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 subcontractors or suppliers to perform their contractual obligations; our failure to meet performance obligations; if the unmanned systems markets do not experience significant growth, 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 associated with pandemics, epidemics or other public health emergencies, such as the outbreak of 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 27, 2020 filed with theU.S. Securities and Exchange Commission (the "SEC") onFebruary 25, 2021 (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 theDoD's 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 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
OnApril 19, 2021 , the Biden administration submitted its fiscal year 2022 budget request, for theU.S. Government's fiscal year ("FY") that begins onOctober 1, 2021 , which includes$753 billion in National Security funding, an increase of 1.6 percent over FY 2021, and$715 billion for theDoD . The 2022 National Security request amounts to a slight decrease for the Pentagon when adjusted for inflation, and is also slightly below the previous administration's$722 billion FY 2022DoD request. The FY 2022 proposal also ends the "off-budget" funding tool known as the Overseas Contingency Operations, or OCO, account. The FY 2022 budget submitted by the Biden administration is known as a "skinny budget", as it included only top line discretionary spending numbers. A more detailed FY 2022 budget is expected in May, 2021. A five- year Future Years Defense Program, or FYDP, strategic priority spending plan that is typically submitted annually along with that year's annual budget request, is not expected to be submitted at this time. The FY 2022 National Security budget includes a focus on research 25 -------------------------------------------------------------------------------- Table of Contents and development for new technologies to address peer and near peer threats, including specificallyChina . The FY 2022 budget request prioritizes defense research and development, test and evaluation funding to invest in breakthrough technologies that are also focused on innovation and the development of next generation defense capabilities. The FY 2022 budget request also supports theDoD's plan to divest legacy systems and programs in order to redirect the related resources to innovation, new technology and new programs, platforms and systems. OnDecember 27, 2020 , the Consolidated Appropriations Act, 2021, was signed into law. The$2.3 trillion spending bill combines$900 billion in stimulus relief for the COVID-19 pandemic inthe United States with a$1.4 trillion omnibus spending bill for the FY 2021 (combining 12 separate annual appropriations bills). The bills allocate$695.9 billion for theDoD , a decrease of$9.7 billion from FY 2020. Also, 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. TheU.S. Government's fiscal year endsSeptember 30 . The budget environment, including COVID-19 spending increases proposed by the new Biden administration, and uncertainty surrounding the debt ceiling and the appropriations process, remain significant short and long-term risks. Considerable uncertainty exists regarding how future budget and program decisions will unfold, including the defense spending priorities of the Administration andCongress and what challenges budget reductions (required by the Budget Control Act of 2011 ("BCA") and otherwise) will present for the defense industry. If annual appropriations bills are not timely enacted, theU.S. Government may again operate under continuing resolution authority ("CRA"), restricting new contract or program starts, restricting increased funding or additional quantities on existing contracts, presenting resource allocation and forecasting challenges and placing limitations on some planned program budgets, and we may face another government shutdown of unknown duration. If a prolonged government shutdown of theDoD were to occur, it 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 our ability to perform on ourU.S. Government contracts and successfully compete for new work. We believe continued budget pressures, CRAs 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 theDoD and other customers indicate are priorities for future defense spending, including in the 2018 and 2020 National Defense Strategy documents, 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 forecasts, estimates, 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 outbreak of COVID-19. 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, including theU.S. Government and as related to theDoD , implementing 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, including our international operations. Notwithstanding our continued operations, COVID-19 has had negative impacts on certain of our operations, 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 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, 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, whichmay 26 -------------------------------------------------------------------------------- Table of Contents significantly hamper our production, operations, including throughout the supply chain. OnMarch 27, 2020 , the Coronavirus Aid, Relief and Economic Security Act, a$2 trillion economic relief bill, was signed into law. Subsequently, onMarch 11, 2021 , the American Rescue Plan Act, a$1.9 trillion economic stimulus bill was enacted. We are continuing to evaluate the impact of these two budget packages including related stimulus and economic relief actions on our business. Since the end of the first quarter of 2020, 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. Importantly, COVID-19 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. 