(Exact name of registrant as specified in its charter)
iDelaware
i13-3818604
(State
or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
i1 Chisholm Trail, iSuite 300
iRound Rock, iTX
(Address of principal executive offices)
i78681
(Zip
Code)
(i512) i238-9840
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title
of each class
Trading Symbol(s)
Name of each exchange on which registered
iCommon Stock, $0.001 par value
iKTOS
iThe
NASDAQ Global Select Market
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. iYesý
No o
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). iYesý No o
Indicate
by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,”“accelerated filer,”“smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
iLarge
accelerated filer
ý
Accelerated filer
☐
Non-accelerated filer
☐
Smaller reporting company
i☐
Emerging
growth company
i☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No i☒
Common
stock, $ii0.001/ par value, ii195,000,000/
shares authorized; ii125,947,889/ and ii123,987,424/
shares issued and outstanding at September 25, 2022 and December 26, 2021, respectively
i—
i—
Additional
paid-in capital
i1,602.1
i1,578.9
Accumulated
other comprehensive income (loss)
(i3.7)
i0.6
Accumulated
deficit
(i663.0)
(i634.4)
Total
stockholders’ equity
i935.4
i945.1
Total
liabilities and stockholders’ equity
$
i1,568.1
$
i1,589.5
The
accompanying notes are an integral part of these condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. iSummary
of Significant Accounting Policies
All references to the “Company” and “Kratos” refer to Kratos Defense & Security Solutions, Inc., a Delaware corporation, and its subsidiaries.
(a)iBasis of Presentation
The
information as of September 25, 2022 and for the three and nine months ended September 25, 2022 and September 26, 2021 is unaudited. The condensed consolidated balance sheet as of December 26, 2021 was derived from the Company’s audited consolidated financial statements at that date. In the opinion of management, these unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the interim periods presented. The results have been
prepared in accordance with the instructions to Form 10-Q and do not necessarily include all information and footnotes necessary for presentation in accordance with accounting principles generally accepted in the U.S. (“GAAP”). These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the related notes included in the Company’s audited annual consolidated financial statements for the fiscal year ended December 26, 2021, included in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 22, 2022 (the “Form 10-K”). Interim operating results
are not necessarily indicative of operating results expected in subsequent periods or for the year as a whole.
(b) iPrinciples of Consolidation
The condensed consolidated financial statements include the accounts of the Company, its 100% owned subsidiaries
and its majority owned subsidiary, KTT CORE, Inc., a Delaware corporation formerly known as KTT CORE, LLC (“KTT Core”), which is i90.05% owned by the Company. All inter-company transactions have been eliminated in consolidation. Noncontrolling interest consists of the remaining i9.95%
interest in KTT Core. See Note 12 for further information related to the redeemable noncontrolling interest.
There
have been no significant changes in the Company’s accounting estimates for the nine months ended September 25, 2022 as compared to the accounting estimates described in the Annual Report on Form 10-K.
(e) iFair Value of Financial Instruments
The
Company uses forward exchange contracts to manage foreign currency risks associated with certain transactions, specifically forecasted materials and salaries paid in foreign currencies. These derivative instruments are measured at fair value using observable market inputs such as forward rates. Based on these inputs, the derivative instruments are classified within Level 2 of the valuation hierarchy. At September 25, 2022, the derivative instruments were included in other current assets and other current liabilities on the Company's Condensed Consolidated Balance Sheets. The carrying amounts and the related fair values of the Company’s derivative instruments
measured at fair value on a recurring basis at September 25, 2022, are presented in Note 15. There were no derivative instruments for forward exchange contracts at December 26, 2021.
The carrying amounts and the related estimated fair values of the Company’s long-term debt financial instruments not measured at fair value on a recurring basis at September 25, 2022 and December 26, 2021 are presented in Note 10. The carrying value of all other financial instruments, including cash equivalents, accounts receivable,
unbilled receivables, accounts
payable, accrued expenses, billings in excess of cost and earnings on uncompleted contracts, income taxes payable and short-term debt, approximated their estimated fair values at September 25, 2022 and December 26, 2021 due to the short-term nature of these instruments.
Note 2. iAcquisitions
CTT
Inc.
On December 10, 2021, the Company acquired CTT Inc. (“CTT”), a company that designs, develops, and manufactures microwave application components and equipment primarily for customers in the defense industry. The purchase price was approximately $i22.0 million in cash subject to adjustment for transaction expenses, indebtedness,
cash on hand and post-closing working capital adjustments. Approximately $i6.3 million of the purchase price was paid on December 10, 2021, $i15.2 million
of the purchase price was paid on December 30, 2021, and the remainder of the purchase price was paid during the three months ended June 26, 2022. The operating results of the acquisition have been included in the Company’s results of operations from the effective acquisition date. The amount of net sales and earnings of CTT included in the condensed consolidated statement of operations for the year ended December 26, 2021 are not material. Had the acquisition occurred as of December 28, 2020, net sales, net income from consolidated operations, net income attributable to Kratos, and basic and diluted net income per share attributable to Kratos on a pro forma basis for the year ended December 26,
2021 would not have been materially different than the reported amounts. CTT is included in the Kratos Government Solutions (KGS) segment.
Cosmic Advanced Engineered Solutions, Inc.
On December 27, 2021, Kratos Integral Holdings, LLC entered into a Stock Purchase Agreement to acquire Cosmic Advanced Engineered Solutions, Inc. (“Cosmic”) from the Carol L. Zanmiller Living Trust and the John G. Hutchens Living Trust for $i37.5 million
in cash (not including a $i0.5 million holdback to be paid at a later date). Cosmic focuses on radio frequency (RF), terrestrial, and space-based communication solutions, including digital signals processing and geolocation analysis. In addition, Cosmic provides overhead persistent infrared for missile defense systems and embedded cyber solutions to U.S. government agencies. On December 27, 2021, the acquisition was completed following
the satisfaction of all closing conditions, including receipt of regulatory approval from all required government authorities. The allocation of the total consideration for this acquisition to the tangible and identifiable intangible assets acquired and liabilities assumed is preliminary until the Company obtains final information regarding their fair values. However, the Company does not expect any adjustment to such allocations to be material to the Company's consolidated financial statements. The operating results of the acquisition have been included in the Company’s results of operations from the effective acquisition date.
Cosmic is included in the KGS segment.
The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The goodwill represents the value the Company expects to be created by integrating Cosmic’s existing business with Kratos’ related products and customers.
The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the identifiable assets acquired and the liabilities assumed be recognized at their fair values as of the acquisition date. The fair value measurements are based primarily on significant inputs not observable in the marketplace and thus
represent Level 3 measurements.
i
The following table summarizes the allocation of the purchase price over the estimated fair values of the major assets acquired and liabilities assumed (in millions):
Based on the Company’s estimate of fair value, as of December 27, 2021, net liabilities included $i6.7 million of current liabilities. The identifiable intangible assets include trade names of
$i1.5 million with a remaining useful life of i5 years, backlog of $i3.0 million
with an estimated useful life of i2 years, customer relationships of $i2.5 million with a remaining useful life of i10
years, and developed technology of $i3.0 million with a remaining useful life of i10 years. The
Company also established a deferred tax liability of $i2.9 million for the difference between the financial statement basis and tax basis of the acquired assets of Cosmic and a corresponding increase in goodwill. The goodwill recorded in this transaction is not expected to be tax-deductible.
The amounts of revenue and operating loss of Cosmic included in the Company’s condensed consolidated statement of operations were $i15.6 million
and $i0.0 million for the three months ended September 25, 2022, respectively, and $i43.3 million
and $i0.2 million for the nine months ended September 25, 2022, respectively.
i
A
summary of the consideration paid for the acquired ownership in Cosmic is as follows (in millions):
Cash paid
$
i39.0
Holdback
to be paid at later date
i0.5
Less: Cash acquired
(i1.5)
Total
consideration
$
i38.0
/
Southern Research
Engineering Division
On March 9, 2022, the Company executed an Asset Purchase Agreement to acquire the assets of the Engineering Division of Southern Research Institute (“SRI”), an Alabama non-profit corporation, for a purchase price of approximately $i80.0 million, comprised of $i75.0 million
in cash, subject to adjustments for working capital, potential earn-out consideration tied to revenue from certain in-development products, indebtedness and transaction expenses, and $i5.0 million in Kratos common stock. SRI’s Engineering Division (“SRE”) is the market leader in assisting customers in the development, modeling, and deployment of advanced materials for extreme environments, including hypersonic, space, missile, missile defense, strategic deterrence,
propulsion systems, and energy applications. SRE also specializes in Intelligence Surveillance and Reconnaissance (ISR) sensor development, electromechanical systems design and integration, aerospace engineering, materials engineering, artificial intelligence and machine learning, directed energy, RF systems design and integration, advanced manufacturing, and computational sciences. The acquisition established Kratos SRE, Inc., a new business within Kratos’ Defense and Rocket Support Services Division.
