Kratos Defense & Security Solutions, Inc 10-Q for FY2020 Q3
Kratos Defense & Security Solutions, Inc. (KTOS)
10-Q
2020-10-29
For: 2020-09-27
View Original
Added on
April 09, 2026
About this 10-Q
Kratos Defense & Security Solutions, Inc filed this 10-Q on October 29, 2020, covering the quarter ended September 27, 2020 (FY2020 Q3).
Headline figures
Quarter ended September 27, 2020, as reported in this filing, compared with the same period a year earlier where the filing states it.
- Revenue
- $202M
- up 9.7% from $184.1M a year earlier
- Net income
- $2.4M
- down 4.0% from net income of $2.5M a year earlier
- Diluted EPS
- $0.02
- unchanged from $0.02 a year earlier
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 27, 2020
or
For the transition period from __________ to __________
Commission file number 001-34460
(Exact name of registrant as specified in its charter)
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | ||||
(858 ) 812-7300
(Address, including zip code, and telephone number, including
area code, of registrant’s principal executive offices)
Securities registered pursuant to Section 12(b) of the Act:
| Title of each class | Trading Symbol(s) | Name of each exchange on which registered | ||||||
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. Yes ý 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 (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ý 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.
ý | Accelerated filer | ☐ | |||||||||
| Non-accelerated filer | ☐ | Smaller reporting company | |||||||||
| Emerging growth company | |||||||||||
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 ☒
As of October 23, 2020, 122,756,128 shares of the registrant’s common stock were outstanding.
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 27, 2020
INDEX
| Page | ||||||||
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
3
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except par value and number of shares)
| September 27, 2020 | |||||||||||
| (Unaudited) | December 29, 2019 | ||||||||||
| Assets | |||||||||||
| Current assets: | |||||||||||
| Cash and cash equivalents | $ | $ | |||||||||
| Restricted cash | |||||||||||
| Accounts receivable, net | |||||||||||
| Unbilled receivables, net | |||||||||||
| Inventoried costs | |||||||||||
| Prepaid expenses | |||||||||||
| Other current assets | |||||||||||
| Current assets of discontinued operations | |||||||||||
| Total current assets | |||||||||||
| Property, plant and equipment, net | |||||||||||
| Operating lease right-of-use assets | |||||||||||
| Goodwill | |||||||||||
| Intangible assets, net | |||||||||||
| Other assets | |||||||||||
| Total assets | $ | $ | |||||||||
Liabilities and Stockholders’ Equity | |||||||||||
| Current liabilities: | |||||||||||
| Accounts payable | $ | $ | |||||||||
| Accrued expenses | |||||||||||
| Accrued compensation | |||||||||||
| Accrued interest | |||||||||||
| Billings in excess of costs and earnings on uncompleted contracts | |||||||||||
| Current portion of operating lease liabilities | |||||||||||
| Other current liabilities | |||||||||||
| Current liabilities of discontinued operations | |||||||||||
| Total current liabilities | |||||||||||
| Long-term debt | |||||||||||
| Operating lease liabilities, net of current portion | |||||||||||
| Other long-term liabilities | |||||||||||
| Long-term liabilities of discontinued operations | |||||||||||
| Total liabilities | |||||||||||
| Commitments and contingencies (Note 15) | |||||||||||
| Redeemable noncontrolling interest | |||||||||||
Stockholders’ equity: | |||||||||||
Preferred stock, $ | |||||||||||
Common stock, $ | |||||||||||
| Additional paid-in capital | |||||||||||
| Accumulated other comprehensive loss | ( | ||||||||||
| Accumulated deficit | ( | ( | |||||||||
Total stockholders’ equity | |||||||||||
Total liabilities and stockholders’ equity | $ | $ | |||||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
4
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in millions, except per share amounts)
(Unaudited)
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Service revenues | $ | $ | $ | $ | |||||||||||||||||||
| Product sales | |||||||||||||||||||||||
| Total revenues | |||||||||||||||||||||||
| Cost of service revenues | |||||||||||||||||||||||
| Cost of product sales | |||||||||||||||||||||||
| Total costs | |||||||||||||||||||||||
| Gross profit | |||||||||||||||||||||||
| Selling, general and administrative expenses | |||||||||||||||||||||||
| Merger and acquisition expenses | |||||||||||||||||||||||
| Research and development expenses | |||||||||||||||||||||||
| Restructuring expenses and other | ( | ||||||||||||||||||||||
| Operating income from continuing operations | |||||||||||||||||||||||
| Other expense: | |||||||||||||||||||||||
| Interest expense, net | ( | ( | ( | ( | |||||||||||||||||||
| Other income (expense), net | ( | ( | |||||||||||||||||||||
| Total other expense, net | ( | ( | ( | ( | |||||||||||||||||||
| Income from continuing operations before income taxes | |||||||||||||||||||||||
| Provision for income taxes from continuing operations | |||||||||||||||||||||||
| Income from continuing operations | |||||||||||||||||||||||
| Discontinued operations: | |||||||||||||||||||||||
| Income(loss) from operations of discontinued component | ( | ( | |||||||||||||||||||||
| Income tax benefit | |||||||||||||||||||||||
| Income (loss) from discontinued operations | ( | ( | |||||||||||||||||||||
| Net income | |||||||||||||||||||||||
| Less: Net income (loss) attributable to noncontrolling interest | ( | ||||||||||||||||||||||
| Net income attributable to Kratos | $ | $ | $ | $ | |||||||||||||||||||
| Basic income per common share attributable to Kratos: | |||||||||||||||||||||||
| Income from continuing operations | $ | $ | $ | $ | |||||||||||||||||||
| Income (loss) from discontinued operations | ( | ||||||||||||||||||||||
| Net income per common share | $ | $ | $ | $ | |||||||||||||||||||
| Diluted income per common share attributable to Kratos: | |||||||||||||||||||||||
| Income from continuing operations | $ | $ | $ | $ | |||||||||||||||||||
| Income (loss) from discontinued operations | ( | ||||||||||||||||||||||
| Net income per common share | $ | $ | $ | $ | |||||||||||||||||||
| Weighted average common shares outstanding: | |||||||||||||||||||||||
| Basic | |||||||||||||||||||||||
| Diluted | |||||||||||||||||||||||
| Comprehensive Income | |||||||||||||||||||||||
| Net income (from above) | $ | $ | $ | $ | |||||||||||||||||||
| Change in cumulative translation adjustment | ( | ( | |||||||||||||||||||||
| Comprehensive income | |||||||||||||||||||||||
| Less: Comprehensive income (loss) attributable to noncontrolling interest | ( | ||||||||||||||||||||||
| Comprehensive income attributable to Kratos | $ | $ | $ | $ | |||||||||||||||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
5
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the three months ended September 29, 2019 and September 27, 2020
(in millions)
(Unaudited)
| Redeemable Noncontrolling Interest | Common Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Accumulated Deficit | Total Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||
| Shares | Amounts | |||||||||||||||||||||||||||||||||||||||||||||||||
| Balance, June 30, 2019 | $ | $ | $ | $ | $ | ( | $ | ( | $ | |||||||||||||||||||||||||||||||||||||||||
| Stock-based compensation | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
Issuance of common stock for employee stock purchase plan, options and warrants | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
Restricted stock issued and related taxes | — | — | ( | — | — | ( | ||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
| Other comprehensive loss, net of tax | — | — | — | — | ( | — | ( | |||||||||||||||||||||||||||||||||||||||||||
| Balance, September 29, 2019 | $ | $ | $ | $ | ( | $ | ( | $ | ||||||||||||||||||||||||||||||||||||||||||
| Redeemable Noncontrolling Interest | Common Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Accumulated Deficit | Total Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||
| Shares | Amounts | |||||||||||||||||||||||||||||||||||||||||||||||||
| Balance, June 28, 2020 | $ | $ | $ | $ | ( | $ | ( | $ | ||||||||||||||||||||||||||||||||||||||||||
| Stock-based compensation | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
Issuance of common stock for employee stock purchase plan, options and warrants | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
Restricted stock issued and related taxes | — | — | ( | — | — | ( | ||||||||||||||||||||||||||||||||||||||||||||
Issuance of common stock for cash | — | — | — | ( | — | — | ( | |||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
| Other comprehensive income, net of tax | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
| Balance, September 27, 2020 | $ | $ | $ | $ | $ | ( | $ | |||||||||||||||||||||||||||||||||||||||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
6
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the nine months ended September 29, 2019 and September 27, 2020
(in millions)
(Unaudited)
| Redeemable Noncontrolling Interest | Common Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Accumulated Deficit | Total Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||
| Shares | Amounts | |||||||||||||||||||||||||||||||||||||||||||||||||
| Balance, December 30, 2018 | $ | $ | $ | $ | ( | $ | ( | $ | ||||||||||||||||||||||||||||||||||||||||||
| Stock-based compensation | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
Issuance of common stock for employee stock purchase plan, options and warrants | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
| Restricted stock issued and related taxes | — | — | ( | — | — | ( | ||||||||||||||||||||||||||||||||||||||||||||
Issuance of common stock for acquisitions | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
| Net income | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
Other comprehensive loss, net of tax | — | — | — | — | ( | — | ( | |||||||||||||||||||||||||||||||||||||||||||
| Changes in noncontrolling interest | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
| Balance, September 29, 2019 | $ | $ | $ | ( | $ | ( | $ | |||||||||||||||||||||||||||||||||||||||||||
| Redeemable Noncontrolling Interest | Common Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Accumulated Deficit | Total Stockholders’ Equity | |||||||||||||||||||||||||||||||||||||||||||||
| Shares | Amounts | |||||||||||||||||||||||||||||||||||||||||||||||||