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, business and operational impacts of COVID-19 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 ofMarch 28, 2021 . Events and changes in circumstances arising afterMarch 28, 2021 , including those resulting from the continuing impacts of COVID-19, will be reflected in management's estimates for future periods. Reportable Segments The Company currently 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, C5ISR/modular systems, turbine technologies, and defense and rocket support services operating segments. The Unmanned Systems ("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
Revenues. Revenues by operating segment for the three months ended
March 28, 2021 March 29, 2020 $ change % change
Kratos Government Solutions
Service revenues $ 56.1 $ 63.6 $ (7.5) (11.8) %
Product sales 82.2 63.3 18.9 29.9 %
Total Kratos Government Solutions 138.3 126.9 11.4 9.0 %
Unmanned Systems
Service revenues 1.2 $ - $ 1.2 - %
Product sales 54.7 42.0 12.7 30.2 %
Total Unmanned Systems 55.9 42.0 13.9 33.1 %
Total revenues $ 194.2 $ 168.9 $ 25.3 15.0 %
Total service revenues $ 57.3 $ 63.6 $ (6.3) (9.9) %
Total product sales 136.9 105.3 31.6 30.0 %
Total revenues $ 194.2 $ 168.9 $ 25.3 15.0 %
27-------------------------------------------------------------------------------- Table of Contents Revenues increased$25.3 million to$194.2 million for the three months endedMarch 28, 2021 from$168.9 million for the three months endedMarch 29, 2020 . Revenues in our KGS segment increased$11.4 million due to the contribution from the recent acquisition of CPI ASC Signal Division, Inc. ("ASC Signal") which contributed approximately$8.6 million and organic growth across all of our business units including our C5ISR, microwave products, turbine technologies, rocket support and space and satellite business, with the exception of our training solutions business as a result of a reduction in scope of certain international training contracts. Revenues in our US segment increased$13.9 million to$55.9 million for the three months endedMarch 28, 2021 primarily due to work performed on our SSAT 177 and Valkyrie programs, and due to contributions of approximately$1.7 million from the recentTechnical Directions, Inc. (" TDI") and 5-D Systems, Inc. ("5-D Systems") acquisitions. Product sales increased$31.6 million to$136.9 million for the three months endedMarch 28, 2021 from$105.3 million for the three months endedMarch 29, 2020 primarily as a result of increased production in certain Unmanned Systems drone programs as well as contribution from the recentASC Signal acquisition. As a percentage of total revenue, product sales were 70.5% for the three months endedMarch 28, 2021 as compared to 62.3% for the three months endedMarch 29, 2020 . Service revenues decreased by$6.3 million to$57.3 million for the three months endedMarch 28, 2021 from$63.6 million for the three months endedMarch 29, 2020 . The decrease was primarily related to lower turbine technologies service revenue (which was offset by higher turbine technologies product sales) as well as the previously mentioned reduction in scope of certain international training contracts. Cost of Revenues. Cost of revenues increased$20.1 million to$143.2 million for the three months endedMarch 28, 2021 from$123.1 million for the three months endedMarch 29, 2020 . The increase in cost of revenues was primarily a result of the increase in product sales discussed above. Gross margin decreased to 26.3% for the three months endedMarch 28, 2021 from 27.1% for the three months endedMarch 29, 2020 . Margins on services decreased to 25.8% for the three months endedMarch 28, 2021 from 28.9% for the three months endedMarch 29, 2020 , due primarily to a less favorable mix of revenues including an increase in developmental programs which typically generate lower margins. Margins on products increased slightly to 26.4% for the three months endedMarch 28, 2021 from 26.0% for the three months endedMarch 29, 2020 , primarily due to a more favorable mix of certain programs and products in more mature program lifecycles for the three months endedMarch 28, 2021 . Margins in the KGS segment decreased to 28.2% for the three months endedMarch 28, 2021 from 30.1% for the three months endedMarch 29, 2020 , primarily due to a less favorable mix of revenues. Margins in the US segment increased to 21.5% for the three months endedMarch 28, 2021 from 18.1% for the three months endedMarch 29, 2020 , primarily due to a more favorable mix of products produced and shipped in the three months endedMarch 28, 2021 . Selling, General and Administrative ("SG&A") Expenses. SG&A expense increased to$37.9 million for the three months endedMarch 28, 2021 from$34.9 million for the three months endedMarch 29, 2020 , primarily due to increased costs as a result of the TDI,Optimized Performance Machining, Inc. ("OPM"),ASC Signal and 5-D Systems acquisitions in 2020. As a percentage of revenues, SG&A decreased to 19.5% atMarch 28, 2021 from 20.7% atMarch 29, 2020 . Research and Development ("R&D") Expenses. R&D expenses increased$2.3 million to$8.0 million for the three months endedMarch 28, 2021 from$5.7 million for the three months endedMarch 29, 2020 , with the primary increases in expenses being in our space and satellite communications business. As a percentage of revenues, R&D increased to 4.1% for the three months endedMarch 28, 2021 from 3.4% for the three months endedMarch 29, 2020 . 