On May 23, 2022, the acquisition was completed following the satisfaction of all closing conditions, including receipt of necessary approval from all required government authorities. The allocation of the total consideration for this acquisition to the tangible and identifiable intangible assets acquired and liabilities assumed is preliminary
until the Company obtains final information regarding their fair values. The operating results of the acquisition have been included in the Company’s results of operations from the effective acquisition date.
The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The goodwill represents the value the Company expects to be created by integrating SRE’s existing business with Kratos’ related products and customers.
The transaction has
been accounted for using the acquisition method of accounting, which requires, among other things, that the identifiable assets acquired and the liabilities assumed be recognized at their fair values as of the acquisition date. The fair value measurements are based primarily on significant inputs not observable in the marketplace and thus represent Level 3 measurements.
The following table summarizes the preliminary allocation of the purchase price over the estimated fair values of the major assets acquired and liabilities assumed (in millions):
Accounts
receivable
$
i3.0
Unbilled receivables
i11.1
Inventory
i0.5
Other
current assets
i0.1
Property and equipment
i22.8
Other
assets
i0.2
Intangible assets
i15.0
Total
identifiable net assets acquired
i52.7
Total identifiable net liabilities assumed
(i2.5)
Goodwill
i29.1
Net
assets acquired, excluding cash
$
i79.3
Based on the Company’s
preliminary estimate of fair value, as of May 23, 2022, net liabilities included $i2.5 million of current liabilities. The identifiable intangible assets include trade names of $i0.7 million
with a remaining useful life of i5 years, contracts and backlog of $i6.0 million
with an estimated useful life of i2 years, customer relationships of $i1.5 million with a remaining useful life of i10
years, in-process research and development of $i1.5 million that will commence amortization at the completion of the development, and developed technology of $i5.3 million
with a remaining useful life of i7 years. The Company also established a deferred tax asset of $i0.2 million
for the difference between the financial statement basis and tax basis of the acquired assets of SRE and a corresponding decrease in goodwill. The goodwill recorded in this transaction is expected to be tax-deductible.
The amounts of revenue and operating income of SRE included in the Company’s condensed consolidated statement of operations were $i12.5 million
and $i0.2 million for the three months ended September 25, 2022, and $i16.6 million
and $i0.7 million for the nine months ended September 25, 2022, respectively.
A summary of the consideration paid for the acquired assets is as follows (in millions):
Cash
paid
$
i74.3
Common stock issued
i5.0
Total
consideration
$
i79.3
Note 3. iRevenue
Recognition
Effective January 1, 2018, the Company adopted the FASB ASU 2014-09, Revenue from Contracts with Customers, and the related amendments, which are codified into Accounting Standards Codification (“ASC”) 606 (“ASC 606”).
To determine revenue recognition for arrangements that the Company determines are within the scope of ASC 606, the Company
performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in each contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. Once the contract is identified and determined to be within the scope of ASC 606, the Company assesses the goods or services promised within each contract,
determines those that are performance obligations, and assesses whether each promised good or service is distinct. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.
A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account in ASC 606. The majority of the Company’s contracts have a single performance obligation as the promise
to transfer the individual goods or services is not separately identifiable from other promises in the contracts and, therefore, not distinct. For contracts with multiple performance obligations, the Company allocates the contract’s transaction price to each performance obligation based on the relative standalone selling price of each distinct good or service in the contract. The
primary method used to estimate standalone selling price is the expected-cost-plus-margin approach, under which the Company forecasts the expected costs of satisfying a performance obligation and then adds an appropriate margin for that distinct good or service.
For the majority of contracts, the Company satisfies the underlying performance obligations over time as the customer obtains control or receives benefits as work is performed on the contract. The
Company generally recognizes revenue over time as work is performed on long-term contracts because of the continuous transfer of control to the customer. For U.S. government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay for costs incurred plus a reasonable profit and take control of any work in process. Similarly, for non-U.S. government contracts, the customer typically controls
the work in process as evidenced either by contractual termination clauses or by our rights to payment of the transaction price associated with work performed to date on products or services that do not have an alternative use to the Company. As a result, under ASC 606, revenue is recognized over time using the cost-to-cost method (cost incurred relative to total estimated cost at completion).
Remaining Performance Obligations
The Company calculates revenues from remaining performance obligations as the dollar value of the remaining performance obligations on executed contracts.
On September 25, 2022, the Company had approximately $i1,068.9 million of remaining performance obligations. The Company expects to recognize approximately i20%
of the remaining performance obligations as revenue in fiscal year 2022, an additional i39% in fiscal year 2023, and the balance thereafter.
Due to the nature of the work required to be performed on many performance obligations, the estimation of total revenue and cost at completion is complex, subject
to many variables, and requires significant judgment. On a quarterly basis, the Company conducts its contract cost Estimate at Completion (“EAC”) process by reviewing the progress and execution of outstanding performance obligations within its contracts. As part of this process, management reviews information including, but not limited to, any outstanding key contract matters, progress towards completion and the related program schedule, identified risks and opportunities and the related changes in estimates of revenues and costs. The risks and opportunities include management’s judgment about the ability
and cost to achieve the schedule (e.g., the number and type of milestone events), technical requirements (e.g., a newly-developed product versus a mature product) and other contract requirements. Management must make assumptions and estimates regarding labor productivity and availability, the complexity of the work to be performed, the availability of materials, the length of time to complete the performance obligation (e.g., to estimate increases in wages and prices for materials and related support cost allocations), execution by subcontractors, the availability and timing of funding from customers and overhead cost rates, among other variables.
In addition, certain of the Company’s long-term contracts
contain award fees, incentive fees, or other provisions that can either increase or decrease the transaction price. These variable amounts generally are awarded upon achievement of certain performance metrics, program milestones, or cost targets and can be based upon customer discretion. Variable consideration is estimated at the most likely amount to which the Company is expected to be entitled. Estimated amounts are included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of the Company’s
anticipated performance and all information (historical, current, and forecasted) that is reasonably available.
Contracts are often modified to account for changes in contract specifications and requirements. Contract modifications are considered to exist when the modification either creates new or changes the existing enforceable rights and obligations. Most of the Company’s contract modifications are for goods or services that are not distinct
from the existing contract due to the significant integration service provided in the context of the contract and are accounted for as if they were part of that existing contract. The effect of a contract modification on the transaction price, and the measure of progress for the performance obligation to which it relates, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) on a cumulative catch-up basis.
As a result of the EAC process, any quarterly adjustments to revenues, cost of
sales, and the related impact to operating income are recognized as necessary in the period they become known. These adjustments may result from positive program performance, and may result in an increase in operating income during the performance of individual performance obligations, if it is determined the Company will be successful in mitigating the risks surrounding the technical, schedule and cost aspects of those performance obligations or realizing related opportunities. Likewise, these adjustments may result in a decrease in operating income if it is determined the Company will not be successful in mitigating these risks or realizing related
opportunities. Changes in estimates of net sales, cost of sales, and the related impact to operating income are recognized quarterly on a cumulative catch-up basis, which recognizes in the current period the cumulative effect of the changes on current and prior periods. A significant change in one or more of these estimates could affect the profitability of one or more of the Company’s contracts. When estimates of total costs to be incurred on a performance obligation exceed total estimates of revenue to be earned, a provision for the entire loss on the performance obligation is recognized in the period the loss is determined. No cumulative catch-up adjustment on any one contract
was material to the Company’s unaudited condensed consolidated financial statements for the three and nine-month periods ended September 25, 2022, and September 26, 2021. Likewise, total cumulative catch-up adjustments were not material for the three and nine-month periods ended September 25, 2022, and September 26, 2021.
For each of the
Company’s contracts, the timing of revenue recognition, customer billings, and cash collections results in a net contract asset or liability at the end of each reporting period. Fixed-price contracts are typically billed to the customer either using progress payments, whereby amounts are billed monthly as costs are incurred or work is completed, or performance based payments, which are based upon the achievement of specific, measurable events or accomplishments defined and valued at contract inception. Cost-type contracts
are typically billed to the customer on a monthly or semi-monthly basis.
Contract assets consist of unbilled receivables, primarily related to long-term contracts where revenue recognized under the cost-to-cost method exceeds amounts billed to customers. Unbilled receivables are classified as current assets and, in accordance with industry practice, include amounts that may be billed and collected beyond one year due to the long-term nature of many of the Company’s contracts. Accumulated contract
costs in unbilled receivables include direct production costs, factory and engineering overhead, production tooling costs, and, for government contracts, recovery of allowable general and administrative expenses. Unbilled receivables also include certain estimates of variable consideration described above. The Company’s contracts that give rise to contract assets are not considered to include a significant financing component as the payment terms are intended to protect the customer in the event the Company does not perform on
its obligations under the contract.