| Balance, December 29, 2019 | $ | $ | $ | $ | ( | $ | ( | $ | ||||||||||||||||||||||||||||||||||||||||||
| Stock-based compensation | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||||||||
Issuance of common stock for employee stock purchase plan, options and warrants | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
Restricted stock issued and related taxes | — | — | ( | — | — | ( | ||||||||||||||||||||||||||||||||||||||||||||
| Issuance of common stock for cash | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
| Net Income (loss) | ( | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
| Other comprehensive income, net of tax | — | — | — | — | ||||||||||||||||||||||||||||||||||||||||||||||
| Balance, September 27, 2020 | $ | $ | $ | $ | $ | ( | $ | |||||||||||||||||||||||||||||||||||||||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
7
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
(Unaudited)
| Nine Months Ended | |||||||||||
| September 27, 2020 | September 29, 2019 | ||||||||||
| Operating activities: | |||||||||||
| Net income | $ | $ | |||||||||
| Income (loss) from discontinued operations | ( | ||||||||||
| Income from continuing operations | |||||||||||
| Adjustments to reconcile income from continuing operations to net cash provided by operating activities from continuing operations: | |||||||||||
| Depreciation and amortization | |||||||||||
| Amortization of lease right-of-use assets | |||||||||||
| Stock-based compensation | |||||||||||
| Deferred income taxes | ( | ( | |||||||||
| Amortization of deferred financing costs | |||||||||||
| Provision for doubtful accounts | |||||||||||
| Changes in assets and liabilities, net of acquisitions: | |||||||||||
| Accounts receivable | |||||||||||
| Unbilled receivables | ( | ||||||||||
| Inventoried costs | ( | ( | |||||||||
| Prepaid expenses and other assets | ( | ( | |||||||||
| Operating lease liabilities | ( | ( | |||||||||
| Accounts payable | ( | ( | |||||||||
| Accrued expenses | ( | ( | |||||||||
| Accrued compensation | |||||||||||
| Accrued interest | |||||||||||
| Billings in excess of costs and earnings on uncompleted contracts | ( | ( | |||||||||
| Income tax receivable and payable | ( | ||||||||||
| Other liabilities | ( | ||||||||||
| Net cash provided by operating activities from continuing operations | |||||||||||
| Investing activities: | |||||||||||
| Cash paid for acquisitions, net of cash acquired | ( | ( | |||||||||
| Capital expenditures | ( | ( | |||||||||
| Proceeds from sale of assets | |||||||||||
| Net cash used in investing activities from continuing operations | ( | ( | |||||||||
| Financing activities: | |||||||||||
| Proceeds from the issuance of long-term debt | |||||||||||
| Proceeds from the issuance of common stock, net of issuance costs | |||||||||||
| Repayment of debt | ( | ||||||||||
| Payments under finance leases | ( | ( | |||||||||
| Proceeds from exercise of restricted stock units, employee stock options, and employee stock purchase plan | |||||||||||
| Net cash provided by financing activities from continuing operations | |||||||||||
| Net cash flows of continuing operations | ( | ||||||||||
| Net operating cash flows of discontinued operations | |||||||||||
| Effect of exchange rate changes on cash, cash equivalents and restricted cash | ( | ||||||||||
| Net increase (decrease) in cash, cash equivalents and restricted cash | ( | ||||||||||
| Cash, cash equivalents and restricted cash at beginning of period | |||||||||||
| Cash, cash equivalents and restricted cash at end of period | $ | $ | |||||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
8
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Summary 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) Basis of Presentation
(b) Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company, its 100% owned subsidiaries and its majority owned subsidiaries, FTT Inc. and FTT Core (each as defined below), each of which is 80.1 19.9
(c) Fiscal Year
The Company has a 52/53 week fiscal year ending on the last Sunday of the calendar year. The three month periods ended September 27, 2020 and September 29, 2019 consisted of 13-week periods. The nine month periods ended September 27, 2020 and September 29, 2019 consisted of 39-week periods. There are 52 calendar weeks in the fiscal years ending on December 27, 2020 and December 29, 2019.
(d) Accounting Estimates
(e) Accounting Standards Updates
9
(f) Fair Value of Financial Instruments
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 27, 2020 and December 29, 2019 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 27, 2020 and December 29, 2019 due to the short-term nature of these instruments.
Note 2. Acquisitions
FTT Entities
On February 27, 2019, the Company acquired 80.1 % of the issued and outstanding shares of capital stock of Florida Turbine Technologies Inc., a Florida corporation (“FTT Inc.”), and 80.1 % of the membership interests in FTT CORE, LLC, a Delaware limited liability company (“FTT Core” and, together with FTT Inc. and their respective subsidiaries, “FTT”), for an aggregate purchase price of approximately $60 million. The purchase price was $33 million in cash, with approximately $17.7 million paid at close and approximately $15.3 million to be paid over a three-year period, subject to adjustments for transaction expenses, indebtedness, cash on hand, certain amounts payable or potentially payable to employees of FTT and post-closing working capital adjustments, and 1,825,406 shares of common stock (with a value of approximately $27 million). On October 6, 2020, final proceeds related to net working capital adjustments of $1.95 million were distributed to the shareholders of FTT.
FTT is a leading turbomachinery design and manufacturing company specializing in engineering, development, and testing of gas turbines, propulsion components, engine and other systems for military and commercial applications. FTT is now the Kratos Turbine Technologies Division (the “KTT Division”), which is focused on the development and production of small, affordable, high-performance jet engines for the next generation of tactical weapon systems and tactical jet unmanned aerial systems. The KTT Division is included in the Kratos Government Solutions (“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 enabling it to accelerate FTT’s small engine development programs, and facilitate integration of these leading-edge engine solutions with evolving Kratos tactical systems.
Simultaneously with the execution of the Purchase Agreement among the Company and the Sellers (as defined in such agreement) (the “Purchase Agreement”) and completion of the acquisition, the Company, FTT Inc., FTT Core and the Sellers entered into an exchange agreement (the “Exchange Agreement”) pursuant to which, among other things, (i) FTT Core was converted into a Delaware corporation, (ii) beginning in January 2024, the Holders (as defined in the Exchange Agreement) will have an annual right (the “Put Right”) to sell all of the minority interests in FTT Inc. and FTT Core (the “Minority Interests”) to the Company at a purchase price based on a specified multiple of the trailing 12 months EBITDA of FTT Inc., FTT Core and each of their respective subsidiaries (the “Acquired Companies”), subject to adjustment as set forth in the Exchange Agreement (the “Minority Interest Purchase Price”) (provided, however, that following certain events, including a change of control, the Put Right will be accelerated and the Minority Interest Purchase Price will be a specified increased multiple of the trailing 12 months EBITDA of the Acquired Companies), and (iii) 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.
The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired, the liabilities assumed, and the noncontrolling interest 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
10
thus represent Level 3 measurements. The following table summarizes the allocation of the purchase price over the estimated fair values of the major assets acquired, liabilities assumed, and noncontrolling interest (in millions):
| Accounts receivable | $ | |||||||
| Unbilled receivables | ||||||||
| Inventoried costs | ||||||||
| Other current assets | ||||||||
| Property and equipment | ||||||||
| Intangible assets | ||||||||
| Goodwill | ||||||||
| Total identifiable net assets acquired | ||||||||
| Total identifiable net liabilities assumed | ( | |||||||
| Net assets before noncontrolling interest | ||||||||
| Noncontrolling interest | ( | |||||||
| Net assets acquired, excluding cash | $ | |||||||
As of February 27, 2019, net liabilities included $7.5 million of current liabilities. There was no contingent purchase consideration associated with the acquisition of an 80.1 % majority interest in FTT. The identifiable intangible assets include customer relationships of $19.7 million with a useful life of 13 years, in-process research and development of $8.5 million that will commence amortization at the completion of the development project, backlog of $2.1 million with a useful life of two years , and trade name of $0.5 million with a useful life of two years . The Company also established a deferred tax liability of $7.0 million for the increase in the financial statement basis of the acquired assets of FTT 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 FTT included in the Company's condensed consolidated statement of operations for the three months ended September 29, 2019 were $16.3 million and $0.7 million, respectively. The amounts of revenue and operating income of FTT included in the Company's condensed consolidated statement of operations for the nine months ended September 29, 2019 were $37.7 million and $1.0 million, respectively. Included in Merger and acquisition expenses for the nine months ended September 29, 2019 were transaction expenses of $1.3 million, related to the acquisition of FTT.
A summary of the consideration paid for the acquired ownership in FTT is as follow:
| Cash paid | $ | |||||||
| Deferred purchase consideration | ||||||||
| Common stock issued | ||||||||
| Less: Cash acquired | ( | |||||||
| Total consideration | $ | |||||||
Pro Forma Financial Information
The following tables summarize the supplemental condensed consolidated statements of operations information on an unaudited pro forma basis as if the acquisition of FTT occurred on December 31, 2018 and include adjustments that were directly attributable to the foregoing transactions. There are no material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transaction been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future.
