and Command, Control, Communication, Computing, Combat, Intelligence Surveillance and Reconnaissance ("C5ISR") Systems and training systems. We believe that our technology, intellectual property, proprietary products and designed-in positions on our customers' programs, platforms and systems, and our ability to rapidly develop, demonstrate and field affordable leading technology systems gives us a competitive advantage and creates a high barrier to entry into our markets. Our workforce is primarily engineering and technically oriented with a significant number of employees holding national security clearances. Much of our work is performed at customer locations, or in a secure manufacturing facility. Our primary end customers are national security related agencies. Our entire organization is focused on executing our strategy of being the leading technology and intellectual property based product and system company in our industry.

Industry Update

On March 15, 2022, President Biden signed into law the Fiscal Year 2022 National Security Budget of $782 billion, a 5.6% increase over the previous year. On March 28, 2022, the Biden administration submitted to Congress a proposed fiscal year 2023 Budget Request of $813.3 Billion for National Security (the "Budget Request"), $773 million of which is for the Department of Defense, a 4% increase above the FY 2022 enacted amount. On May 21, 2022, the President signed the Additional Ukraine Supplemental Appropriations Act, 2022, providing an additional $40 billion to support Ukraine.This included $6 billion in security assistance, $9 billion to replenish U.S. stocks, and $4 billion for foreign military financing.

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We believe continued budget pressures, Continuing Resolution Authorizations ("CRAs"), Federal Government debt ceiling issues, or Federal Government shutdowns would have serious negative consequences for the security of our country, the defense industrial base, including the Company and the customers, employees, suppliers, investors, and communities that rely on companies in the defense industrial base. It is likely budget and program decisions made in such an uncertain environment would have long-term implications for our Company and the entire defense industry.

Additionally, funding for certain programs in which we currently participate may be reduced, delayed or cancelled, and budget uncertainty or funding cuts globally could adversely affect the viability of our partners, teammates, subcontractors and suppliers, and our employee base. While we believe that our business is well-positioned in areas that the DoD and other customers indicate are priorities for future defense spending, including in the Budget Request, the short and long-term impact of federal budgetary uncertainty, CRAs, the Budget Control Act of 2011 or similar budgetary restrictions or limitations, other defense spending cuts, including the budget impacts of COVID-19 and the conflict in Ukraine, challenges in the appropriations process, the debt ceiling and the ongoing fiscal debates remain uncertain. Such a challenging federal and DoD budgetary environment may negatively impact our business and programs and could have a material adverse effect on our forecasts, estimates, financial position, results of operations and/or cash flows.

The nature of our operations exposes us to risks associated with pandemics, epidemics or other public health emergencies, including the COVID-19 pandemic. We are a company operating in a "critical infrastructure industry", as defined by the U.S. Department of Homeland Security. Consistent with federal guidelines and with state and local orders to date, we have continued to operate, including our international operations. Notwithstanding our continued operations, COVID-19 has had and is currently expected to continue to have negative impacts on certain of our operations, workforce, supply chain, vendors, transportation networks and customers, which have reduced certain of our sales and our margins, including as a result of preventative and precautionary measures that we, our suppliers, other businesses and governments are taking. The COVID-19 outbreak is a widespread public health crisis that is adversely affecting the economies and financial markets globally. Any resulting economic downturn could adversely affect demand for our products. The progression of COVID-19 could also negatively impact our business or results of operations through the temporary closure of our operating locations or those of our customers or suppliers.

The ability of our employees, our suppliers' and our customers' employees to work may be significantly impacted by individuals contracting or being exposed to COVID-19, or as a result of the control measures noted above, which may significantly hamper our production and operations, including throughout the supply chain. On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act, a $2 trillion economic relief bill, was signed into law. Subsequently, on March 11, 2021, the American Rescue Plan Act, a $1.9 trillion economic stimulus bill was enacted.