Contract liabilities include advance payments and billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of the Company’s performance obligations on the contract. These amounts are recorded as contract liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. The
Company’s contracts that give rise to contract liabilities do not include a significant financing component as the underlying advance payments received are generally utilized to pay for contract costs within a one-year period or are used to ensure the customer meets contractual requirements.
i
Net
contract assets and liabilities are as follows (in millions):
Contract
assets increased $i27.7 million during the nine months ended September 25, 2022, primarily due to the recognition of revenue related to the satisfaction or partial satisfaction of performance obligations for which the Company has not yet billed the customers. There were no significant impairment losses related to any receivables or contract
assets arising from the Company’s contracts with customers during the nine months ended September 25, 2022. Contract liabilities decreased $i9.2 million during the nine months ended September 25,
2022, primarily due to revenue recognized in excess of payments received on these performance obligations. For the three and nine months ended September 25, 2022, the Company recognized revenue of $i6.6 million and $i42.6 million,
respectively, that was previously included in the contract liabilities that existed at December 26, 2021. For the three and nine months ended September 26, 2021the Company recognized revenue of $i1.8 million and $i24.6 million,
respectively, that was previously included in the contract liabilities that existed at December 27, 2020.
In November 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) its costs incurred in settling with subcontractors and preparing and settling the termination proposal.
Under a T for C, the Company would 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. At
September 25, 2022, approximately $i4.8
million in unbilled receivables remained outstanding on this project. In March 2022, the Company and the customer agreed to a settlement of $i6.0 million for a portion of the amounts outstanding on this project, which was collected in July 2022. The remaining unbilled balance of $i4.8 million
is subject to negotiation and settlement with the customer.
The Company was also in dispute with an international customer in the Unmanned Systems (US) segment concerning the completion of certain system requirements and certain contractual milestones related to a contractthe Company acquired with the acquisition of CEi in 2012. On June 30, 2022, the parties entered into a settlement agreement to resolve their dispute and to settle all claims and counterclaims, and are currently in the process of implementing the terms of the settlement agreement. The
Company has recorded a $i5.5 million litigation settlement charge included in restructuring expenses and other in the quarter ended June 26, 2022, with a remaining $i5.6 million
carrying value of assets on the balance sheet in inventory as of September 25, 2022 which are expected to be settled by the end of the year. In the quarter ended September 25, 2022, the Company paid approximately $i3.7 million related to the settlement agreement.
Disaggregation of Revenue
i
The
following series of tables presents the Company’s revenue disaggregated by several categories. For the majority of contracts, revenue is recognized over time as work is performed on the contract. Revenue by contract type was as follows (in millions):
(1)Sales to the U.S. Government include sales from contracts for which the Company is the prime contractor, as well as those for which the
Company is a subcontractor and the ultimate customer is the U.S. Government. Each of the Company’s segments derives substantial revenue
from the U.S. Government. These sales include foreign military sales contracted through the U.S. Government.
(2)International sales include sales from contracts
for which the Company is the prime contractor, as well as those for which the Company is a
subcontractor and the ultimate customer is an international customer. These sales include direct sales with governments outside the U.S. and
commercial sales with customers outside the U.S.
Note 4. iDiscontinued
Operations
On February 28, 2018, the Company entered into a Stock Purchase Agreement to sell the operations of Kratos Public Safety & Security Solutions, Inc., a Delaware corporation and wholly owned subsidiary of the Company (“PSS”), to Securitas Electronic Security, Inc., a Delaware corporation (“Buyer”). On June 11, 2018, the Company completed the sale of all of the issued and outstanding capital stock of PSS to Buyer for a purchase price of $i69
million in cash, subject to a closing net working capital adjustment (the “Transaction”). To date, the Company has received approximately $i68.7 million of aggregate net cash proceeds from the Transaction, after taking into account amounts that were paid by the Company pursuant to a negotiated transaction services agreement between the
Company and the Buyer, receipt of approximately $i7.3 million in net working capital retained by the Company, and associated transaction fees and expenses, including the impact of the final settlement and determination of the closing net working capital adjustment and litigation which was settled with the Buyer in the fourth quarter of 2021 and first quarter of 2022, respectively.
Consolidated
amortization expense related to intangible assets subject to amortization was $i3.0 million and $i1.1 million for the three months ended September 25,
2022 and September 26, 2021, respectively, and $i6.3 million and $i3.7 million for the nine months
ended September 25, 2022 and September 26, 2021, respectively.
Note 6. iInventoried Costs
i
Inventoried
costs, consisted of the following components (in millions):
The
Company calculates net income (loss) per share in accordance with FASB ASC Topic 260, Earnings per Share (Topic 260). Under Topic260, basic net income (loss) per common share attributable to the Kratos shareholders is calculated by dividing net income (loss) attributable to Kratos by the weighted-average number of common shares outstanding during the reporting period. Diluted net income (loss) per common share reflects the effects of potentially dilutive securities.
Shares from stock options and awards, excluded from the calculation of diluted net loss per share because their inclusion would have been anti-dilutive, were i1.9
million and i1.5 million for the three and nine months ended September 25, 2022, respectively, and i0.2 million
for the three months ended September 26, 2021.
Note 8. iiLeases/
The
Company leases certain facilities, office space, vehicles and equipment. Lease assets and lease liabilities are recognized at the commencement of an arrangement where it is determined at inception that a lease exists. Lease assets
represent the right to use an underlying asset for the lease term, and lease liabilities represent the obligation to make lease payments arising from the lease. These assets and liabilities are initially recognized based on the present value of lease payments over the lease term calculated using an incremental borrowing rate generally applicable to the location of the lease asset, unless the implicit rate is readily determinable. Lease assets also include any upfront lease payments
made and exclude lease incentives. Lease terms include options to extend or terminate the lease when it is reasonably certain that those options will be exercised. The Company has operating lease arrangements with lease and non-lease components. The non-lease components in these arrangements are not significant when compared to the lease components. For all operating leases, the Company accounts for the lease and non-lease components as a single component.
Variable lease payments are generally expensed as incurred. Leases with an initial term of 12 months or less are not recorded on the balance sheet, and the expense for these short-term leases is recognized on a straight-line basis over the lease term.
The
depreciable life of lease assets and leasehold improvements is limited by the expected lease term, unless there is a transfer of title or purchase option reasonably certain of exercise.
iThe components of lease expense were as follows (in millions):
A reconciliation of the total income tax provision (benefit) to the amount computed by applying the statutory federal income tax rate of 21% to income (loss) from continuing operations before income taxes for the three and nine months ended September 25, 2022 and September 26, 2021 is as follows (in millions):
Income tax expense (benefit) at federal statutory rate
$
(i1.8)
$
i1.0
$
(i7.0)
$
i0.3
Nondeductible
expenses and other
i1.4
i5.7
i3.9
i2.1
Stock
compensation - excess tax benefits
(i0.2)
(i0.1)
(i0.8)
(i2.7)
Federal
impact of research & development tax credits
(i0.2)
(i0.9)
(i0.7)
(i0.3)
Expense
(benefit) for income taxes from continuing operations
$
(i0.8)
$
i5.7
$
(i4.6)
$
(i0.6)
/
The
Company calculates its interim income tax provision in accordance with ASC Topic 270, “Interim Reporting,” and ASC Topic 740, “Accounting for Income Taxes.” Historically, the Company calculated the provision for income taxes during the interim reporting periods by applying an estimate of the annual effective tax rate for the full fiscal year to “ordinary” income or loss (pretax income or loss excluding unusual or infrequently occurring discrete items) for the reporting period. The Company determined that since small changes in estimated “ordinary” income would result in significant changes in the
estimated annual effective tax rate, the historical method would not provide a reliable estimate for the nine months ended September 25, 2022. Therefore, a discrete effective tax rate method was used to calculate taxes for the nine months ended September 25, 2022.
As of December 26, 2021, the Company had $i25.9
million of unrecognized tax benefits that, if recognized, would impact the Company’s effective income tax rate. During the nine months ended September 25, 2022 unrecognized tax benefits increased by $i0.2 million relating to various current year tax positions.
The
Company recognizes interest and penalties related to unrecognized tax benefits in its provision for income taxes. For the nine months ended September 25, 2022 and September 26, 2021, the Company recorded an expense for interest and penalties of $i0.3 million and $i0.5 million,
respectively. For the nine months ended September 25, 2022 and September 26, 2021, there was no material benefit recorded related to the removal of interest and penalties. The Company believes that it is reasonably possible that as much as $i0.5 million of the liabilities for uncertain tax positions will expire within the next twelve
months due to the expiration of various applicable statutes of limitations.