11
For the nine months ended September 29, 2019 (all amounts, except per share amounts, are in millions):
| Pro forma revenues | $ | ||||
| Pro forma net income before tax | $ | ||||
| Pro forma net income | $ | ||||
| Pro forma net income attributable to Kratos | $ | ||||
| Basic pro forma income per share attributable to Kratos | $ | ||||
| Diluted pro forma income per share attributable to Kratos | $ | ||||
The weighted average common shares used to calculate income per share also reflects the issuance of 1,825,406 shares of our common stock in conjunction with the acquisition. Comparable amounts for the three months ended September 29, 2019 are not presented as the results for FTT for the quarter were fully included in the condensed consolidated financial statements.
Technical Directions, Inc.
On February 24, 2020, the Company acquired Technical Directions, Inc.(“TDI”), a turbine technology company focused on tactical unmanned aerial drones, missile and other systems for approximately $10.5 million in cash, subject to adjustments for transaction expenses, indebtedness, cash on hand, and post-closing working capital adjustments. Working capital adjustments of $0.3 million were settled in the third quarter of 2020. 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. The amount of net sales and earnings of TDI included in the condensed consolidated statement of operations for the nine months ended September 27, 2020 are not material. Had the acquisition occurred as of December 29, 2019, 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 nine months ended September 27, 2020 would not have been materially different than the reported amounts. TDI is included in the Kratos Unmanned Systems (“US”) segment.
Optimized Performance Machining, Inc.
On April 17, 2020, the Company acquired Optimized Performance Machining, Inc.(“OPM”), a company that primarily operates in the industrial machinery and equipment repair business industry for approximately $1.8 million in cash, subject to adjustments for transaction expenses, indebtedness, cash on hand, and post-closing working capital adjustments. Working capital adjustments of $0.03 million were settled in the third quarter of 2020. 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 unaudited condensed consolidated financial statements. 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 OPM included in the condensed consolidated statement of operations for the nine months ended September 27, 2020 are not material. Had the acquisition occurred as of December 29, 2019, 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 nine months ended September 27, 2020 would not have been materially different than the reported amounts. OPM is included in the Kratos US segment.
CPI ASC Signal Division, Inc.
On June 15, 2020, Kratos Integral Holdings, LLC entered into a Stock Purchase Agreement to acquire CPI ASC Signal Division, Inc. (“ASC Signal”) from Communications & Power Industries LLC for approximately $35 million in cash, subject to adjustments for transaction expenses, indebtedness, cash on hand, and working capital adjustments. ASC Signal is a manufacturer of high-performance, highly engineered antenna systems for satellite communications, radar, electronic warfare, and high frequency applications. On June 30, 2020, the acquisition was completed following the satisfaction of all closing conditions, including receipt of regulatory approval from all required government authorities.
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 ASC Signal’s existing business with Kratos’ related products and customers.
12
The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the 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 | $ | |||||||
| Unbilled receivables | ||||||||
| Inventoried costs | ||||||||
| Other current assets | ||||||||
| Property and equipment | ||||||||
| Intangible assets | ||||||||
| Goodwill | ||||||||
| Total identifiable net assets acquired | ||||||||
| Total identifiable net liabilities assumed | ( | |||||||
| Net assets acquired, excluding cash | $ | |||||||
Based on the Company’s preliminary estimate of fair value, as of June 30, 2020, net liabilities included $9.1 million of current liabilities. The identifiable intangible assets include trade names of $0.1 million with a remaining useful life of 1 year, customer relationships of $2.0 million with remaining useful lives of 5 years, and developed technology of $2.2 million with a remaining useful life of 7 years. The Company also established a deferred tax liability of $1.3 million for the difference between the financial statement basis and tax basis of the acquired assets of ASC Signal 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 income of ASC Signal included in the Company's condensed consolidated statement of operations for the three months ended September 27, 2020 were $10.2 million and $0.7 million, respectively. Included in Merger and acquisition expenses for the three and nine months ended September 27, 2020 were transaction expenses of $0.1 million and $1.1 million, respectively, related to the acquisition of ASC Signal.
A summary of the consideration paid for the acquired ownership in ASC Signal is as follows:
| Cash paid | $ | |||||||
| Less: Cash acquired | ( | |||||||
| Total consideration | $ | |||||||
Pro Forma Financial Information
The following tables summarize the supplemental condensed consolidated statements of operations information on an unaudited pro forma basis as if the acquisition of ASC Signal occurred on December 30, 2019 and include adjustments that were directly attributable to the foregoing transactions. There are no material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings (loss). The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transaction been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future.
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For the nine months ended September 27, 2020 (all amounts, except per share amounts, are in millions):
| Pro forma revenues | $ | ||||
| Pro forma net loss before tax | $ | ( | |||
| Pro forma net loss | $ | ( | |||
| Basic pro forma loss per share | $ | ( | |||
| Diluted pro forma loss per share | $ | ( | |||
Note 3. Revenue Recognition
The Company recognizes revenue in accordance with Accounting Standards Codification 606, Revenue from Contracts with Customers (“ASC 606”). Under ASC 606 revenue is recognized when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration that the Company expects to be entitled to receive in exchange for these goods or services.
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 the 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 and 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.
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 27, 2020, the Company had approximately $873.1 million of remaining performance obligations. The Company expects to recognize approximately 22 % of the remaining performance obligations as revenue in 2020, an additional 35 % by 2021, and the balance thereafter.
Contract Estimates
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.
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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 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 27, 2020, and September 29, 2019. Likewise, total cumulative catch-up adjustments were not material for the three and nine-month periods ended September 27, 2020, and September 29, 2019.
Contract Assets and Liabilities
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.
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Net contract assets and liabilities are as follows (in millions):
| September 27, 2020 | December 29, 2019 | Net Change | |||||||||||||||
| Contract assets | $ | $ | $ | ||||||||||||||
| Contract liabilities | $ | $ | $ | ||||||||||||||
| Net contract assets | $ | $ | $ | ||||||||||||||
Contract assets increased $13.3 million during the nine months ended September 27, 2020, 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 27, 2020. Contract liabilities increased $2.0 million during the nine months ended September 27, 2020, primarily due to payments received in excess of revenue recognized on these performance obligations. For the three and nine months ended September 27, 2020 the Company recognized revenue of $3.5 million and $23.5 million, respectively, that was previously included in the contract liabilities that existed at December 29, 2019. For the three and nine months ended September 29, 2019 the Company recognized revenue of $5.3 million and $26.6 million, respectively, that was previously included in the contract liabilities that existed at December 30, 2018.
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 27, 2020 and December 29, 2019, approximately $11.5 10.0
16
Disaggregation of Revenue
The following series of tables presents the Company’s revenue disaggregated by several categories. For the majority of contracts, the customer obtains control or receives benefits as work is performed on the contract. Revenue by contract type was as follows (in millions):
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Kratos Government Solutions | |||||||||||||||||||||||
| Fixed price | $ | $ | $ | $ | |||||||||||||||||||
| Cost plus fee | |||||||||||||||||||||||
| Time and materials | |||||||||||||||||||||||
| Total Kratos Government Solutions | |||||||||||||||||||||||
| Unmanned Systems | |||||||||||||||||||||||
| Fixed price | |||||||||||||||||||||||
| Cost plus fee | |||||||||||||||||||||||
| Time and materials | |||||||||||||||||||||||
| Total Unmanned Systems | |||||||||||||||||||||||
| Total Revenues | $ | $ | $ | $ | |||||||||||||||||||
Revenue by customer was as follows (in millions):
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Kratos Government Solutions | |||||||||||||||||||||||
U.S. Government (1) | $ | $ | $ | $ | |||||||||||||||||||
International (2) | |||||||||||||||||||||||
| U.S. Commercial and other customers | |||||||||||||||||||||||
| Total Kratos Government Solutions | |||||||||||||||||||||||
| Unmanned Systems | |||||||||||||||||||||||
U.S. Government (1) | |||||||||||||||||||||||
International (2) | |||||||||||||||||||||||
| U.S. Commercial and other customers | |||||||||||||||||||||||
| Total Unmanned Systems | |||||||||||||||||||||||
| Total Revenues | $ | $ | $ | $ | |||||||||||||||||||
(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. Discontinued Operations
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To date, the Company has collected approximately $6.8 million of the retained net working capital. The Company currently expects that the remaining net working capital retained by the Company will be collected during 2020 once certain legacy projects are completed and the project close-out process has been completed. The Company currently expects to recognize a net approximate break-even on the sale of the PSS business once the aggregate net proceeds from the Transaction have been collected, excluding the impact of the final settlement and determination of the closing net working capital adjustment. Any changes or adjustments to the expected net proceeds will be reflected in future periods.
