KRATOS DEFENSE & SECURITY SOLUTIONS, INC. 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 theU.S. Department of Defense (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 24
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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 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; or 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 integration, cost reduction or divestiture strategies; risks related to security breaches, cybersecurity attacks or other significant disruptions of our information systems; risks associated with pandemics, epidemics or other public health emergencies, such as the recent 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, in "Item 1A-Risk Factors" of our Annual Report on Form 10-K for the fiscal year endedDecember 29, 2019 filed with theU.S. Securities and Exchange Commission (the "SEC") onFebruary 24, 2020 (the "Form 10-K"), and in other reports that we have filed with theSEC . 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
Overview
Kratos is a government contractor at the forefront of theDoD's recapitalization of strategic weapon systems to address peer and near peer threats and its related Rapid Innovation Initiatives. Kratos is a leading technology, intellectual property, proprietary product and system company focused on theU.S. and its allies' national security. Kratos is a recognized industry leader in the rapid development, demonstration and fielding of high technology systems and products at an affordable cost. Kratos' primary focus areas are unmanned systems, space and satellite communications, microwave electronics, cyber security/warfare, training systems, rocket systems and missile defense, turbine technologies, and C5ISR. 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 Kratos 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 becoming the leading technology and intellectual property based product and system company in our industry.
Industry Update
OnDecember 18, 2019 ,President Trump signed two 2020 spending bills totaling$1.4 trillion . The bills allocate$738 billion to National Defense and$632 billion to non-defense agencies, representing increases over fiscal 2019 of$22 billion and$27 billion , respectively. The National Defense Authorization Act grants a base budget of approximately$666.5 billion (including the establishment of a new, sixth armed service for space) and an additional$71.5 billion for overseas contingency operations funding, a.k.a. the war budget. The federal budget and debt ceiling are expected to continue to be the subject of considerable debate, which could have a significant impact on defense spending broadly and the Company's programs in particular. The overall Federal Government budget environment, including budget caps mandated by the Budget Control Act of 2011 ("BCA") for fiscal years 2020 and 2021, and uncertainty surrounding the debt ceiling and the appropriations process, remain significant short and long-term risks. Considerable uncertainty exists regarding how future federal budget and program decisions will unfold, including the defense spending priorities of the current Trump or potential future Administration(s) andCongress and what challenges budget reductions (required by the BCA and otherwise) could present for the defense industry. If annual appropriations bills are not timely enacted for theU.S. Government's fiscal year 2021 or future years, theU.S. Government may again operate under a Continuing Resolution Authorization ("CRA"), restricting new contract or program starts and restricting planned increases on existing production contracts, presenting resource allocation challenges and placing limitations on future planned program budgets, and we may also face another government shutdown of unknown duration. If a prolonged CRA or government shutdown of theDoD were to occur, either could result in program cancellations, disruptions and/or stop work orders and could limit theU.S. Government's ability to effectively progress programs and to make timely payments, and could also impact our ability to perform on ourU.S. Government contracts and successfully compete for new work. 25
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We believe continued budget pressures 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 cuts globally could adversely affect the viability of our subcontractors and suppliers, and our employee base. While we believe that our business is well-positioned in areas that theDoD and other customers have indicated are priorities for future defense spending, the short and long-term impact of federal budgetary uncertainty, CRAs, the BCA, other defense spending cuts, challenges in the appropriations process, the debt ceiling and the ongoing fiscal debates remain uncertain. Such a challenging federal andDoD budgetary environment may negatively impact our business and programs and could have a material adverse effect on our financial position, results of operations and/or cash flows. The nature of our operations expose us to risks associated with pandemics, epidemics or other public health emergencies, such as the recent outbreak of coronavirus disease 2019 (COVID-19) which has spread fromChina to many other countries across the globe, includingthe United States . InMarch 2020 , theWorld Health Organization categorized COVID-19 as a pandemic, and the President ofthe United States declared the COVID-19 outbreak a national emergency. The outbreak has resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, "shelter in place" and "stay at home" orders, travel restrictions, business curtailments, school closures, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19. We are a company operating in a critical infrastructure industry, as defined by theU.S. Department of Homeland Security . Consistent with federal guidelines and with state and local orders to date, we currently continue to operate. Notwithstanding our continued operations, COVID-19 has begun to have and may have further negative impacts on our operations, supply chain, transportation networks and customers, which may compress our sales and our margins, including as a result of preventative and precautionary measures that we, 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 of many countries. Any resulting economic downturn could adversely affect demand for our products. The progression of this matter 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 and our suppliers' and 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, including throughout the supply chain. OnMarch 27, 2020 , the President ofthe United States signed and enacted into law the CARES Act, a$2 trillion economic relief bill. We are evaluating the impact of the CARES Act including related stimulus and economic relief actions on our business. Since the end of our first quarter, COVID-19 has continued to impact our markets and operations, including supply chain disruptions, delays of certain supplier deliveries, difficulties gaining access to certain locations, difficulties gaining access to customers related to previously scheduled demonstrations and exercises, and decreased demand requirements of certain of our commercial aero and power customers. 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 this matter to have a material impact on our results of operations, cash flows and financial position, the current level of uncertainty over the economic and operational impacts of COVID-19 means the related financial impact cannot be reasonably estimated at this time. Our consolidated financial statements and discussion and analysis of financial condition and results of operations reflect estimates and assumptions made by management as ofMarch 29, 2020 . Events and changes in circumstances arising afterMarch 29, 2020 , including those resulting from the impacts of COVID-19, will be reflected in management's estimates for future periods.