On August 16, 2022, the Inflation Reduction Act of 2022 (“IRA”), was signed into law. Among other things, the IRA imposes a 15% corporate alternative minimum tax for tax years beginning after December 31, 2022, levies a 1% excise tax on net stock purchases after December 31, 2022, and provides tax incentives to promote clean energy. The IRA is not expected to have a material impact on our results of operations or financial position.
Note 10. iDebt
(a)
New Credit Facility
On February 18, 2022, the Company completed the refinancing of its outstanding $i90 million revolving credit facility and $i300 million
i6.5% Senior Secured Notes (the “Senior Secured Notes”), with a new i5-year $i200 million
Revolving Credit Facility and i5-year $i200 million Term Loan A (collectively, the “New Credit Facility”). The Company incurred debt issuance costs of $i3.2 million
associated with the New Credit Facility. The Company has drawn approximately $i200 million under the Term Loan A (partially offset by a $i1.2 million
principal payment on June 30, 2022) and $i100 million on the new Revolving Credit Facility, with $i100 million
remaining in borrowing capacity, less approximately $i8.0 million of letters of credit outstanding.
On February 18, 2022, the proceeds of $i300 million
from the New Credit Facility, along with cash funded by the Company for the i3.25% call premium to redeem the Company’s outstanding Senior Secured Notes, plus accrued interest, was distributed to the trustee for redemption of the Senior Secured Notes. The redemption of the Company’s outstanding $i300 million
i6.5% Senior Secured Notes due November 2025 closed on March 14, 2022, for an amount of cash equal to i103.25% of the principal
amount thereof plus accrued and unpaid interest thereon. The Company incurred a loss on the extinguishment of debt of $i9.8 million related to the call premium on the Senior Secured Notes and the write-off of $i3.2 million
of unamortized debt issuance costs, resulting in a total loss on extinguishment of debt of $i13.0 million.
The New Credit Facility is governed by a Credit Agreement (the “Credit Agreement”), which establishes the i5-year
senior secured credit facility which is comprised of the $i200 million Revolving Credit Facility (which includes sub-facilities for the incurrence of up to $i10.0 million
of swingline loans and the issuance of up to $i50.0 million of Letters of Credit) and the $i200 million Term Loan A. The Credit Agreement contemplates
uncommitted incremental credit facilities of up to $i200 million (which amount would be reduced by the aggregate amount of any and all incremental credit facilities actually established under the Credit Agreement) plus additional uncommitted incremental capacity subject to a limitation based on the Company’s pro forma total net leverage ratio (including any such additional uncommitted incremental capacity).
Borrowings
under the revolving credit facility and the term loan credit facility may take the form of base rate loans or Secured Overnight Financing Rate (“SOFR”) loans. Base rate loans under the Credit Agreement will bear interest at a rate per annum equal to the sum of the Applicable Margin (as defined in the Credit Agreement) from time to time in effect plus the highest of (i) the Agent’s (as defined in the Credit Agreement) prime lending rate, as in effect at such time, (ii) the Federal Funds Rate (as defined in the Credit Agreement), as in effect at such time, plus i0.50%,
(iii) the Adjusted Term SOFR (as defined in the Credit Agreement) for a one-month tenor in effect on such day, plus i1.00% and (iv) i1.00%. SOFR loans will bear interest
at a rate per annum equal to the sum of the Applicable Margin from time to time in effect plus the Adjusted Term SOFR for an Interest Period (as defined in the Credit Agreement) selected by the Company of one, three or six months. The Applicable Margin varies between i1.25% and i2.25%
per annum for SOFR loans and between i0.25% and i1.25% per annum for base rate loans, and is based on the
Company’s total net leverage ratio from time to time.
Mandatory amortization on the Term Loan A is i2.5% in each of the first and second years and i5.0%
in each of the third, fourth and fifth years, with the remaining outstanding balance due at maturity. The Credit Agreement contains certain covenants, which include, but are not limited to, restrictions on indebtedness, liens, fundamental changes, restricted payments, asset sales, and investments, and places limits on various other payments. The Company was in compliance with the covenants contained in the Credit Agreement as of September 25, 2022.
Term Loan and Revolving Credit Debt
i
Term
loan and revolving credit debt and the current period interest rates are as follows (in millions):
Future
long-term debt principal payments at September 25, 2022 were as follows (in millions):
2022
$
i2.5
2023
i5.0
2024
i8.7
2025
i10.0
2026
i10.0
2027
i262.5
$
i298.7
/
(b)
i6.5% Senior Secured Notes due 2025
In November 2017, the Company issued and sold $i300
million aggregate principal amount of i6.5% Senior Secured Notes due 2025, or the Senior Secured Notes, in a private placement conducted pursuant to Rule 144A and Regulation S under the Securities Act of 1933, as amended. The Company incurred debt issuance costs of $i6.6
million associated with the Senior Secured Notes. The Senior Secured Notes were redeemed on March 14, 2022.
(c) Other Indebtedness
Credit and Security Agreement
On November 20, 2017, the Company entered into an amended and restated credit and security agreement (the “Credit and Security Agreement”), which established a ifive-year
senior secured revolving credit facility in the aggregate principal amount of $i90.0 million consisting of a subline for letters of credit in an amount not to exceed $i50.0
million, as well as a swingline loan in an aggregate principal amount at any time outstanding not to exceed $i10.0 million. The Credit and Security Agreement was replaced by the New Credit Facility on February 18, 2022.
Carrying amounts and the related estimated fair values of the Company’s Senior Secured Notes not measured at fair value on a recurring basis at December 26, 2021 are presented in the following table:
The
fair value of the Company’s Senior Secured Notes was based upon actual trading activity (Level 1, Observable inputs-quoted prices in active markets).
As of December 26, 2021, the difference between the carrying amount of $i296.7 million and the principal amount of $i300.0
million presented in the above table is the unamortized debt issuance costs of $i3.3 million, which were being accreted to interest expense over the term of the related debt. The Senior Secured Notes were redeemed on March 14, 2022.
Note 11. iSegment
Information
The Company operates in itwo reportable segments. The KGS reportable segment is comprised of an aggregation of KGS operating business units, including the Company’s microwave electronics products, space, satellite and cyber, training solutions, C5ISR/modular systems, turbine technologies and defense
and rocket support services operating segments. The US reportable segment consists of the Company’s unmanned aerial, unmanned ground, unmanned seaborne and command, control and communications system business. The KGS and US segments provide products, solutions and services for mission critical national security programs. KGS and US customers primarily include national security related agencies, the U.S. Department of Defense (the “DoD”), intelligence agencies and classified agencies, and to a lesser degree, international government agencies and domestic and international commercial customers.
The Company organizes its reportable segments based on the nature of the products, solutions and services offered.
Transactions between segments are generally negotiated and accounted for under terms and conditions similar to other government and commercial contracts. In the following table, total operating income from continuing operations of the reportable business segments is reconciled to the corresponding consolidated amount. The reconciling item Corporate activities includes costs for certain stock-based compensation programs (including stock-based compensation costs for stock options, the employee stock purchase plan and restricted stock units), the effects of items not considered part of management’s evaluation of segment operating performance, merger and acquisition expenses, corporate costs not allocated to the segments, and other miscellaneous corporate activities.
iRevenues, depreciation and amortization, and operating income (loss) generated by the Company’s reportable segments for the three and nine month periods ended September 25, 2022 and September 26, 2021 are as follows (in millions):
Operating
income (loss) from continuing operations:
Kratos Government Solutions
$
i3.3
$
i14.6
$
i18.4
$
i27.6
Unmanned
Systems
(i0.1)
i2.6
(i4.6)
i10.9
Corporate
activities
(i6.8)
(i6.7)
(i20.5)
(i19.8)
Total
operating income (loss) from continuing operations
$
(i3.6)
$
i10.5
$
(i6.7)
$
i18.7
The
US Operating loss for the nine months ended September 25, 2022 includes a $i5.5 million litigation settlement charge related to the resolution of a dispute with an international customer, for which the contractual arrangement was entered into in March 2011, prior to Kratos’ acquisition of Composite Engineering Inc. (“CEi”). The KGS Operating income for the three and nine months ended September 25, 2022 includes $ii6.4/ million of
expenses related to certain non-recoverable costs, including rate and cost growth items, resulting from the inability to hire the required planned direct labor base both internally and by the Company’s subcontractors to execute on its backlog, due to a continuing challenging environment in both hiring and retaining skilled manufacturing personnel, including approximately $i3.4 million in expenses in the
Company’s C5ISR business, and non-recoverable indirect cost rate growth resulting from a smaller than planned direct labor base due to delays in customer program execution and awards in the Company’s Training Solutions business of approximately $i3.0 million.