The following table presents the results of discontinued operations (in millions):
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Revenue | $ | $ | $ | $ | |||||||||||||||||||
| Cost of sales | |||||||||||||||||||||||
| Selling, general and administrative expenses | |||||||||||||||||||||||
| Other (income) expense | ( | ||||||||||||||||||||||
| Income (loss) from discontinued operations before income taxes | ( | ( | |||||||||||||||||||||
| Income tax benefit | |||||||||||||||||||||||
| Income (loss) from discontinued operations | $ | ( | $ | $ | ( | $ | |||||||||||||||||
Revenue and operating results for the three and nine months ended September 27, 2020 and September 29, 2019 reflected the performance on contracts related to the working capital retained by the Company and legal expenses incurred related to the ongoing working capital dispute with the Buyer of PSS.
| September 27, 2020 | December 29, 2019 | ||||||||||
| Accounts receivable, net | $ | $ | |||||||||
| Current assets of discontinued operations | $ | $ | |||||||||
| Accounts payable | $ | $ | |||||||||
| Accrued expenses | |||||||||||
| Other current liabilities | |||||||||||
| Current liabilities of discontinued operations | $ | $ | |||||||||
| Other long-term liabilities of discontinued operations | $ | $ | |||||||||
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Note 5. Goodwill and Intangible Assets
(a) Goodwill
| As of September 27, 2020 | |||||||||||||||||
| Kratos Government Solutions | Unmanned Systems | Total | |||||||||||||||
| Gross value | $ | $ | $ | ||||||||||||||
| Less accumulated impairment | |||||||||||||||||
| Net | $ | $ | $ | ||||||||||||||
| As of December 29, 2019 | |||||||||||||||||
| Kratos Government Solutions | Unmanned Systems | Total | |||||||||||||||
| Gross value | $ | $ | $ | ||||||||||||||
| Less accumulated impairment | |||||||||||||||||
| Net | $ | $ | $ | ||||||||||||||
(b) Purchased Intangible Assets
The following table sets forth information for finite-lived and indefinite-lived intangible assets (in millions):
| As of September 27, 2020 | As of December 29, 2019 | ||||||||||||||||||||||||||||||||||
| Gross Value | Accumulated Amortization | Net Value | Gross Value | Accumulated Amortization | Net Value | ||||||||||||||||||||||||||||||
| Acquired finite-lived intangible assets: | |||||||||||||||||||||||||||||||||||
| Customer relationships | $ | $ | ( | $ | $ | $ | ( | $ | |||||||||||||||||||||||||||
| Contracts and backlog | ( | ( | |||||||||||||||||||||||||||||||||
| Developed technology and technical know-how | ( | ( | |||||||||||||||||||||||||||||||||
| Trade names | ( | ( | |||||||||||||||||||||||||||||||||
| In-process research and development | |||||||||||||||||||||||||||||||||||
| Total finite-lived intangible assets | ( | ( | |||||||||||||||||||||||||||||||||
| Indefinite-lived trade names | — | — | |||||||||||||||||||||||||||||||||
| Total intangible assets | $ | $ | ( | $ | $ | $ | ( | $ | |||||||||||||||||||||||||||
Consolidated amortization expense related to intangible assets subject to amortization was $1.7 million and $1.7 million for the three months ended September 27, 2020 and September 29, 2019, respectively, and $5.4 million and $5.2 million for the nine months ended September 27, 2020 and September 29, 2019, respectively.
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Note 6. Inventoried Costs
Inventoried costs, consisted of the following components (in millions):
| September 27, 2020 | December 29, 2019 | ||||||||||
| Raw materials | $ | $ | |||||||||
| Work in process | |||||||||||
| Finished goods | |||||||||||
| Total inventoried costs | $ | $ | |||||||||
Note 7. Net Income (Loss) per Common Share
The Company calculates net income (loss) per share in accordance with FASB Accounting Standards Codification Topic 260, Earnings per Share (Topic 260). Under Topic 260, 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 attributable to the Kratos shareholders reflects the effects of potentially dilutive securities. The dilutive impact of potentially dilutive common shares is determined by applying the treasury stock method.
Shares from stock options and awards, excluded from the calculation of diluted net income per share because their inclusion would have been anti-dilutive, were 0.0 million and 0.6 million for the three and nine months ended September 27, 2020, respectively.
Note 8. Leases
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.
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| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Amortization of right of use assets - finance leases | $ | $ | $ | $ | |||||||||||||||||||
| Interest on lease liabilities - finance leases | |||||||||||||||||||||||
| Operating lease cost | |||||||||||||||||||||||
| Short-term lease cost | |||||||||||||||||||||||
| Variable lease cost (cost excluded from lease payments) | |||||||||||||||||||||||
| Sublease income | ( | ( | ( | ( | |||||||||||||||||||
Total lease cost | $ | $ | $ | $ | |||||||||||||||||||
The components of leases on the balance sheet were as follows (in millions):
| September 27, 2020 | December 29, 2019 | ||||||||||
| Operating Leases: | |||||||||||
Operating lease right-of-use assets | $ | $ | |||||||||
Current portion of operating lease liabilities | $ | $ | |||||||||
Operating lease liabilities, net of current portion | $ | $ | |||||||||
| Finance leases: | |||||||||||
Property, plant and equipment, net | $ | $ | |||||||||
| $ | $ | ||||||||||
| $ | $ | ||||||||||
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Cash paid for amounts included in the measurement of lease liabilities was as follows (in millions):
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Finance lease - cash paid for interest | $ | $ | $ | $ | |||||||||||||||||||
| Finance lease - financing cash flows | $ | $ | $ | $ | |||||||||||||||||||
| Operating lease - operating cash flows (fixed payments) | $ | $ | $ | $ | |||||||||||||||||||
Other supplemental noncash information (in millions):
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Operating lease liabilities arising from obtaining right-of-use assets, including impact of ASC 842 adoption | $ | $ | $ | $ | |||||||||||||||||||
| Finance lease liabilities arising from obtaining right-of-use assets, including impact of ASC 842 adoption | $ | $ | $ | $ | |||||||||||||||||||
| Weighted-average remaining lease term (in years): | |||||||||||||||||||||||
Operating leases | |||||||||||||||||||||||
Finance leases | |||||||||||||||||||||||
| Weighted-average discount rate: | |||||||||||||||||||||||
Operating leases | % | % | |||||||||||||||||||||
Finance leases | % | % | |||||||||||||||||||||
The maturity of lease liabilities is (in millions):
| Operating Leases | Finance Leases | ||||||||||
2020 (1) | $ | $ | |||||||||
| 2021 | |||||||||||
| 2022 | |||||||||||
| 2023 | |||||||||||
| 2024 | |||||||||||
| Thereafter | |||||||||||
| Total lease payments | |||||||||||
| Less: imputed interest | ( | ( | |||||||||
| Total present value of lease liabilities | $ | $ | |||||||||
(1) Excludes the nine months ended September 27, 2020. | |||||||||||
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Note 9. Income Taxes
On March 27, 2020, the President signed into law the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”), which, along with earlier issued IRS guidance, provides for the deferral of certain taxes. The CARES Act, among other things, removed the 80% limitation on the utilization of net operating losses in tax years 2018-2020, and contains numerous other provisions which may benefit the Company. The CARES Act did not have a material impact on the Company’s effective tax rate for the nine months ended September 27, 2020.
A reconciliation of the income tax expense (benefit) from continuing operations computed by applying the statutory federal income tax rate of 21% to income from continuing operations before income taxes to the provision for income taxes from continuing operations for the three and nine months ended September 27, 2020 and September 29, 2019 was as follows (in millions):
| For the Three Months Ended | For the Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Income tax expense at federal statutory rate | $ | $ | $ | $ | |||||||||||||||||||
| State and foreign taxes, net of federal tax benefit and valuation allowance | |||||||||||||||||||||||
| Release of valuation allowance due to acquisitions | ( | ( | ( | ( | |||||||||||||||||||
| Nondeductible expenses and other | |||||||||||||||||||||||
| Impact of deferred tax liabilities for indefinite-lived assets | |||||||||||||||||||||||
| Increase in reserves for uncertain tax positions | |||||||||||||||||||||||
| Decrease in federal valuation allowance | ( | ( | ( | ( | |||||||||||||||||||
| Provision for income taxes from continuing operations | $ | $ | $ | $ | |||||||||||||||||||
In assessing the Company’s ability to realize deferred tax assets, management considers, on a periodic basis, whether it is more likely than not that some portion or all of its deferred tax assets will not be realized. In making this assessment, the Company has concluded that negative evidence, including cumulative losses in recent years, continues to outweigh the positive evidence. Accordingly, the Company has maintained a full valuation allowance against the Company’s U.S. federal, combined state and certain foreign net deferred tax assets. However, given the Company’s more recent earnings history, management believes that it is possible that within the next 12 months, sufficient positive evidence may become available to allow management to reach a conclusion that a significant portion of the valuation allowance will no longer be needed. Release of the valuation allowance would result in the recognition of certain deferred tax assets with a potential corresponding decrease to income tax expense for the period the release is recorded. The exact timing and amount of the valuation allowance release would be predicated on the basis of the level of profitability that the Company is able to actually achieve and believes that it would sustain.
Federal and state income tax laws impose restrictions on the utilization of net operating loss (“NOL”) and tax credit carryforwards in the event that an “ownership change” occurs for tax purposes, as defined by Section 382 of the Internal Revenue Code of 1986, as amended (“Section 382”). In general, an ownership change occurs when shareholders owning 5% or more of a “loss corporation” (a corporation entitled to use NOLs or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any three-year period. The annual base Section 382 limitation is calculated by multiplying the loss corporation’s value at the time of the ownership change by the greater of the long-term tax-exempt rate determined by the Internal Revenue Service in the month of the ownership change or the two preceding months. This base limitation is subject to adjustments, including an increase for built-in gains recognized in the five-year period after the ownership change.
In March 2010, an “ownership change” occurred that will limit the utilization of NOL carryforwards. In July 2011, another “ownership change” occurred. The March 2010 ownership change limitation is more restrictive. In prior years, the Company acquired corporations with NOL carryforwards at the date of acquisition (“Acquired NOLs”). The Acquired NOLs are subject to separate limitations that may further restrict the use of Acquired NOLs. As a result, the Company’s federal annual utilization of NOL carryforwards was limited to $27.0 million a year for the five years succeeding the March 2010 ownership change and $11.6 million for each year thereafter subject to separate limitations for Acquired NOLs. If the entire limitation amount is not utilized in a year, the excess can be carried forward and utilized in future years.