COVID-19 continues to impact our business in 2022, primarily driven by the emergence of the Omicron variant in late 2021 with a resulting increase in COVID-19 cases in early 2022. COVID-19 has continued to impact our customers, markets and operations, including supply chain disruptions, delays of certain supplier deliveries, difficulties gaining access to certain locations, difficulties gaining access to customers, including instances related to previously scheduled drone and rocket system flights, demonstrations and exercises, and decreased demand requirements of certain of our commercial aero, power and satcom customers. Additionally, customer and contractor-related travel and social distancing restrictions have delayed a number of our target drone, tactical drone and rocket system programs, missions and exercises, and has delayed delivery and execution on certain of our international commercial satcom projects. Despite progress in vaccination efforts, global economic activity remains uncertain and cannot be predicted with confidence. Public health officials and medical professionals have warned that COVID-19 cases may continue to spike due to the Delta, Omicron and other variants. The extent to which COVID-19 may further impact our business depends on future developments, which are highly uncertain and unpredictable, including new information concerning the severity of the outbreak and the effectiveness of actions globally to contain or mitigate its effects.

While we currently do not expect COVID-19 to have a material impact on our results of operations, cash flows and financial position, the current level of uncertainty over the economic, business and operational impacts of COVID-19, including the impact on employee absenteeism, vendor and supply chain and other resources, means the related financial impact cannot be reasonably estimated at this time. Our Condensed Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations reflect estimates and assumptions made by management as of June 26, 2022. Events and changes in circumstances arising after June 26, 2022, including those resulting from the continuing impacts of COVID-19, will be reflected in management's estimates for future periods.

In addition to the challenges that COVID-19 is presenting to the industry and Kratos, significant adverse supply chain disruptions continue throughout the industry and for the Company, including delays in the receipt and delivery of materials,

Reportable Segments

The Company currently operates in two reportable segments. The KGS reportable segment is comprised of an aggregation of KGS operating segments, including our microwave electronic products, space and satellite communications, training and cybersecurity, C5ISR/modular systems, turbine technologies, and defense and rocket support services operating segments. The US reportable segment consists of our unmanned aerial, unmanned ground, unmanned seaborne and command, control and communications system businesses.

We organize our business segments based primarily on the nature of the products, solutions and services offered. Transactions between segments are negotiated and accounted for under terms and conditions similar to other government and commercial contracts, and these intercompany transactions are eliminated in consolidation. For additional information regarding our reportable segments, see Note 11 of the accompanying Condensed Consolidated Financial Statements. From a customer and solutions perspective, we view our business as an integrated whole, leveraging skills and assets wherever possible.







        Comparison of Results for the Three Months Ended June 26, 2022 to the Three
        Months Ended June 27, 2021
        Revenues.  Revenues by operating segment for the three months ended June 26,
        2022 and June 27, 2021 are as follows (dollars in millions):
                                             June 26, 2022       June 27, 2021       $ change       % change
        Kratos Government Solutions
        Service revenues                    $         77.2      $         56.7      $    20.5         36.2  %
        Product sales                                 90.6                88.1            2.5          2.8  %
        Total Kratos Government Solutions            167.8               144.8           23.0         15.9  %
        Unmanned Systems
        Service revenues                    $          1.6      $          1.3      $     0.3         23.1  %
        Product sales                                 54.8                59.0           (4.2)        (7.1) %
        Total Unmanned Systems                        56.4                60.3           (3.9)        (6.5) %
        Total revenues                      $        224.2      $        205.1      $    19.1          9.3  %
        Total service revenues              $         78.8      $         58.0      $    20.8         35.9  %
        Total product sales                          145.4               147.1           (1.7)        (1.2) %
        Total revenues                      $        224.2      $        205.1      $    19.1          9.3  %
        


Revenues increased $19.1 million to $224.2 million for the three months ended June 26, 2022 from $205.1 million for the three months ended June 27, 2021. Revenues in our KGS segment increased $23.0 million primarily due to the contribution of $21.5 million in revenues from the recent acquisitions of Cosmic, CTT and SRE, and an increase of $6.0 million in our space, satellite and cyber businesses and increases of $6.2 million in our C5ISR, defense rocket support and turbine engine businesses, offset partially by a reduction of $8.6 million in our training solutions business and $2.1 million in our microwave products business due primarily to supply chain disruptions. Revenues in our US segment decreased $3.9 million to $56.4 million for the three months ended June 26, 2022, primarily due to a reduction in tactical drone programs as a result of timing of program contract awards as compared to the three months ended June 27, 2021.