Note 12. iRedeemable
Noncontrolling Interest
On February 27, 2019, the Company acquired i80.1% of the issued and outstanding shares of capital stock of Florida Turbine Technologies Inc., a Florida corporation (“FTT Inc.”), and i80.1%
of the membership interests in KTT Core, a Delaware limited liability company, for an aggregate purchase price of approximately $i60 million. On February 18, 2022, the capital stock of FTT Inc. was conveyed to KTT Core for organizational purposes such that FTT Inc is now a wholly owned subsidiary of KTT Core. In connection with the Company’s acquisition of FTT Inc, and KTT Core, (i) beginning in
January 2024, the holders (the “Holders”) of the minority interests in KTT Core (the “Minority Interests”) will have an annual right (the “Put Right”) to sell all of the Minority Interests to the Company at a purchase price based on a specified multiple of the trailing 12 months EBITDA of KTT Core and its subsidiaries (the “Acquired Companies”), subject to adjustment as set forth in the Exchange Agreement entered into by and among the Company, the Acquired Companies and the Holders, as amended on February 18, 2022 (the “Exchange Agreement”) (provided, however, that following certain events, including a change of control, the
Put Right will be accelerated and the Minority Interest Purchase Price (as defined in the Exchange Agreement) will be a specified increased multiple of the trailing 12 months EBITDA of the Acquired Companies); and (ii) beginning in January 2025, the Company will have an annual right to purchase all of the Minority Interests from the Holders at the Minority Interest Purchase Price.
On June 13, 2022, the Company entered into an Equity Purchase Agreement (the “Equity Purchase Agreement”) to acquire an additional i9.95%
(the “Purchased Shares”) of the issued and outstanding shares of capital stock of KTT Core (together with its wholly-owned subsidiaries including FTT Inc.), a majority owned subsidiary of the Company, for an aggregate estimated purchase price of approximately $i6.4 million, to be paid in shares of Kratos common stock. Pursuant to the
Equity Purchase Agreement, the Company paid consideration of $i2.7 million, paid in i190,258
shares of its common stock, based upon Kratos’ trading price on the date of distribution, representing half of the aggregate estimated purchase price to be paid by the Company for the Purchased Shares. Following the closing of the transactions contemplated by the Equity Purchase Agreement, the Company owned i90.05% of KTT Core. The unpaid portion of the aggregate estimated purchase price for the Purchased
Shares is expected to be paid in shares of Kratos common stock in March 2023, subject to certain adjustments.
The Put Right and annual purchase right of the Holders and the Company, respectively, remain available under the Exchange Agreement as to the remaining i9.95% minority interest in KTT Core.
The
Company adjusts the carrying value of such redeemable noncontrolling interest based on an allocation of subsidiary earnings based on ownership interest. Redeemable noncontrolling interest is recorded outside of permanent equity at the higher of its carrying value or management’s estimate of the amount (the “Redemption Amount”) that the Company could be required to pay in connection with the Put Right. Adjustments to the Redemption Amount will have a corresponding effect on net income per share attributable to Kratos shareholders. As a result of the Company’s acquisition of an additional i9.95%
of the issued and outstanding shares of capital stock of KTT Core, the carrying value of the redeemable noncontrolling interest was adjusted. As of September 25, 2022, no additional adjustment of the carrying value of the remaining redeemable noncontrolling interest was required.
Note 13. iSignificant Customers
Revenue
from the U.S. Government, which includes foreign military sales contracted through the U.S. Government, includes revenue from contracts for which the Company is the prime contractor as well as those for which the Company is a subcontractor and the ultimate customer is the U.S. Government. The KGS and US segments have substantial revenue from the U.S. Government. Sales to the U.S. Government amounted to approximately $i158.1
million and $i143.7 million, or i69% and i72%
of total Kratos revenue, for the three months ended September 25, 2022 and September 26, 2021, respectively, and $i453.8 million and $i432.1 million,
or i70% and i72% of total Kratos revenue, for the nine months ended September 25, 2022 and September 26, 2021, respectively.
Note 14.
iCommitments and Contingencies
In addition to commitments and obligations in the ordinary course of business, the Company is subject to various claims, pending and potential legal actions for damages, investigations relating to governmental laws and regulations and other matters arising out of the normal conduct of the
Company’s business. The Company assesses contingencies to determine the degree of probability and range of possible loss for potential accrual in its unaudited condensed consolidated financial statements. An estimated loss contingency is accrued in the unaudited condensed consolidated financial statements if it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Because litigation is inherently unpredictable and unfavorable resolutions could occur, assessing litigation contingencies is highly subjective and requires judgments about future events. When evaluating contingencies, the Company may be unable to provide a meaningful estimate due to a number of factors, including but not limited to the procedural status of the matter in question, the
presence of complex or novel legal theories, and the ongoing discovery and development of information important to the matters. In addition, damage amounts claimed in litigation against it may be unsupported, exaggerated or unrelated to possible outcomes and, as such, are not meaningful indicators of its potential liability. The Company regularly reviews contingencies to determine the adequacy of its accruals and related disclosures. The amount of ultimate loss may differ from these estimates. It is possible that cash flows or results of operations could be materially affected in any particular period by the unfavorable resolution of one or more of these contingencies. Whether any losses finally determined in any claim, action, investigation or proceeding could reasonably have a material effect on the
Company’s business, financial condition, results of operations or cash flows will depend on a number of variables, including the timing and amount of such losses; the structure and type of any remedies; the monetary significance any such losses, damages or remedies may have on the condensed consolidated financial statements; and the unique facts and circumstances of the particular matter that may give rise to additional factors.
Legal and Regulatory Matters
U.S. Government Cost Claims
The Company’s contracts with the DoD are subject to audit by the Defense Contract
Audit Agency (“DCAA”). As a result of these audits, from time to time the Company is advised of claims concerning potential disallowed, overstated or disputed costs. For example, during the course of recent audits of the Company’s contracts, the DCAA is closely examining and questioning certain of the established and disclosed practices that it had previously audited and accepted. The Company’s personnel regularly scrutinize costs incurred and allocated to contracts with the U.S. Government for compliance with
regulatory standards. For those Company subsidiaries and fiscal years which have not yet been audited by the DCAA or for those audits which are in process which have not yet been completed by the DCAA, the Company cannot reasonably estimate the range of loss, if any, that may result given the inherent difficulty in predicting regulatory action, fines and penalties, if any, and the various remedies and levels of judicial review available to the Company in the event of an adverse finding. As a result, the Company has not recorded any liability related to these matters.
Other
Litigation Matters
The Company is subject to normal and routine litigation arising from the ordinary course and conduct of business and, at times, as a result of mergers, acquisitions and dispositions. Such disputes include, for example, commercial, employment, intellectual property, environmental, and securities matters. The aggregate amounts accrued related to these matters are not material to the total liabilities of the Company. The Company intends to defend itself in any such matters and does not currently believe that the outcome of any such matters will have a material adverse impact on the
Company’s financial condition, results of operations or cash flows.
Note 15. iDerivative Financial Instruments
The Company’s derivative portfolio consists of forward
exchange contracts. Derivative financial instruments are recognized on the Condensed Consolidated Balance Sheets as either assets or liabilities and are measured at fair value. Changes in the fair values of derivatives are recorded each period in earnings. As of September 25, 2022, the Company did not use hedge accounting. The Company did inot
have any forward exchange contracts at December 26, 2021. The notional value of the Company’s foreign currency forward contracts at September 25, 2022, was $i10.2 million. At September 25,
2022, the fair value amounts of the forward exchange contracts were a $i0.1 million asset and a $i0.3 million liability.
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 Department of Defense, or 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; risks relating to the ongoing conflict in Ukraine; risks related to continued interest rate increases by the Federal Reserve; 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 products, cybersecurity/warfare, rocket, hypersonic and missile defense systems, turbine technologies, and Command, Control, Communication, Computing, Combat, Intelligence Surveillance and Reconnaissance (“C5ISR”) Systems and training solutions. 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 billion of which is for the DoD, a 4% increase above the FY 2022 enacted amount. On September 30, 2022, Congress enacted a Continuing Resolution Authorization (“CRA”) to carry forward the fiscal year 2022 funding levels into fiscal year 2023 while negotiations continue
regarding
full year appropriations. The CRA also included an additional $12 billion in aid to Ukraine, bringing total appropriations for Ukraine assistance to $39 billion.
The current budget environment, including COVID-19 and Ukraine funding support, heightened levels of inflation, and uncertainty surrounding the debt ceiling and the appropriations process, creates 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 Biden administration and Congress.
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
and 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 that budget and program decisions made in such an uncertain environment will 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 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 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 have 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.
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 September 25,
2022. Events and changes in circumstances arising after September 25, 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, parts, supplies, etc., which in certain instances and for certain items is significant.