Reportable Segments
The Company operates in two reportable segments. The Kratos Government Solutions
("KGS") reportable segment is comprised of an aggregation of KGS operating
segments, including our microwave electronic products, space, training, and
cybersecurity, modular systems, rocket systems and missile defense, and turbine
technologies operating segments. The
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Unmanned Systems ("US") reportable segment consists of our unmanned aerial system and unmanned ground and seaborne 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
Revenues. Revenues by operating segment for the three months ended
March 29, 2020 March 31, 2019 $ change % change
Kratos Government Solutions
Service revenues $ 63.6 $ 62.6 $ 1.0 1.6 %
Product sales 63.3 62.9 0.4 0.6 %
Total Kratos Government Solutions 126.9 125.5 1.4 1.1 %
Unmanned Systems product sales 42.0 34.9 7.1 20.3 %
Total revenues $ 168.9 $ 160.4 Total service revenues $ 63.6 $ 62.6$ 1.0 1.6 % Total product sales 105.3 97.8 7.5 7.7 % Total revenues $ 168.9 $ 160.4$ 8.5 5.3 % Revenues increased$8.5 million to$168.9 million for the three months endedMarch 29, 2020 from$160.4 million for the three months endedMarch 31, 2019 . Revenues in our KGS segment increased$1.4 million due to the acquisition of FTT, which contributed approximately$9.8 million of additional revenue in the first quarter of 2020 compared to the first quarter of 2019, and increases in our microwave products, rocket system and cyber businesses with aggregate increased revenue of$4.3 million , partially offset by reductions in our training solutions business primarily as a result of the completion of a large foreign material sales contract, reduced revenues in our satellite communications business as a result of the transition to a software-based solution, and the continued contraction of our legacy government services business, which resulted in aggregate reductions of$13.4 million . Revenues in our US segment increased primarily due to new aerial target awards from theU.S. Army and work on new tactical drone development awards. Product sales increased$7.5 million to$105.3 million for the three months endedMarch 29, 2020 from$97.8 million for the three months endedMarch 31, 2019 primarily due to increased production in our US business and our microwave products business partially offset by reductions in our space and satellite business. As a percentage of total revenue, product sales were 62.3% for the three months endedMarch 29, 2020 as compared to 61.0% for the three months endedMarch 31, 2019 . Service revenues increased by$1.0 million to$63.6 million for the three months endedMarch 29, 2020 from$62.6 million for the three months endedMarch 31, 2019 . The increase was primarily related to work performed in our recently acquired FTT business. Cost of Revenues. Cost of revenues increased$7.6 million to$123.1 million for the three months endedMarch 29, 2020 from$115.5 million for the three months endedMarch 31, 2019 . The increase in cost of revenues was primarily a result of the increase in revenues discussed above. Gross margin decreased to 27.1% for the three months endedMarch 29, 2020 from 28.0% for the three months endedMarch 31, 2019 . Margins on services decreased to 28.9% for the three months endedMarch 29, 2020 from 32.9% for the three months endedMarch 31, 2019 , due primarily to a less favorable mix of revenues, primarily in our Space, Training & Cyber business and our recently acquired FTT business. Margins on products increased to 26.0% for the three months endedMarch 29, 2020 from 24.8% for the three months endedMarch 31, 2019 , primarily due to the mix of products produced. Margins in the KGS segment decreased slightly to 30.1% for the three months endedMarch 29, 2020 from 30.3% for the three months endedMarch 31, 2019 . Margins in the US segment decreased to 18.1% for the three months endedMarch 29, 2020 27
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from 19.8% for the three months endedMarch 31, 2019 , primarily due to a less favorable mix of products being produced as well as a less favorable mix of revenues reflecting an increase in lower margin development programs during the three months endedMarch 29, 2020 . Selling, General and Administrative ("SG&A") Expenses. SG&A expense was$34.9 million for the three months endedMarch 29, 2020 and$31.5 million for the three months endedMarch 31, 2019 . As a percentage of revenues, SG&A increased to 20.7% atMarch 29, 2020 from 19.6% atMarch 31, 2019 , due primarily to an increase in stock compensation expense of$2.1 million and an increase in depreciation and amortization expense of$0.6 million in the three months endedMarch 29, 2020 compared to the three months endedMarch 31, 2019 . Research and Development ("R&D") Expenses. R&D expenses increased$1.8 million to$5.7 million for the three months endedMarch 29, 2020 from$3.9 million for the three months endedMarch 31, 2019 , with the primary increases in our space and satellite communications business. As a percentage of revenues, R&D increased to 3.4% for the three months endedMarch 29, 2020 from 2.4% for the three months endedMarch 31, 2019 . R&D expenditures are primarily related to investments we are making in conjunction with