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 decreased to$0.0 million from$0.1 million for the three months endedMarch 28, 2021 andMarch 29, 2020 , respectively. Total Other Expense, Net. Total other expense, net decreased to$5.7 million from$5.9 million for the three months endedMarch 28, 2021 andMarch 29, 2020 , respectively. Benefit for Income Taxes from Continuing Operations. The income tax benefit from continuing operations for the three months endedMarch 28, 2021 andMarch 29, 2020 was$2.7 million and$1.4 million , respectively. For the three months endedMarch 28, 2021 , a$2.4 million tax benefit was recorded resulting from the federal and state impact of stock-based compensation related to restricted stock units. Loss from Discontinued Operations. The loss from discontinued operations was$0.0 million for the three months endedMarch 28, 2021 , and$0.4 million for the three months endedMarch 29, 2020 . 28 -------------------------------------------------------------------------------- Table of Contents Backlog OnMarch 28, 2021 , we had approximately$892.9 million of total backlog, of which$620.7 million was funded. We expect to recognize approximately 49% of the remaining total backlog as revenue in 2021, an additional 18% in 2022 and the balance thereafter. Our comparable total backlog balance as ofMarch 29, 2020 , was approximately$646.8 million of which$549.8 million was funded. 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 28, 2021 , we had cash and cash equivalents of$383.6 million compared with cash and cash equivalents of$380.8 million as ofDecember 27, 2020 , which includes$33.7 million and$29.2 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), net of issuance costs of$4.1 million , increased from$301.5 million atDecember 27, 2020 to$301.6 million atMarch 28, 2021 , due to the amortization of debt issuance costs during the three months endedMarch 28, 2021 (as more fully described in Note 10 of the accompanying Condensed Consolidated Financial Statements). 29 -------------------------------------------------------------------------------- Table of Contents We use our operating cash flow to finance trade accounts receivable, fund necessary increases in inventory, fund internal investments of engineering costs, fund capital expenditures, our internal research and development investments and our ongoing operations, service our debt, security infrastructure, including cyber security infrastructure 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 decreased from 133 days as ofDecember 27, 2020 to 124 days atMarch 28, 2021 , primarily reflecting the achievement of certain contractual billing milestones. Our DSO's are impacted by the 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. InNovember 2019 , a large training solutions program was terminated for convenience ("T for C") by the customer. Under a T for C, a contractor is entitled to seek specified costs through a termination settlement process including (1) the contract price for completed supplies and services accepted by the government but not previously paid for; (2) the cost incurred in the performance of work terminated plus a reasonable profit on those costs; and (3) and its costs incurred in settling with subcontractors and preparing and settling the termination proposal. However, we will not be able to collect the total withheld amounts until the settlement terms of the T for C have been negotiated and agreed to with the customer. AtMarch 28, 2021 , approximately$11.5 million in unbilled receivables remain outstanding on this project. In addition, we are currently in dispute with an international customer in our US segment over approximately$10.0 million in unbilled receivables outstanding as ofMarch 28, 2021 . The dispute concerns the completion of certain system requirements and contractual milestones. The Company alleges breach of contract, as well as other claims against the customer and seeks damages and other equitable relief. The customer has asserted counterclaims seeking liquidated damages and additional relief. We have evaluated the present facts of the matters and performed a reassessment of the contractual amounts due, as well as the claims asserted by each of the parties, and have determined that no adjustment to previously recognized revenue, or the corresponding unbilled receivables, is necessary atMarch 28, 2021 .
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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