In addition, inflation and the related costs of inputs needed to execute the business, including materials, parts, supplies, consultants, subcontractors, vendors, etc. are significantly impacting the costs for Kratos to do business and are significantly adversely impacting our operations, profit margins and financial forecasts. Also, the cost of labor and for the Company’s employees and labor base have also increased significantly, and the ability to hire, obtain and retain employees, is also extremely challenging and is adversely impacting Kratos’ ability to execute its business. There is also a significant industry wide labor shortage, including in the science, technology, engineering, and math discipline areas, and for employees willing and/or able to obtain national security clearances. In addition, recent actions by the Federal Reserve to continue to increase interest rates have
impacted our interest expense on our outstanding debt borrowings. Each of these matters and issues are expected to remain for the foreseeable future and to adversely impact the Company’s operations, financial results and financial forecasts.
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 electronics products, space, satellite and cyber, training solutions, 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.
Revenues increased $28.0 million to $228.6 million for the three months ended September 25, 2022 from $200.6 million for the three months ended September 26, 2021. Revenues in our KGS segment increased $39.3 million primarily due to
the contribution of $30.2 million in revenues from the recent acquisitions of Cosmic, CTT and SRE, and an increase of $13.6 million in our C5ISR, defense and rocket support services, turbine technologies, and microwave electronics products businesses, offset partially by a reduction of $2.8 million in our training solutions business and a reduction of approximately $1.8 million due to the wind-down of a federal services satellite contract. Revenues in our US segment decreased $11.3 million to $50.0 million for the three months ended September 25, 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 September 26,
2021.
Product sales decreased $9.0 million to $140.0 million for the three months ended September 25, 2022 from $149.0 million for the three months ended September 26, 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 61.2% for the three months ended September 25, 2022 as compared to 74.3% for the three months ended September 26, 2021. Service
revenues increased by $37.0 million to $88.6 million for the three months ended September 25, 2022 from $51.6 million for the three months ended September 26, 2021, primarily as a result of the recent Cosmic and SRE acquisitions.
Cost of Revenues. Cost of revenues increased $33.7 million to $173.7 million for the three months ended September 25, 2022 from $140.0 million for the three months ended September 26, 2021. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.
Gross Margin. Gross margin decreased to
24.0% for the three months ended September 25, 2022 from 30.2% for the three months ended September 26, 2021. Margins on services decreased to 26.5% for the three months ended September 25, 2022 from 31.2% for the three months ended September 26, 2021. Margins on products decreased to 22.4% for the three months ended September 25, 2022 from 29.9% for the three months end September 26, 2021. Margins in the KGS segment decreased to 24.7% for the three months ended September 25, 2022 from 34.3% for the three months ended September 26, 2021, primarily due to a less favorable mix
of revenues, as well as due to a $4.5 million impact to cost of sales related to certain non-recoverable costs, including rate and cost growth items, resulting from the inability to hire the required planned direct labor base both internally and by the Company’s subcontractors to execute on its backlog, due to a continuing challenging environment in both hiring and retaining skilled manufacturing personnel, including an approximately $3.4 million impact to the Company’s C5ISR business, and non-recoverable indirect cost rate growth resulting from a smaller than planned direct labor base due to delays in customer program execution and awards in the Company’s Training Solutions business of approximately $1.1 million.
Margins in the US segment increased to 21.4% for the three months ended September 25, 2022 from 20.9% for the three months ended September 26, 2021, primarily due to a more favorable mix of products produced and shipped in the three months ended September 25, 2022.
Selling, General and Administrative (“SG&A”) Expenses. SG&A expenses increased $6.7 million to $48.5 million for the three months ended September 25, 2022 from $41.8 million for the three months ended September 26, 2021. As a percentage of revenues, SG&A increased to 21.2% at September 25,
2022 from 20.8% at September 26, 2021. Included in SG&A was the impact of the recent CTT, Cosmic and SRE acquisitions and an increase of $0.2 million in the US segment primarily related to increased headcount. In addition, $1.9 million impact to SG&A is related to the non-recoverable indirect cost rate growth in the Company’s Training Solutions business for the three months ended September 25, 2022. Amortization expense of purchase intangibles increased from $1.1 million for the three months ended September 26, 2021 to $3.0 million for the three months ended September 25, 2022, reflecting the recent acquisitions.
Research
and Development (“R&D”) Expenses. R&D expenses increased $1.6 million to $9.6 million for the three months ended September 25, 2022 from $8.0 million for the three months ended September 26, 2021, primarily due to increased development efforts in our Unmanned Systems business of $1.0 million. As a percentage of revenues, R&D increased to 4.2% for the three months ended September 25, 2022 from 4.0% for the three months ended September 26, 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 $0.2 million from $0.0 million for the three months ended September 25, 2022 and September 26, 2021, respectively.
Total Other Expense, Net. Total other expense, net decreased to $5.2 million from $5.9 million for the three months ended September 25, 2022 and September 26, 2021, respectively.
The decrease in expense of $0.7 million was primarily related to a reduction in interest expense of $1.7 million as a result of our debt refinancing in February of 2022, offset by an increase in expense of $1.2 million related to foreign transaction losses.
Provision (Benefit) for Income Taxes from Continuing Operations. The income tax benefit from continuing operations for the three months ended September 25, 2022 was $0.8 million and the income tax expense from continuing operations for the three months ended September 26, 2021 was $5.7 million. For the three months ended September 25, 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 September 26, 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.
Loss from Discontinued Operations. The
loss from discontinued operations was $0.0 million for the three months ended September 25, 2022. The loss from discontinued operations was $0.8 million for the three months ended September 26, 2021, primarily reflecting costs related to the ongoing closing net working capital adjustment dispute with the buyer of the Kratos Public Safety & Security Solutions, Inc. (“PSS”) business.
Revenues
increased $49.1 million to $649.0 million for the nine months ended September 25, 2022 from $599.9 million for the nine months ended September 26, 2021. Revenues in our KGS segment increased $67.6 million, primarily due to the contribution of $66.4 million in revenues from the recent Cosmic, CTT and SRE acquisitions, increased revenues in our space, satellite and cyber business of $5.5 million, increases in our defense and rocket support services and turbine technologies businesses of $9.8 million, and increases in our C5ISR businesses of $4.9 million, partially offset by an $18.6 million reduction in our training solutions business, resulting primarily from the completion of training solutions contracts. Revenues in our US segment decreased $18.5 million to $159.0 million for the
nine months ended September 25, 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 nine months ended September 26, 2021.
Product sales decreased $19.3 million to $413.7 million for the nine months ended September 25, 2022 from $433.0 million for the nine months ended September 26, 2021, primarily as a result of decreased production activity in our US segment and reductions in our training solutions business. As a percentage of total revenue, product sales were 63.7% for the nine months ended September 25,
2022 as compared to 72.2% for the nine months ended September 26, 2021. Service revenues increased by $68.4 million to $235.3 million for the nine months ended September 25, 2022 from $166.9 million for the nine months ended September 26, 2021. The increase was primarily a result of the recent Cosmic and SRE acquisitions.
Cost of Revenues. Cost of revenues increased $48.1 million to $484.4 million for the nine months ended September 25, 2022 from $436.3 million for the nine months ended September 26, 2021. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.
Gross
Margin. Gross margin decreased to 25.4% for the nine months ended September 25, 2022 from 27.3% for the nine months ended September 26, 2021. Margins on services decreased to 27.2% for the nine months ended September 25, 2022 from 28.5% for the nine months ended September 26, 2021. Margins on product sales decreased to 24.3% for the nine months ended September 25, 2022 from 26.8% for the nine months ended September 26, 2021. Margins in the KGS segment decreased to 26.9% for the nine months ended September 25, 2022 from 29.9% for the nine months ended September 26,
2021 due to a less favorable mix of revenues, as well as due to a $4.5 million impact to cost of sales related to certain non-recoverable costs, including rate and cost growth items, resulting from the inability to hire the required planned direct labor base both internally and by the Company’s subcontractors to execute on its backlog, due to a continuing challenging environment in both hiring and retaining skilled manufacturing personnel, including an approximately $3.4 million impact to
the Company’s C5ISR business , and non-recoverable
indirect cost rate growth resulting from a smaller than planned direct labor base due to delays in customer program execution and awards in the Company’s Training Solutions business of approximately $1.1 million. Margins in the US segment decreased to 20.5% for the nine months ended September 25, 2022, from 21.1% for the nine months ended September 26, 2021, primarily due to a less favorable mix of products produced and shipped during the nine months ended September 25, 2022.
SG&A Expenses. SG&A expenses were $136.3 million for the nine months ended September 25, 2022 and $117.9 million
for the nine months ended September 26, 2021. As a percentage of revenues, SG&A increased to 21.0% at September 25, 2022, from 19.7% at September 26, 2021.Included in SG&A, was an increase of $0.7 million of stock compensation expense from $19.2 million for the nine months ended September 26, 2021 to $19.9 million for the nine months ended September 25, 2022 as well as increased SG&A expenses related to the recent acquisitions of CTT, Cosmic and SRE. In addition, $1.9 million impact to SG&A is related to the non-recoverable indirect cost rate growth in the Company’s Training
Solutions business for the nine months ended September 25, 2022. Amortization expense of purchase intangibles increased from $3.7 million for the nine months ended September 26, 2021 to $6.3 million for the nine months ended September 25, 2022, reflecting the recent acquisitions.