Product sales decreased $1.7 million to $145.4 million for the three months ended June 26, 2022 from $147.1 million for the three months ended June 27, 2021, primarily as a result of decreased production in our US segment, offset partially by increases in our KGS segment. As a percentage of total revenue, product sales were 64.9% for the three months ended June 26, Table of Contents

Cost of Revenues. Cost of revenues increased $13.3 million to $166.4 million for the three months ended June 26, 2022 from $153.1 million for the three months ended June 27, 2021. The increase in cost of revenues was primarily a result of the increase in revenues.

Gross Margin. Gross margin increased to 25.8% for the three months ended June 26, 2022 from 25.4% for the three months ended June 27, 2021. Margins on services decreased to 28.7% for the three months ended June 26, 2022 from 28.8% for the three months ended June 27, 2021. Margins on products increased to 24.2% for the three months ended June 26, 2022 from 24.0% for the three months end June 27, 2021. Margins in the KGS segment increased to 27.8% for the three months ended June 26, 2022 from 27.2% for the three months ended June 27, 2021, primarily due to a more favorable mix of revenues. Margins in the US segment decreased to 19.7% for the three months ended June 26, 2022 from 20.9% for the three months ended June 27, 2021, primarily due to a less favorable mix of products produced and shipped in the three months ended June 26, 2022.

Selling, General and Administrative ("SG&A") Expenses. SG&A expense increased $6.3 million to $44.5 million for the three months ended June 26, 2022 from $38.2 million for the three months ended June 27, 2021. As a percentage of revenues, SG&A increased to 19.8% at June 26, 2022 from 18.6% at June 27, 2021. Included in SG&A was the impact of the recent CTT, Cosmic and SRE acquisitions and an increase of $0.9 million in the US segment related to increased headcount.

Research and Development ("R&D") Expenses. R&D expenses decreased $1.0 million to $9.2 million for the three months ended June 26, 2022 from $10.2 million for the three months ended June 27, 2021, primarily due to increased development efforts in our Unmanned Systems business of $1.3 million offset by decreases in our KGS segment. As a percentage of revenues, R&D decreased to 4.1% for the three months ended June 26, 2022 from 5.0% for the three months ended June 27, 2021. R&D expenses are made by the Company, typically in conjunction with our customers, for the Company to achieve a "first to market" position with our products or technology. We also invest in R&D expenses to achieve market leading "designed in" positions on major programs, platforms or systems.

Restructuring Expenses and Other. Restructuring expenses and other increased to $5.9 million from $0.2 million for the three months ended June 26, 2022 and June 27, 2021, respectively, primarily as a result of a $5.5 million litigation settlement charge related to the resolution of a dispute with an international customer in our US segment.

Total Other Expense, Net. Total other expense, net decreased to $2.9 million from $5.7 million for the three months ended June 26, 2022 and June 27, 2021, respectively. The decrease in expense of $2.8 million was primarily related to a reduction in interest expense as a result of our debt refinancing in February of 2022.

Provision (Benefit) for Income Taxes from Continuing Operations. The income tax expense from continuing operations for the three months ended June 26, 2022 was $0.5 million and the income tax benefit from continuing operations for the three months ended June 27, 2021 was $3.6 million. For the three months ended June 26, 2022, the Company has utilized the discrete effective tax rate method. The discrete method is applied when it is not possible to reliably estimate our full year effective tax rate due to significant permanent differences in relation to pre-tax book income, resulting in significant variability to our effective tax rate. For the three months ended June 27, 2021, the income tax expense was a function of the estimated effective tax rate for the year. The estimated effective tax rate is driven by estimated foreign taxes, estimated federal and state taxes, permanent book/tax differences, and the projected income or loss for the year.

Income (Loss) from Discontinued Operations. The income from discontinued operations was $0.9 million for the three months ended June 26, 2022, and includes a $0.9 million gain as a result of the release of an indemnification liability following the lapse of the statute of limitations associated with a potential tax liability that was recorded in 2019 as part of the sale of PSS. The loss from discontinued operations was $0.3 million for the three months ended June 27, 2021.