For the nine months ended September 27, 2020, there was no impact of such limitations on the income tax provision, since the amount of taxable income did not exceed the annual limitation amount. However, future equity offerings or
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acquisitions that have equity as a component of the purchase price could also cause an “ownership change.” If and when any other “ownership change” occurs, utilization of the NOLs or other tax attributes may be further limited.
As discussed elsewhere, deferred tax assets relating to the NOL and credit carryforwards are offset by a full valuation allowance. In addition, utilization of state tax loss carryforwards is dependent upon sufficient taxable income apportioned to the states.
The Company is subject to taxation in the U.S. and various state and foreign tax jurisdictions. The Company’s tax years for 2000 and later are subject to examination by the U.S. and state tax authorities due to the existence of the NOL carryforwards. Generally, the Company’s tax years for 2002 and later are subject to examination by various foreign tax authorities as well.
As of December 29, 2019, the Company had $24.0 million of unrecognized tax benefits that, if recognized, would impact the Company’s effective income tax rate, subject to possible offset by a change in the deferred tax asset valuation allowance. During the nine months ended September 27, 2020, unrecognized tax benefits increased by $1.1 million relating to various current and prior year positions.
The Company recognizes interest and penalties related to unrecognized tax benefits in its provision for income taxes. For the nine months ended September 27, 2020 and September 29, 2019, the Company recorded an expense for interest and penalties of $0.3 million and $1.1 million, respectively. For the nine months ended September 27, 2020 and September 29, 2019, 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 $0.2 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.
Note 10. Debt
(a) Issuance of 6.5 % Senior Secured Notes due 2025
In November 2017, the Company issued and sold $300 million aggregate principal amount of 6.5 % Senior Secured Notes due 2025 (the “6.5 % 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 $6.6 million associated with the 6.5 % Notes. The Company utilized the net proceeds from the sale of the 6.5 % Notes, as well as cash from its recent equity offering to extinguish its outstanding 7.00 % Senior Secured Notes due in 2019 (the “7 % Notes”). The total reacquisition price of the 7 % Notes was $385.2 million, including a $12.0 million call premium, and $0.3 million of accrued interest.
The 6.5 % Notes are governed by the Indenture, dated as of November 20, 2017 (the “Indenture”), among the Company, the Company’s existing and future domestic subsidiaries parties thereto (the “Subsidiary Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent. A Subsidiary Guarantor can be released from its guarantee if (a) all of the capital stock issued by such Subsidiary Guarantor or all or substantially all of the assets of such Subsidiary Guarantor are sold or otherwise disposed of; (b) the Company designates such Subsidiary Guarantor as an Unrestricted Subsidiary (as defined in the Indenture); (c) the Company exercises its legal defeasance option or its covenant defeasance option; or (d) upon satisfaction and discharge of the Indenture or payment in full in cash of the principal of, premium, if any, and accrued and unpaid interest on the 6.5 % Notes.
The 6.5 % Notes bear interest at a rate of 6.5 % per year from the date of original issuance or from the most recent payment date on which interest has been paid or provided for. Interest on the 6.5 % Notes is payable in arrears on May 30 and November 30 of each year, beginning on May 30, 2018. The 6.5 % Notes are fully and unconditionally guaranteed by the Subsidiary Guarantors.
The 6.5 % Notes and the guarantees (as set forth in the Indenture) are the Company’s senior secured obligations and are equal in right of payment with all other senior obligations of the Subsidiary Guarantors’ existing and future secured debt to the extent of the assets securing that secured debt. The Company’s obligations under the 6.5 % Notes are secured by a first priority lien on substantially all of the Company’s assets and the assets of the Subsidiary Guarantors, except with respect to accounts receivable, inventory, deposit accounts, securities accounts, cash, securities and general intangibles (other than intellectual property), on which the holders of the 6.5 % Notes have a second priority lien, junior to the lien securing the Company’s obligations under the Credit Agreement (as defined below).
The 6.5 % Notes will be redeemable by the Company, in whole or in part, at any time on or after November 30, 2020 at the respective redemption prices specified in the Indenture. In addition, the Company may redeem up to 40 % of the 6.5 % Notes
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before November 30, 2020 with the net proceeds of certain equity offerings. The Company may also redeem some or all of the 6.5 % Notes before November 30, 2020 at a redemption price of 100 % of the principal amount thereof plus accrued and unpaid interest, to, but excluding, the redemption date, if any, plus a “make whole” premium. In addition, during each 12-month period commencing on the issue date and ending on or prior to November 30, 2020, the Company may redeem up to 10 % of the original aggregate principal amount of the 6.5 % Notes issued under the Indenture at a redemption price of 103.000 % of the principal amount thereof, plus accrued and unpaid interest, to, but excluding, the date of redemption, if any. The Company may also be required to make an offer to purchase the 6.5 % Notes upon a change of control and certain sales of its assets.
The Indenture contains covenants limiting, among other things, the Company’s ability and the Subsidiary Guarantors’ ability to: (a) pay dividends on or make distributions or repurchase or redeem the Company’s capital stock or make other restricted payments; (b) incur additional debt and guarantee debt; (c) prepay, redeem or repurchase certain debt; (d) issue certain preferred stock or similar equity securities; (e) make loans and investments; (f) sell assets; (g) incur liens; (h) consolidate, merge, sell or otherwise dispose of all or substantially all of the Company’s assets; (i) enter into transactions with affiliates; and (j) enter into agreements restricting the Company’s ability and certain of its subsidiaries’ ability to pay dividends. These covenants are subject to a number of exceptions. As of September 27, 2020, the Company was in compliance with the covenants contained in the Indenture governing the 6.5 % Notes.
The terms of the Indenture require that the net cash proceeds from asset dispositions be either utilized to (i) repay or prepay amounts outstanding under the Credit Agreement unless such amounts are reinvested in similar collateral, (ii) permanently reduce other indebtedness, (iii) make an investment in assets that replace the collateral of the 6.5 % Notes or (iv) a combination of (i), (ii) and (iii). To the extent there are any remaining net proceeds from the asset disposition after application of (i), (ii) and (iii), such amounts are required to be utilized to repurchase the 6.5 % Notes at par.
The Indenture also provides for events of default which, if any such event occurs, would permit or require the principal, premium, if any, interest, if any, and any other monetary obligations on all the then-outstanding 6.5 % Notes to become or to be declared due and payable immediately.
As of September 27, 2020, there was $300.0 million of 6.5 % Notes outstanding.
(b) Other Indebtedness
Credit and Security Agreement
On November 20, 2017, the Company entered into an amended and restated credit and security agreement (the “Credit Agreement”), with the lenders from time to time party thereto, SunTrust Bank, as Agent (the “Agent”), PNC Bank, National Association (“PNC Bank”), as Joint Lead Arranger and Documentation Agent, and SunTrust Robinson Humphrey, Inc. (“SunTrust”), as Joint Lead Arranger and Sole Book Runner. The Credit Agreement 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 as described therein), 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 obligations under the Credit Agreement are secured by (i) a first priority lien on the Company’s accounts receivable, inventory, deposit accounts, securities accounts, cash, securities and general intangibles (other than intellectual property) and (ii) a second priority lien, junior to the lien securing the Company’s 6.5 % Notes, on all of the Company’s other assets.
Borrowings under the revolving credit facility may take the form of a base rate revolving loan, Eurodollar revolving loan or swingline loan. Base rate revolving loans and swingline loans 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 prime lending rate, as in effect at such time, (ii) the federal funds rate, as in effect at such time, plus 0.50 % per annum and (iii) the Adjusted LIBO Rate (as defined in the Credit Agreement) determined at such time for an interest period of one month, plus 1.00 % per annum. Eurodollar revolving 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 LIBO Rate. The Applicable Margin varies between 1.00 %-1.50 % for base rate revolving loans and swingline loans and 2.00 %-2.50 % for Eurodollar loans, and is based on several factors including the Company’s then-existing borrowing base and the lenders’ total commitment amount and revolving credit exposure. The calculation of the Company’s borrowing base takes into account several items relating to the Company and its subsidiaries, including amounts due and owing under billed and unbilled accounts receivable, then held eligible raw materials inventory, work-in-process inventory, and applicable reserves.
The Credit Agreement contains certain covenants, which include, but are not limited to, restrictions on indebtedness,
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liens, and investments, and limits on other various payments, as well as a financial covenant relating to a minimum fixed charge coverage ratio. Events of default under the terms of the Credit Agreement include, but are not limited to: failure of the Company to pay any principal of any loans in full when due and payable; failure of the Company to pay any interest on any loan or any fee or other amount payable under the Credit Agreement within three business days after the date when due and payable; failure of the Company or any of its subsidiaries to comply with certain covenants and agreements, subject to applicable grace periods and/or notice requirements; any representation, warranty or statement made in or pursuant to the Credit Agreement or any related writing or any other material information furnished by the Company or any of its subsidiaries to the Agent or the lenders proving to be false or erroneous; and the occurrence of an event or condition having or reasonably likely to have a material adverse effect, which includes a material adverse effect on the business, operations, condition (financial or otherwise) or prospects of the Company or the ability of the Company to repay its obligations. Where an event of default arises from certain bankruptcy events, the commitments will automatically and immediately terminate and the principal of, and interest then outstanding on, all of the loans will become immediately due and payable. Subject to certain notice requirements and other conditions, upon the occurrence of an event of default, including the occurrence of a condition having or reasonably likely to have a material adverse effect, commitments may be terminated and the principal of, and interest then outstanding on, all of the loans may become immediately due and payable. As of September 27, 2020, no event of default had occurred and the Company believes that events or conditions having a material adverse effect, giving rise to an acceleration of any amounts outstanding under the Credit Agreement, have not occurred and the likelihood of such events or conditions occurring is remote.