our customers, with the objectives of our products being the new platform for or "designed-in" to certain new long-term program opportunities and our ownership of certain intellectual property rights for products that support these programs as well as investments we are making in our space and satellite communications business related to new software based and open space platforms and technologies. Restructuring Expenses and Other. The expense of$0.1 million for the three months endedMarch 29, 2020 was primarily due to employee termination costs related to personnel reduction actions taken in the first quarter of 2020. The expense of$0.1 million for the three months endedMarch 31, 2019 was primarily due to employee termination costs related to personnel reduction actions taken in the first quarter of 2019. Total Other Expense, Net. Total other expense, net decreased to$5.9 million from$6.0 million for the three months endedMarch 29, 2020 andMarch 31, 2019 , respectively. Benefit for Income Taxes from Continuing Operations. The income tax benefit from continuing operations for the three months endedMarch 29, 2020 andMarch 31, 2019 was$1.4 million and$1.5 million , respectively. For the three months endedMarch 29, 2020 the benefit was primarily related to the acquisition of TDI. In accordance with ASC Topic 805 Business Combinations ("ASC Topic 805"), we established deferred tax liabilities of approximately$0.9 million for the increase in the financial statement basis of the acquired assets of TDI. As a result of our ability to recognize deferred tax assets for these deferred tax liabilities, we released valuation allowance against our deferred tax assets and recognized an income tax benefit of$0.9 million . The additional$0.5 million benefit 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, tax amortization of intangible assets that have an indefinite life under GAAP and the projected income or loss for the year. The benefit for the three months endedMarch 31, 2019 was primarily related to the acquisition of FTT. In accordance with ASC Topic 805, we established deferred tax liabilities of approximately$4.4 million for the increase in the financial statement basis of the acquired assets of FTT. As a result of our ability to recognize deferred tax assets for these deferred tax liabilities, we released the valuation allowance against our deferred tax assets and recognized an income tax benefit of$3.4 million . This benefit was partially offset by current federal, foreign and state taxes of$0.3 million and uncertain tax position liabilities of$1.6 million . Loss from Discontinued Operations. The loss from discontinued operations was$0.4 million for the three months endedMarch 29, 2020 , primarily reflecting the work performed in relation to outstanding tasks on legacy projects retained by us following the sale of the PSS business. The loss from discontinued operations was$0.6 million for the three months endedMarch 31, 2019 . Backlog OnMarch 29, 2020 , we had approximately$646.8 million of total backlog, of which$549.8 million was funded. We expect to recognize approximately 54% of the remaining total backlog as revenue in 2020, an additional 22% by 2021 and the balance thereafter. Our comparable total backlog balance as ofMarch 31, 2019 , was approximately$620.2 million of which$539.5 million was funded. 28
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Total backlog is our estimate of the amount of revenue expected to be realized over the remaining life of awarded contracts and task orders that we have in hand as of the measurement date. Total backlog can include award fees, incentive fees, or other variable consideration estimated based on the most likely amount we expect to be entitled to receive, to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur. Total backlog can include both funded and unfunded future revenue under government contracts. Total backlog does not include orders for which neither party has performed and which each party has the unilateral right to terminate a wholly unperformed contract without compensating the other party. As such, total backlog generally does not include options for additional performance obligations which have not been executed unless they are considered a material right of the base agreement/contract. For indefinite delivery or indefinite quantity contracts, only awarded or funded task orders are included for backlog purposes. We define funded backlog as estimated future revenue under government contracts and task orders for which funding has been appropriated byCongress and authorized for expenditure by the applicable agency, plus an estimate of the future revenue expected to be realized from commercial contracts that are under firm orders. Funded backlog does not include the full potential value of our contracts becauseCongress often appropriates funds to be used by an agency for a particular program of a contract on a yearly or quarterly basis even though the contract may call for performance over a number of years. As a result, contracts typically are only partially funded at any point during their term, and all or some of the work to be performed under the contracts may remain unfunded unless and untilCongress makes subsequent appropriation and the