R&D Expenses. R&D expenses were $28.0 million for the nine months ended September 25, 2022 and $26.2 million for the nine months ended September 26, 2021, with the primary increases in expenses in ourUS segment. As a percentage of revenues, R&D decreased to 4.3% for the nine months
ended September 25, 2022 from 4.4% for the nine months ended September 26, 2021.
Restructuring Expenses and Other. Restructuring expenses and other increased to $6.4 million for the nine months ended September 25, 2022 from $0.2 million for the nine months ended September 26, 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 $26.9 million from $17.3 million for the nine months ended September 25,
2022 and September 26, 2021, respectively. The increase in expense of $9.6 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 $4.7 million as a result of the reduced rate on our new debt.
Benefit for Income Taxes from Continuing Operations. The income tax benefit from continuing operations for the nine months ended September 25, 2022 and September 26, 2021 was $4.6 million and $0.6 million, respectively. For the nine months ended September 25, 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 estimated effective tax rate. For the nine months ended September 26, 2021, a $2.7 million tax benefit was recorded resulting from the federal and state tax implications of stock-based compensation in the form of restricted stock units. The remaining $2.1 million 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 $0.7 million for the nine months ended September 25, 2022, and includes a $0.9 million benefit 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 $1.1 million for the nine months ended September 26, 2021, primarily reflecting the work performed in relation to outstanding tasks on legacy projects retained by us following the sale of PSS, as well as costs related to the ongoing closing net working capital adjustment dispute with the buyer of the PSS business.
Backlog
On
September 25, 2022, we had approximately $1,068.9 million of total backlog, of which $696.1 million was funded. We expect to recognize approximately 20% of the remaining total backlog as revenue in fiscal year 2022, an additional 39% in fiscal year 2023 and the balance thereafter. Our comparable total backlog balance as of September 26, 2021, was approximately $839.1 million, of which $618.0 million was funded. Backlog as of September 25, 2022 as compared to September 26, 2021 has increased primarily as a result of contract awards in our C5ISR, Space, Satellite and Cyber, Turbine Technologies and Unmanned Systems businesses, and to a lesser degree due to the impact of the acquisitions
of Cosmic, CTT and SRE, which contributed approximately $102.2 million as of September 25, 2022.
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 by Congress 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 because Congress 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 until Congress makes a 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 or if 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 our 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, all U.S. Government contracts included in backlog, whether or not funded, may be terminated at the convenience of the U.S. Government.
Liquidity and Capital Resources
As of September 25, 2022, we had cash and cash equivalents of $125.2 million compared with cash and cash equivalents of $349.4 million as of December 26, 2021, which includes $19.8 million and $29.4
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 the United States they could be repatriated, and their repatriation into the United States may cause us to incur additional foreign withholding taxes. We do not currently intend to repatriate these earnings.
Our total long-term debt increased from $296.7
million at December 26, 2021 to $297.3 million at September 25, 2022. Under the New Credit Facility, on February 18, 2022, we completed the refinancing of our outstanding $90 million revolving credit facility and $300 million of Senior Secured Notes, with a new 5-year $200 million Revolving Credit Facility and 5-year $200 million Term Loan A. We incurred debt issuance costs of $3.2 million associated with the New Credit Facility. We have drawn approximately $200 million under the Term Loan A and $100 million on the new Revolving Credit Facility, with $100 million remaining in borrowing capacity, less $8.0 million for outstanding letters of credit (as more fully described in Note 10 of the accompanying Condensed Consolidated Financial Statements).
On February 18, 2022, the proceeds of $300 million from the New Credit Facility, along with cash funded by us for the 3.25% call premium to redeem the Company’s outstanding Senior Secured Notes, plus accrued interest, was distributed to the trustee for redemption of the Senior Secured Notes. The redemption of the outstanding $300 million of Senior Secured Notes closed on March 14, 2022, for an amount of cash equal to 103.25% of the principal amount thereof plus accrued and unpaid interest thereon. We incurred a loss on the extinguishment of debt of $9.8 million related to the call premium on the Senior Secured Notes and the write-off of $3.2 million of unamortized debt issuance costs
resulting in a total loss on extinguishment of debt of $13.0 million.
We use our operating cash flow to finance trade accounts receivable, fund necessary increases in inventory including increasing inventory stock levels and advance buys in larger lot sizes to gain pricing benefits where possible, in order to mitigate the impact of supply chain disruptions and price increases, fund internal investments of engineering costs, fund capital expenditures, our internal research and development investments and our ongoing operations, service our debt, enhance our 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 because a number of our receivables are contractually billable
and due to us only when certain contractual milestones are achieved. Financing increases in inventory balances are necessary to fulfill shipment requirements to meet delivery schedules of our customers. These financing requirements have increased and have recently negatively impacted our operating cash flows due to actions we have taken to advance inventory purchases in an attempt to mitigate supply chain disruptions and to bolster our inventory levels. For the nine months ended September 25, 2022, approximately $28.0 million of operating cash flow was used to fund inventory purchases. 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 128 days as of December 26,
2021 to 120 days at September 25, 2022, primarily reflecting outstanding contractual billing milestones. Our DSOs 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.
In November 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. At September 25, 2022, approximately $4.8 million in unbilled receivables remain outstanding on this project. In March 2022, we agreed, together with the customer, to a litigation settlement of $6.0 million for a portion of the amounts outstanding on this project, which was collected in July 2022. The remaining unbilled balance of $4.8 million is subject to negotiation and settlement with the customer.
We
were also in dispute with an international customer in our US segment concerning the completion of certain system requirements and contractual milestones related to a contractthe Company acquired with the acquisition of CEi in 2012. In June 2022, the parties entered into a settlement agreement to resolve their dispute and to resolve all claims and counterclaims, and we are currently in the process of implementing the terms of the settlement agreement.The Company recorded a $5.5 million litigation settlement charge in the quarter ended June 26, 2022, with a remaining $5.6 million carrying value of assets on the
balance sheet as of September 25, 2022 which are expected to be settled by the end of the year. During the quarter ended September 25, 2022, we paid approximately $3.7 million related to the settlement.
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):
Net cash provided by (used in) operating activities from continuing operations
$
(32.3)
$
34.6
Net cash used in investing activities from continuing operations
(166.9)
(35.1)
Net
cash used in financing activities from continuing operations
(21.4)
(9.0)
Net operating cash flows of discontinued operations
(0.3)
(1.1)
Net cash used in operating activities from continuing operations was $32.3 million for the nine months ended September 25, 2022. Net cash used in operating activities
from continuing operations was primarily a result of the net loss of $28.3 million. Net cash provided by operating activities from continuing operations was $34.6 million for the nine months ended September 26, 2021, primarily a result of the net income of $2.0 million, stock compensation, depreciation, amortization and other noncash charges of $45.1 million and changes of $12.5 million in net working capital accounts.
Net cash used in investing activities from continuing operations for the nine months ended September 25, 2022 is comprised of cash paid for acquisitions, net of cash acquired of $132.2 million, and $34.8 million in capital expenditures. Cash used for acquisitions included $74.0 million related to the acquisition of the assets of SRE, $37.5 million related to the acquisition
of Cosmic, $15.3 million for the remaining purchase price due on the acquisition of CTT, and a $5.4 million payment due under the acquisition agreement for KTT Core, of which we purchased a controlling interest in February 2019. Net cash used in investing activities from continuing operations for the nine months ended September 26, 2021 is comprised of a payment due under the KTT Core acquisition agreement and capital expenditures, which were partially offset by insurance proceeds. Capital expenditures consist primarily of investments in machinery, computer hardware and software and improvement of our physical properties in order to maintain suitable conditions in which to conduct our business, including enhancements for secure facilities required for contracts we have been awarded or expect to be awarded, and include investments
we are making to build capital aerial targets and related support equipment. During the nine months ended September 25, 2022, capital expenditures of approximately $18.6 million were incurred in our US business, primarily related to our unmanned combat target initiative. We expect our capital expenditures for our fiscal year 2022 to continue to be significant for investments we are making, specifically in our US business totaling approximately $25 to $28 million, including approximately $18 to $20 million for capital aerial targets and related support equipment.