The measurement of a minimum fixed charge coverage ratio under the Credit Agreement was modified in November 2017 to require measurement if Excess Availability (as defined in the Credit Agreement) is less than 50 % of the lesser of the borrowing base or the total commitment amount.
On June 11, 2018, the Company entered into a first amendment (the “First Amendment”) to the amended and restated Credit Agreement. Among other things, the First Amendment permitted the sale of the PSS business, provided that certain conditions, including application of the proceeds in accordance with the terms of documents governing the Company’s outstanding indebtedness, were satisfied.
As of September 27, 2020, there were no borrowings outstanding on the Credit Agreement and $6.1 million was outstanding on letters of credit, resulting in net borrowing base availability of $69.1 million. The Company was in compliance with the financial covenants of the Credit Agreement and its amendments as of September 27, 2020.
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 $4.8 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 is paid by the State of Israel with subsequent interest and principal payments due monthly, commencing in August 2021. The Company intends to repay these loans at the end of the first year.
Fair Value of Long-term Debt
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 27, 2020 and December 29, 2019 are presented in the following table:
| As of September 27, 2020 | As of December 29, 2019 | |||||||||||||||||||||||||||||||||||||
| $ in millions | Principal | Carrying Amount | Fair Value | Principal | Carrying Amount | Fair Value | ||||||||||||||||||||||||||||||||
| Total long-term debt including current portion | $ | $ | $ | $ | $ | $ | ||||||||||||||||||||||||||||||||
The fair value of the Company’s long-term debt was based upon actual trading activity (Level 1, Observable inputs -quoted prices in active markets).
As of September 27, 2020, the difference between the carrying amount of $300.5 million and the principal amount of $304.8 million presented in the table above is the unamortized debt issuance costs of $4.3 million, which are being accreted to interest expense over the term of the related debt. As of December 29, 2019, the difference between the carrying amount of $295.1 million and the principal amount of $300.0 million presented in the table above is the unamortized debt issuance costs of $4.9 million, which are being accreted to interest expense over the term of the related debt.
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Note 11. Segment Information
The Company operates in two reportable segments. The KGS reportable segment is comprised of an aggregation of KGS operating segments, including the microwave electronic products, satellite, training, and cybersecurity, modular systems, defense and rocket support services, and turbine technologies operating segments. The Unmanned Systems (“US”) reportable segment consists of its unmanned aerial system and unmanned ground and seaborne system businesses. 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. This presentation is consistent with the Company’s operating structure. 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, 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.
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||
| September 27, 2020 | September 29, 2019 | September 27, 2020 | September 29, 2019 | ||||||||||||||||||||
| Revenues: | |||||||||||||||||||||||
| Kratos Government Solutions | |||||||||||||||||||||||
| Service revenues | $ | $ | $ | $ | |||||||||||||||||||
| Product sales | |||||||||||||||||||||||
| Total Kratos Government Solutions | |||||||||||||||||||||||
| Unmanned Systems product sales | |||||||||||||||||||||||
| Total revenues | $ | $ | $ | $ | |||||||||||||||||||
| Depreciation & amortization: | |||||||||||||||||||||||
| Kratos Government Solutions | $ | $ | $ | $ | |||||||||||||||||||
| Unmanned Systems | |||||||||||||||||||||||
| Total depreciation and amortization | $ | $ | $ | $ | |||||||||||||||||||
| Operating income from continuing operations: | |||||||||||||||||||||||
| Kratos Government Solutions | $ | $ | $ | $ | |||||||||||||||||||
| Unmanned Systems | |||||||||||||||||||||||
| Corporate activities | ( | ( | ( | ( | |||||||||||||||||||
| Total operating income from continuing operations | $ | $ | $ | $ | |||||||||||||||||||
Included in Corporate activities for the three and nine months ended September 27, 2020 is $0.1 million and $1.1 million of transaction expenses, respectively, related to the acquisition of ASC Signal. Included in Corporate activities for the three and nine months ended September 29, 2019 is $0.0 million and $1.3 million of transaction expenses, respectively, related to the acquisition of FTT.
Note 12. Redeemable Noncontrolling Interest
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Note 13. Stockholders’ Equity – Common Stock
Note 14. Significant Customers
Note 15. Commitments 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
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questioning certain of the established and disclosed practices that it had previously audited and accepted. The Company’s personnel regularly scrutinizes 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 been completed by the DCAA, the Company cannot reasonably estimate the range of loss, if any, that may result from audits and reviews in which it is currently involved 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 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.
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 U.S. Department of Defense (the “DoD”), which could cause delays, cancellations or reductions of key government contracts; bid protests; changes in the scope or timing of our projects; the timing, rescheduling or cancellation of significant customer contracts and agreements; failure by our subcontractors or suppliers to perform their contractual obligations; our failure to meet performance obligations; if the unmanned systems markets do not experience significant growth, if we cannot expand our customer base or if our products do not achieve broad acceptance which could impact our ability to achieve our anticipated level of growth; consolidation by or the loss of key customers; risks of adverse regulatory action or litigation; risks associated with debt leverage; failure to successfully achieve our integration, cost reduction or divestiture strategies; risks related to security breaches, cybersecurity attacks or other significant disruptions of our information systems; risks associated with pandemics, epidemics or other public health emergencies, such as the recent outbreak of COVID-19;risks related to unknown defects or errors in our products; and competition in the marketplace, which could reduce revenues and profit margins, as well as the additional risks and uncertainties described in this Quarterly Report, in “Item 1A-Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 29, 2019 filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 24, 2020 (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 high technology systems and products at an affordable cost. At Kratos, affordability is a technology. Kratos’ primary focus areas are unmanned systems, space and satellite communications, microwave electronics, cybersecurity/warfare, rocket, hypersonic and missile defense systems, turbine
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technologies, and Command, Control, Communication, Computing, Combat, Intelligence Surveillance and Reconnaissance (C5ISR) Systems.
We believe that our technology, intellectual property, proprietary products and designed-in positions on our customers’ programs, platforms and systems, and our ability to rapidly develop, demonstrate and field affordable leading technology systems gives us a competitive advantage. We believe that our extensive past performance qualifications and demonstrated ability to meet or exceed our customers’ demanding requirements creates a high barrier to entry into our markets. Our workforce is primarily engineering and technically oriented with a significant number of Kratos employees holding national security clearances. Much of our work is performed at customer locations, or in a secure manufacturing facility. Our primary end customers are national security related agencies or entities. Our entire organization is focused on executing our strategy of becoming the leading technology and intellectual property based product and system company in our industry.
Industry Update
On December 18, 2019, President Trump signed 2020 spending bills totaling $1.4 trillion. The bills allocate $738 billion to National Defense and $632 billion to non-defense agencies for fiscal 2020, representing increases over fiscal 2019 of $22 billion and $27 billion, respectively. The National Defense Authorization Act grants a base budget of approximately $666.5 billion (including the establishment of a new, sixth armed service for space) and an additional $71.5 billion for overseas contingency operations funding, a.k.a. the war budget. The federal budget and debt ceiling are expected to continue to be the subject of considerable debate, which could have a significant impact on defense spending broadly and the Company’s programs in particular. The spending Bill signed by the President also authorized approximately $741 billion for fiscal 2021 DoD, National Security and related spending. The U.S. Government’s fiscal year ends September 30.
The overall Federal Government budget environment, including budget caps mandated by the Budget Control Act of 2011 (“BCA”) for fiscal years 2020 and 2021, and uncertainty surrounding the debt ceiling and the appropriations process, remain significant risks. Considerable uncertainty exists regarding how future federal budget and program decisions will unfold, including the defense spending priorities of the current Trump or other potential future Administration(s) and Congress and what challenges budget reductions (required by the BCA or otherwise) could present for the defense industry. On October 1, 2020, the Federal Government began to operate under a Continuing Resolution Authorization (“CRA”) related to the fiscal year 2021 Federal budget. A CRA restricts new contract and program starts and restricts planned increases on existing production and other contracts, presenting resource allocation challenges for the Government customer and placing limitations on future planned program budgets. Additionally, if an annual appropriations bill for fiscal 2021 is not timely enacted, we may face another federal government shutdown of unknown duration. If a prolonged CRA and/or government shutdown of the DoD were to occur, either could result in program delays, cancellations, disruptions and/or stop work orders and could limit the U.S. Government’s ability to effectively execute programs and to make timely payments, and could also impact our ability to perform on our U.S. Government contracts and successfully compete for new work.
We believe continued budget pressures, CRAs or Federal Government shutdowns would have serious negative consequences for the security of our country, the defense industrial base, including the Company and the customers, employees, suppliers, investors, and communities that rely on companies in the defense industrial base. It is likely budget and program decisions made in such an uncertain environment would have long-term implications for our Company and the entire defense industry.