procuring agency allocates funding to the contract. Contracts undertaken by us may extend beyond one year. Accordingly, portions are carried forward from one year to the next as part of backlog. Because many factors affect the scheduling of projects, no assurance can be given as to when revenue will be realized on projects included in our backlog. Although funded backlog represents only business that is considered to be firm, we cannot guarantee that cancellations or scope adjustments will not occur. The majority of funded backlog represents contracts with terms that would entitle us to all or a portion of our costs incurred and potential fees upon cancellation by the customer. A significant number of the programs that Kratos' systems, products and solutions support are multi-year/multi-decade in nature. Accordingly, based on historical customer usage or operational tempo, we have reasonable expectations or visibility of what ultimate orders for Kratos' systems, products and solutions will be. We do not include these expected amounts in its backlog until a related contract award is received. Management believes that year-to-year comparisons of backlog are not necessarily indicative of future revenues. The actual timing of receipt of revenues, if any, on projects included in backlog could change because many factors affect the scheduling of projects. In addition, cancellations or adjustments to contracts may occur. Backlog is typically subject to large variations from quarter-to-quarter as existing contracts are renewed or new contracts are awarded. Additionally, allU.S. Government contracts included in backlog, whether or not funded, may be terminated at the convenience of theU.S. Government .
Liquidity and Capital Resources
As ofMarch 29, 2020 , we had cash and cash equivalents of$158.6 million compared with cash and cash equivalents of$172.6 million as ofDecember 29, 2019 , which includes$27.0 million and$24.6 million , respectively, of cash and cash equivalents held by our foreign subsidiaries. We are not presently aware of any restrictions on the repatriation of these funds, however, earnings of these foreign subsidiaries are essentially considered permanently invested in these foreign subsidiaries. If these funds were needed to fund our operations or satisfy obligations in theU.S. they could be repatriated, and their repatriation into theU.S. may cause us to incur additional foreign withholding taxes. We do not currently intend to repatriate these earnings. Our total long-term debt, including principal due on our 6.5% Notes (as defined below), increased from$295.1 million atDecember 29, 2019 to$295.3 million atMarch 29, 2020 , due to the amortization of debt issuance costs. We use our operating cash flow to finance trade accounts receivable, fund necessary increases in inventory, fund capital expenditures, our internal research and development investments and our ongoing operations, service our debt and make strategic acquisitions. Financing trade accounts receivable is necessary because, on average, our customers do not pay us as quickly as we pay our vendors and employees for their goods and services since a number of our receivables are contractually billable and due to us only when certain contractual milestones are achieved. Financing increases in inventory balances is necessary to fulfill shipment requirements to meet delivery schedules of our customers. Cash from continuing operations is primarily derived from our customer contracts in progress and associated changes in working capital components. Our days sales outstanding ("DSO") have increased from 134 days as ofDecember 29, 2019 to 140 days atMarch 29, 2020 , primarily as a result of certain contractual billing milestones that have not yet been achieved and collected. Our DSOs are impacted by the 29
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achievement of contractual billing milestones such as equipment shipments and deliveries on certain products, and for certain flight requirements that must be fulfilled on certain aerial target programs, or final billings which are not due until completion on certain projects, and therefore we are unable to contractually bill for amounts outstanding related to those milestones at this time. We are currently in dispute with an international customer in our US segment over approximately$10.0 million in unbilled receivables outstanding as ofMarch 29, 2020 . The dispute concerns the completion of certain system requirements and contractual milestones. Although there could be a delay in billing and collecting amounts due to us under the aforementioned contracts, we have evaluated the present facts of the matters and performed a reassessment of the contractual amounts due and have determined that no adjustment to previously recognized revenue, or the corresponding unbilled receivables, is necessary atMarch 29, 2020 .
A summary of our net cash provided by (used in) operating activities from continuing operations, investing activities from continuing operations, and financing activities from continuing operations and our cash flows from discontinued operations from our condensed consolidated statements of cash flows is as follows (in millions):
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