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Revenues. Revenues by operating segment for the six months ended June 26, 2022 and June 27, 2021 are as follows (dollars in millions):







                                              June 26, 2022       June 27, 2021       $ change       % change
        Kratos Government Solutions
        Service revenues                     $        144.0      $        112.8      $    31.2         27.7  %
        Product sales                                 167.4               170.3           (2.9)        (1.7) %
         Total Kratos Government Solutions            311.4               283.1           28.3         10.0  %
        Unmanned Systems
        Service revenues                     $          2.7                 2.5            0.2          8.0  %
        Product sales                                 106.3               113.7           (7.4)        (6.5) %
        Total Unmanned Systems                        109.0               116.2           (7.2)        (6.2) %
        Total revenues                       $        420.4      $        399.3      $    21.1          5.3  %
        Total service revenues               $        146.7      $        115.3      $    31.4         27.2  %
        Total product sales                           273.7               284.0          (10.3)        (3.6) %
        Total revenues                       $        420.4      $        399.3      $    21.1          5.3  %
        


Revenues increased $21.1 million to $420.4 million for the six months ended June 26, 2022 from $399.3 million for the six months ended June 27, 2021. Revenues in our KGS segment increased $28.3 million, primarily due to the contribution of $36.2 million in revenues from the recent Cosmic, CTT and SRE acquisitions, increased revenues in our space and satellite business of $7.3 million, increases in our rocket support and turbine technologies businesses of $3.8 million, partially offset by an $15.8 million reduction in our training solutions business and a $3.1 million reduction in our microwave products and C5ISR businesses, resulting primarily from supply chain disruptions. Revenues in our US segment decreased $7.2 million to $109.0 million for the six months ended June 26, 2022 primarily due to a reduction in tactical drone based revenues, including as a result of timing of program contract awards, as compared to the six months ended June 27, 2021.

Product sales decreased $10.3 million to $273.7 million for the six months ended June 26, 2022 from $284.0 million for the six months ended June 27, 2021, primarily as a result of decreased production activity in our US segment and reductions in our training product solutions business. As a percentage of total revenue, product sales were 65.1% for the six months ended June 26, 2022 as compared to 71.1% for the six months ended June 27, 2021. Service revenues increased by $31.4 million to $146.7 million for the six months ended June 26, 2022 from $115.3 million for the six months ended June 27, 2021. The increase was primarily a result of the recent Cosmic and SRE acquisitions.

Cost of Revenues. Cost of revenues increased $14.4 million to $310.7 million for the six months ended June 26, 2022 from $296.3 million for the six months ended June 27, 2021. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.

Gross margin increased to 26.1% for the six months ended June 26, 2022 from 25.8% for the six months ended June 27, 2021. Margins on services increased to 27.7% for the six months ended June 26, 2022 from 27.3% for the six months ended June 27, 2021. Margins on product sales remained the same at 25.2% for the six months ended June 26, 2022 and June 27, 2021. Margins in the KGS segment increased to 28.2% for the six months ended June 26, 2022 from 27.7% for the six months ended June 27, 2021. Margins in the US segment decreased to 20.1% for the six months ended June 26, 2022, from 21.2% for the six months ended June 27, 2021, primarily due to a less favorable mix of products produced and shipped during the six months ended June 26, 2022.

SG&A Expenses. SG&A expenses were $87.8 million for the six months ended June 26, 2022 and $76.1 million for the six months ended June 27, 2021. As a percentage of revenues, SG&A increased to 20.9% at June 26, 2022, from 19.1% at June 27, 2021. Included in SG&A, was an increase of $0.5 million of stock compensation expense from $12.8 million for the six months ended June 27, 2021 to $13.3 million for the six months ended June 26, 2022 as well as increased SG&A expenses related to the recent acquisitions of CTT, Cosmic and SRE.

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Restructuring Expenses and Other. Restructuring expenses and other increased to $6.2 million for the six months ended June 26, 2022 from $0.2 million for the six months ended June 27, 2021, primarily as a result of the $5.5 million litigation charge related to the settlement of a dispute with an international customer in our US segment.

Total Other Expense, Net. Total other expense, net, increased to $21.7 million from $11.4 million for the six months ended June 26, 2022 and June 27, 2021, respectively. The increase in expense of $10.3 million was primarily related to the $13.0 million loss on the extinguishment of our Senior Secured Notes which was partially offset by a reduction in interest expense of $3.0 million as a result of the reduced rate on our new debt. . . .

Aug 04, 2022

COMTEX_411611016/2041/2022-08-04T16:27:06

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