Additionally, funding for certain programs in which we currently participate may be reduced, delayed or cancelled, and budget uncertainty or funding cuts globally could adversely affect the viability of our partners, teammates, subcontractors and suppliers, and our employee base. While we believe that our business is well-positioned in areas that the DoD and other customers indicate are priorities for future defense spending, including in the 2018 and 2020 National Defense Strategy documents, the short and long-term impact of federal budgetary uncertainty, CRAs, the BCA, other defense spending cuts, challenges in the appropriations process, the debt ceiling and the ongoing fiscal debates remain uncertain. Such a challenging federal 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 expose us to risks associated with pandemics, epidemics or other public health emergencies, such as the outbreak of COVID-19 which has spread from China to many other countries across the globe, including the United States. In March 2020, the World Health Organization categorized COVID-19 as a pandemic, and the President of the United States declared the COVID-19 outbreak a national emergency. The outbreak has resulted in governments around the world, including the U.S. Government and as related to the DoD, implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.
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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 currently continue to operate, including our international operations. Notwithstanding our continued operations, COVID-19 has had negative impacts on certain of our operations, supply chain, vendors, transportation networks and customers, which have reduced certain of our sales and our margins, including as a result of preventative and precautionary measures that we, our suppliers, other businesses and governments are taking. The COVID-19 outbreak is a widespread public health crisis that is adversely affecting the economies and financial markets globally. Any resulting economic downturn could adversely affect demand for our products. The progression of this matter could also negatively impact our business or results of operations through the temporary closure of our operating locations or those of our customers or suppliers.
The ability of our employees, our suppliers’ and our customers’ employees to work may be significantly impacted by individuals contracting or being exposed to COVID-19, or as a result of the control measures noted above, which may significantly hamper our production, operations, including throughout the supply chain. On March 27, 2020, the President of the United States signed and enacted into law the CARES Act, a $2 trillion economic relief bill. We are continuing to evaluate the impact of the CARES Act including related stimulus and economic relief actions on our business.
Since the end of our first quarter, COVID-19 has continued to impact our customers, markets and operations, including supply chain disruptions, delays of certain supplier deliveries, difficulties gaining access to certain locations, difficulties gaining access to customers, including instances related to previously scheduled drone and rocket system flights, demonstrations and exercises, and decreased demand requirements of certain of our commercial aero, power and satcom customers. Importantly, COVID-19 customer and contractor-related travel and social distancing restrictions have delayed a number of our target drone, tactical drone and rocket system programs, missions and exercises. The extent to which COVID-19 may further impact our business depends on future developments, which are highly uncertain and unpredictable, including new information concerning the severity of the outbreak and the effectiveness of actions globally to contain or mitigate its effects. While we currently do not expect this matter to have a material impact on our results of operations, cash flows and financial position, the current level of uncertainty over the economic, business and operational impacts of COVID-19 means the related financial impact cannot be reasonably estimated at this time. Our consolidated financial statements and discussion and analysis of financial condition and results of operations reflect estimates and assumptions made by management as of September 27, 2020. Events and changes in circumstances arising after September 27, 2020, including those resulting from the continuing impacts of COVID-19, will be reflected in management’s estimates for future periods.
Reportable Segments
The Company operates in two reportable segments. The Kratos Government Solutions (“KGS”) reportable segment is comprised of an aggregation of KGS operating segments, including our microwave electronic products, space, training, and cybersecurity, modular systems, rocket systems and missile defense, and turbine technologies operating segments. The Unmanned Systems (“US”) reportable segment consists of our unmanned aerial system and unmanned ground and seaborne system businesses.
We organize our business segments based primarily on the nature of the products, solutions and services offered. Transactions between segments are negotiated and accounted for under terms and conditions similar to other government and commercial contracts, and these intercompany transactions are eliminated in consolidation. For additional information regarding our reportable segments, see Note 11 of the accompanying Condensed Consolidated Financial Statements. From a customer and solutions perspective, we view our business as an integrated whole, leveraging skills and assets wherever possible.
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Comparison of Results for the Three Months Ended September 27, 2020 to the Three Months Ended September 29, 2019
Revenues. Revenues by operating segment for the three months ended September 27, 2020 and September 29, 2019 are as follows (dollars in millions):
| September 27, 2020 | September 29, 2019 | $ change | % change | ||||||||||||||||||||
| Kratos Government Solutions | |||||||||||||||||||||||
| Service revenues | $ | 67.6 | $ | 70.8 | $ | (3.2) | (4.5) | % | |||||||||||||||
| Product sales | 80.9 | 67.6 | 13.3 | 19.7 | % | ||||||||||||||||||
| Total Kratos Government Solutions | 148.5 | 138.4 | 10.1 | 7.3 | % | ||||||||||||||||||
| Unmanned Systems product sales | 53.5 | 45.7 | 7.8 | 17.1 | % | ||||||||||||||||||
| Total revenues | $ | 202.0 | $ | 184.1 | $ | 17.9 | 9.7 | % | |||||||||||||||
| Total service revenues | $ | 67.6 | $ | 70.8 | $ | (3.2) | (4.5) | % | |||||||||||||||
| Total product sales | 134.4 | 113.3 | 21.1 | 18.6 | % | ||||||||||||||||||
| Total revenues | $ | 202.0 | $ | 184.1 | $ | 17.9 | 9.7 | % | |||||||||||||||
Revenues increased $17.9 million to $202.0 million for the three months ended September 27, 2020 from $184.1 million for the three months ended September 29, 2019. Revenues in our KGS segment increased $10.1 million due to the contribution from the recent acquisition of CPI ASC Signal Division, Inc. (“ASC Signal”) which contributed approximately $10.2 million and due to organic revenue growth in our defense and rocket support, microwave products and C5ISR businesses which generated aggregate increased revenues of $10.6 million, offset by aggregate revenue reductions of approximately $10.7 million, comprised primarily of reductions of $6.3 million in our training solutions business primarily as a result of the completion of a large foreign military sales contract, reduced revenues in our satellite communications business of approximately $1.6 million primarily as a result of the completion of large foreign satellite infrastructure deployments as well as impacts resulting from COVID-19, and reduced demand of $2.8 million from commercial aero turbine customers which have been impacted by COVID-19. Revenues in our US segment increased $7.8 million to $53.5 million for the three months ended September 27, 2020 due primarily to production progress on our SSAT 177 target drone program and certain confidential programs.
Product sales increased $21.1 million to $134.4 million for the three months ended September 27, 2020 from $113.3 million for the three months ended September 29, 2019 primarily due to increased production from our KGS segment due to the contribution from the ASC Signal acquisition and the organic revenue growth in our defense and rocket support, microwave products and C5ISR businesses as well as increased revenues from our US business due primarily to the production progress on our SSAT 177 target drone program and certain confidential programs as detailed above. As a percentage of total revenue, product sales were 66.5% for the three months ended September 27, 2020 as compared to 61.5% for the three months ended September 29, 2019. Service revenues decreased by $3.2 million to $67.6 million for the three months ended September 27, 2020 from $70.8 million for the three months ended September 29, 2019. The decrease was primarily related to reductions in certain of the Company’s training solutions international contracts.
Cost of Revenues. Cost of revenues increased $9.4 million to $144.9 million for the three months ended September 27, 2020 from $135.5 million for the three months ended September 29, 2019. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.
Gross margin increased to 28.3% for the three months ended September 27, 2020 from 26.4% for the three months ended September 29, 2019. Margins on services decreased to 25.3% for the three months ended September 27, 2020 from 29.1% for the three months ended September 29, 2019, due primarily to a less favorable mix of revenues, primarily in our Space, Training & Cyber business and our recently acquired FTT (as defined below) business. Margins on products increased to 29.8% for the three months ended September 27, 2020 from 24.7% for the three months ended September 29, 2019, primarily due to a more favorable mix of certain programs and products in more mature program lifecycles for the three months ended September 27, 2020. Margins in the KGS segment increased to 30.7% for the three months ended September 27, 2020 from 28.0% for the three months ended September 29, 2019, primarily due to a more favorable mix of products including products in more mature production lifecycles. Margins in the US segment decreased to 21.5% for the three months ended September 27, 2020 from 21.7% for the three months ended September 29, 2019, primarily due to a less favorable mix of products being produced.
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Selling, General and Administrative (“SG&A”) Expenses. SG&A expense was $36.3 million for the three months ended September 27, 2020 and $32.5 million for the three months ended September 29, 2019. As a percentage of revenues, SG&A increased to 18.0% at September 27, 2020 from 17.7% at September 29, 2019, due primarily to an increase in stock compensation expense of $2.2 million from $2.8 million in the three months ended September 29, 2019 to $5.0 million in the three months ended September 27, 2020.
Research and Development (“R&D”) Expenses. R&D expenses increased $3.1 million to $7.7 million for the three months ended September 27, 2020 from $4.6 million for the three months ended September 29, 2019, with the primary increases in our space and satellite communications business. As a percentage of revenues, R&D increased to 3.8% for the three months ended September 27, 2020 from 2.5% for the three months ended September 29, 2019. 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 $0.3 million for the three months ended September 27, 2020 from $0.1 million of income for the three months ended September 29, 2019. The expenses for the three months ended September 27, 2020 are primarily employee termination costs related to personnel reduction actions taken in the period.
Total Other Expense, Net. Total other expense, net decreased to $5.1 million from $6.1 million for the three months ended September 27, 2020 and September 29, 2019, respectively.