Net cash used in financing activities from continuing operations was $21.4 million for the nine months ended September 25, 2022 and included $309.8 million used to redeem our $300 million of Senior Secured Notes including the call
premium of $9.8 million, debt issuance costs of $3.2 million, payroll withholding taxes paid from vested restricted stock traded for taxes of $12.3 million and payments made on financing lease obligations of $1.0 million. These uses were partially offset by $300.0 million in proceeds from our New Credit Facility (partially offset by a $1.2 million principal payment on June 30, 2022) and employee stock purchase plan receipts of $6.1 million. Net cash used in financing activities from continuing operations was $9.0 million for the nine months ended September 26, 2021, and consisted primarily of repayment of our Israel debt of $5.1 million, payroll withholding taxes paid from vested restricted stock traded for taxes of $9.1 million and payments made on financing lease obligations of $0.7 million offset by employee stock purchase plan receipts of $5.9 million.
The
net operating cash flows of discontinued operations for the nine months ended September 25, 2022 was a use of $0.3 million. The net operating cash flows of discontinued operations for the nine months ended September 26, 2021 was a use of $1.1 million.
Contractual Obligations and Commitments
New Credit Facility
Under the New Credit Facility, on February 18, 2022, the Company completed the refinancing
of its outstanding $90 million revolving credit facility and $300 million Senior Secured Notes, with a new 5-year $200 million Revolving Credit Facility and 5-year $200 million Term Loan A. The Company incurred debt issuance costs of $3.2 million associated with the New Credit Facility. The Company has drawn approximately $200 million under the Term Loan A (partially offset by a $1.2 million principal payment on June 30, 2022) and $100 million on the new Revolving Credit Facility, with $100 million remaining in borrowing capacity, less $8.0 million for outstanding letters of credit.
On February 18, 2022, the proceeds of $300 million from the New Credit Facility along with cash funded by the Company for the 3.25% call premium to redeem the Company’s outstanding Senior Secured Notes, plus accrued interest, was distributed to the trustee for redemption of the Senior Secured Notes. The redemption of the Company’s outstanding $300 million 6.5% Senior Secured Notes due November 2025 closed on March 14, 2022, for an amount of cash equal to 103.25% of the principal amount thereof plus accrued and unpaid interest thereon. The
Company incurred a loss on the extinguishment of debt of $9.8 million related to the call premium on the Senior Secured Notes and the write-off of $3.2 million of unamortized debt issuance costs resulting in a total loss on extinguishment of debt of $13.0 million.
The New Credit Facility is governed by a Credit Agreement (the “Credit Agreement”), which establishes the 5-year senior secured credit facility which is comprised of the $200 million Revolving Credit Facility (which includes sub-facilities for the incurrence of up to $10.0 million of swingline loans and the issuance of up to $50.0 million of Letters of Credit) and the $200 million Term Loan A. The Credit Agreement contemplates uncommitted incremental credit facilities of up to $200 million (which amount would be reduced by the aggregate amount of any and all incremental credit facilities actually established under
the Credit Agreement) plus additional uncommitted incremental capacity subject to a limitation based on the Company’s pro forma total net leverage ratio (including any such additional uncommitted incremental capacity).
Borrowings under the revolving credit facility and the term loan credit facility may take the form of base rate loans or SOFR loans. Base rate loans under the Credit Agreement will bear interest at a rate per annum equal to the sum of the Applicable Margin (as defined in the Credit Agreement) from time to time in effect plus the highest of (i) the Agent’s(as defined in the Credit Agreement) prime lending rate, as in effect at such time, (ii) the Federal Funds Rate (as defined in the Credit Agreement), as in effect at such time, plus 0.50%, (iii) the Adjusted Term SOFR (as defined in the
Credit Agreement) for a one-month tenor in effect on such day, plus 1.00% and (iv) 1.00%. SOFR loans will bear interest a rate per annum equal to the sum of the Applicable Margin from time to time in effect plus the Adjusted Term SOFR for an Interest Period (as defined in the Credit Agreement) selected by the Company of one, three or six months. The Applicable Margin varies between 1.25% and 2.25% per annum for SOFR loans and between 0.25% and 1.25% per annum for base rate loans, and is based on the Company’s total net leverage ratio from time to time.
Mandatory amortization on the Term Loan A is 2.5% in each of the first and second years and 5.0% in each of the third, fourth and fifth years, with the remaining outstanding
balance due at maturity. The Credit Agreement contains certain covenants, which include, but are not limited to, restrictions on indebtedness, liens, fundamental changes, restricted payments, asset sales, and investments, and places limits on various other payments. The Company was in compliance with the covenants contained in the Credit Agreement as of September 25, 2022.
6.5% Senior Secured Notes due 2025
In November 2017, the Company issued and sold $300 million aggregate principal amount of Senior Secured Notes due 2025 in a private placement conducted pursuant to Rule 144A and Regulation S under the Securities
Act of 1933, as amended. The Company incurred debt issuance costs of $6.6 million associated with the Senior Secured Notes. The Senior Secured Notes were redeemed on March 14, 2022.
Other Indebtedness
Credit and Security Agreement
On November 20, 2017, the Company entered into the amended and restated credit and security agreement (the “Credit and Security Agreement”), which established a five-year senior secured revolving credit facility in the aggregate principal
amount of $90.0 million (subject to a potential increase of the aggregate principal amount to $115.0 million, subject to the agent’s and applicable lenders’ approval), consisting of a subline for letters of credit in an amount not to exceed $50.0 million, as well as a swingline loan in an aggregate principal amount at any time outstanding not to exceed $10.0 million. The Credit and Security Agreement was replaced by the New Credit Facility on February 18, 2022.
Israel Debt
During August 2020, the Company entered into two 5-year term loans with two banks in Israel representing an aggregate principal amount of approximately $5.1 million. These loans were subsidized by
the State of Israel as part of a COVID-19 relief package with interest at Israeli NIS prime interest, plus a margin of 1.5%. The first year of interest was paid by the State of Israel with subsequent interest and principal payments due monthly, commencing in August 2021. The Company repaid all amounts outstanding under this debt in the third quarter of fiscal year 2021.
In connection with the acquisition of 5-D Systems, the
Company assumed a loan in the amount of approximately $0.5 million with an interest rate of 1.0% that had been obtained under the Small Business Administration Paycheck Protection Program as part of a COVID-19 relief package. Payment of interest and principal was due monthly with the balance due in April 2022. The sellers of 5-D Systems applied for forgiveness of this loan, the application was accepted and the loan was forgiven in July 2021.
Other Liquidity Matters
We believe that our cash on hand, together with funds available under the Credit Agreement and cash expected to be generated from operating activities, will be sufficient to fund our anticipated working capital and other cash needs for
at least the next 12 months. As discussed below and in Part I, Item 1A, “Risk Factors” of our Annual Report on Form 10-K, our quarterly and annual operating results have fluctuated in the past and may vary in the future due to a variety of factors, many of which are external to our control. If the conditions in our industry deteriorate or our customers cancel or postpone projects or if we are unable to sufficiently increase our revenues or further reduce our expenses, we may experience a significant long-term negative impact to our financial results and cash flows from operations. In such a situation, we could fall out of compliance with our financial and other covenants, which, if not waived, could limit our liquidity and capital resources.
Critical Accounting Principles
and Estimates
The foregoing discussion of our financial condition and results of operations is based on the Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. The preparation of these Condensed Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, and the related disclosures of contingencies. We base these estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates.
There have been no significant changes to our “Critical Accounting Policies or
Estimates” as compared to the significant accounting policies described in our Annual Report on Form 10-K.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Since December 26, 2021, there have been no material changes in the quantitative or qualitative aspects of our market risk profile. For additional information regarding our exposure to certain market risks, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” included in our Annual Report on Form 10-K.
Item 4.
Controls and Procedures.
Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures
We maintain disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized
that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) promulgated under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report.
Based on the foregoing, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and
procedures were effective at the reasonable assurance level as of September 25, 2022.
Changes in Internal Control Over Financial Reporting
We operate under the Committee of Sponsoring Organizations 2013 Framework. There was no change in our internal control over financial reporting during the three months ended September 25, 2022 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
See Note 14 of the Notes to Condensed Consolidated Financial Statements contained within this Quarterly Report for a discussion of our legal proceedings.
Item 1A. Risk Factors.
In evaluating us and our common stock, we urge you to carefully consider the risks and other information in this Quarterly Report on Form 10-Q, as well
as the risk factors disclosed in Item 1A. to Part I of our Annual Report on Form 10-K, and other reports that we have filed with the SEC. Any of the risks discussed in such reports, as well as additional risks and uncertainties not currently known to us or that we currently deem immaterial, could materially and adversely affect our results of operations, financial condition or prospects. During the period covered by this Quarterly Report on Form 10-Q, there have been no material changes in our risk factors as previously disclosed.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
* Certain confidential portions of the exhibit have been redacted from the filed version of the exhibit and are marked with a [***]. The Company agrees to furnish supplementally to the Securities and Exchange Commission an unredacted copy of the exhibit upon request.
** Certain confidential information contained in this Exhibit has been omitted because it is both (i) not material and (ii) the type of information that the registrant treats as private or confidential.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