Provision for Income Taxes from Continuing Operations. The income tax expense from continuing operations for the three months ended September 27, 2020 and September 29, 2019 was $5.0 million and $2.8 million, respectively. For the three months ended September 27, 2020, the expense included current foreign, federal and state taxes of $1.9 million and uncertain tax positions of $2.3 million. The expense for the three months ended September 29, 2019 included a $1.3 million benefit recorded in the third quarter of 2019 for the acquisition of 80.1% of the issued and outstanding shares of capital stock of Florida Turbine Technologies Inc., a Florida corporation (“FTT Inc.”), and 80.1% the membership interest in FTT CORE, LLC, a Delaware limited liability company (“FTT Core” and, together with FTT, Inc., and their respective subsidiaries, “FTT”). In accordance with ASC Topic 805, we established deferred tax liabilities of approximately $1.3 million for the increase in the financial statement basis of the acquired assets of FTT. As a result of our ability to recognize deferred tax assets for these deferred tax liabilities, we released the valuation allowance against our deferred tax assets and recognized an income tax benefit of $1.3 million. This benefit was partially offset by current foreign, federal and state taxes of $1.3 million and uncertain tax position liabilities of $2.5 million.
Income (Loss) from Discontinued Operations. The loss from discontinued operations was $0.2 million for the three months ended September 27, 2020, primarily reflecting the work performed in relation to outstanding tasks on legacy projects retained by us following the sale of Kratos Public Safety & Security Solutions, Inc. (“PSS”), as well as legal expenses related to the ongoing closing net working capital adjustment dispute with the buyer of the PSS business. The income from discontinued operations was $0.0 million for the three months ended September 29, 2019.
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Comparison of Results for the Nine Months Ended September 27, 2020 to the Nine Months Ended September 29, 2019
Revenues. Revenues by operating segment for the nine months ended September 27, 2020 and September 29, 2019 are as follows (dollars in millions):
| September 27, 2020 | September 29, 2019 | $ change | % change | ||||||||||||||||||||
| Kratos Government Solutions | |||||||||||||||||||||||
| Service revenues | $ | 194.1 | $ | 207.1 | $ | (13.0) | (6.3) | % | |||||||||||||||
| Product sales | 209.7 | 202.2 | 7.5 | 3.7 | % | ||||||||||||||||||
| Total Kratos Government Solutions | 403.8 | 409.3 | (5.5) | (1.3) | % | ||||||||||||||||||
| Unmanned Systems product sales | 137.5 | 123.1 | 14.4 | 11.7 | % | ||||||||||||||||||
| Total revenues | $ | 541.3 | $ | 532.4 | $ | 8.9 | 1.7 | % | |||||||||||||||
| Total service revenues | $ | 194.1 | $ | 207.1 | $ | (13.0) | (6.3) | % | |||||||||||||||
| Total product sales | 347.2 | 325.3 | 21.9 | 6.7 | % | ||||||||||||||||||
| Total revenues | $ | 541.3 | $ | 532.4 | $ | 8.9 | 1.7 | % | |||||||||||||||
Revenues increased $8.9 million to $541.3 million for the nine months ended September 27, 2020 from $532.4 million for the nine months ended September 29, 2019. Revenues in our KGS segment decreased $5.5 million due to reduced revenues in our training solutions business of $25.2 million primarily reflecting the completion and rescoping of certain international and foreign military sales contracts and reductions in our commercial satellite business as a result of the completion of large foreign satellite infrastructure deployments and from impacts resulting from COVID-19. These reductions were partially offset by revenues from the recent FTT and ASC Signal acquisitions, which contributed an aggregate of approximately $14.0 million, and increases in our microwave products, defense and rocket support and C5ISR businesses. Revenues in our US segment increased $14.4 million to $137.5 million for the nine months ended September 27, 2020 primarily due to work performed on certain confidential drone programs.
Product sales increased $21.9 million to $347.2 million for the nine months ended September 27, 2020 from $325.3 million for the nine months ended September 29, 2019, primarily as a result of increased production activity in our US segment, and increased production in our microwave products, modular systems and rocket support businesses offset partially by reductions in our space and satellite business. As a percentage of total revenue, product sales were 64.1% for the nine months ended September 27, 2020 as compared to 61.1% for the nine months ended September 29, 2019. Service revenues decreased by $13.0 million to $194.1 million for the nine months ended September 27, 2020 from $207.1 million for the nine months ended September 29, 2019. The decrease was primarily related to the completion or rescoping of certain international contracts in our training solutions business, reductions in our space and satellite communications business primarily resulting from the completion of large international satellite infrastructure deployments as well as impacts resulting from COVID-19, and reduced demand in our commercial turbine business as a result of COVID-19.
Cost of Revenues. Cost of revenues increased $1.6 million to $392.4 million for the nine months ended September 27, 2020 from $390.8 million for the nine months ended September 29, 2019. The increase in cost of revenues was primarily a result of the revenue changes discussed above.
Gross margin increased to 27.5% for the nine months ended September 27, 2020 from 26.6% for the nine months ended September 29, 2019. Margins on services decreased to 26.9% for the nine months ended September 27, 2020 from 31.0% for the nine months ended September 29, 2019. Margins on product sales increased to 27.9% for the nine months ended September 27, 2020 from 23.8% for the nine months ended September 29, 2019, primarily due to a favorable mix of certain programs and products in more mature lifecycles. Margins in the KGS segment increased to 29.9% for the nine months ended September 27, 2020 from 28.5% for the nine months ended September 29, 2019, primarily due to a more favorable mix of products including products in more mature production lifecycles during the nine months ended September 27, 2020. Margins in the US segment increased to 20.6% for the nine months ended September 27, 2020 from 20.4% for the nine months ended September 29, 2019, primarily due to a more favorable mix of products produced and shipped during the nine months ended September 27, 2020.
SG&A Expenses. SG&A expense was $107.2 million for the nine months ended September 27, 2020 and $97.7 million for the nine months ended September 29, 2019. As a percentage of revenues, SG&A increased to 19.8% at
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September 27, 2020 from 18.4% at September 29, 2019, due primarily to an increase in stock compensation expense of $6.3 million from $8.2 million in the nine months ended September 29, 2019 to $14.5 million in the nine months ended September 27, 2020.
R&D Expenses. R&D expenses were $19.4 million for the nine months ended September 27, 2020 and $13.0 million for the nine months ended September 29, 2019. As a percentage of revenues, R&D increased to 3.6% for the nine months ended September 27, 2020 from 2.4% for the nine months ended September 29, 2019. 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 $0.5 million for the nine months ended September 27, 2020 from $0.3 million for the nine months ended September 29, 2019. These expenses are primarily employee termination costs related to personnel reduction actions taken in each period.
Total Other Expense, Net. Total other expense, net, decreased to $16.3 million from $17.3 million for the nine months ended September 27, 2020 and September 29, 2019, respectively.
Provision for Income Taxes from Continuing Operations. The income tax expense from continuing operations for the nine months ended September 27, 2020 and September 29, 2019 was $1.8 million and $3.8 million, respectively. For the nine months ended September 27, 2020, a benefit was recorded related to the acquisitions of ASC Signal and Technical Directions, Inc. (“TDI”). In accordance with ASC Topic 805, we established deferred tax liabilities of approximately $1.0 million for the increase in the financial statement basis of the acquired assets of ASC Signal and TDI. As a result of our ability to recognize deferred tax assets for these deferred tax liabilities, we released the valuation allowance against our deferred tax assets and recognized an income tax benefit of $1.0 million. This benefit was partially offset by current foreign, federal and state taxes of $1.2 million and uncertain tax position liabilities of $1.2 million. The expense for the nine months ended September 29, 2019 included a $4.7 million benefit recorded for the acquisition of 80.1% of the issued and outstanding shares of capital stock of FTT Inc., and 80.1% the membership interest in FTT Core. In accordance with ASC Topic 805, we established deferred tax liabilities of approximately $4.7 million for the increase in the financial statement basis of the acquired assets of FTT. As a result of our ability to recognize deferred tax assets for these deferred tax liabilities, we released the valuation allowance against our deferred tax assets and recognized an income tax benefit of $4.7 million. This benefit was partially offset by current foreign, federal and state taxes of $2.5 million and uncertain tax position liabilities of $5.4 million.
Income (Loss) from Discontinued Operations. The loss from discontinued operations was $0.8 million for the nine months ended September 27, 2020, primarily reflecting the work performed in relation to outstanding tasks on legacy projects retained by us following the sale of the PSS business, as well as legal expenses related to the ongoing net closing working capital adjustment dispute with the buyer of the PSS business. The income from discontinued operations was $2.4 million for the nine months ended September 29, 2019, and includes a $3.6 million gain as a result of the release of an indemnification liability following the lapse of the statute of limitations associated with a potential tax liability that was recorded in 2015 as part of the sale of the our Electronics Products Division. This gain was offset by a loss of $1.2 million from operating activities primarily reflecting the work performed in relation to outstanding tasks on legacy projects retained by us following the sale of the PSS business and legal expenses related to the closing net working capital adjustment dispute with the buyer of the PSS business.
Backlog
On September 27, 2020, we had approximately $873.1 million of total backlog, of which $579.3 million was funded. We expect to recognize approximately 22% of the remaining total backlog as revenue in 2020, an additional 35% by 2021 and the balance thereafter. Our comparable total backlog balance as of September 29, 2019, was approximately $608.7 million of which $518.7 million was funded.
Total backlog is our estimate of the amount of revenue expected to be realized over the remaining life of awarded contracts and task orders that we have in hand as of the measurement date. Total backlog can include award fees, incentive fees, or other variable consideration estimated based on the most likely amount we expect to be entitled to receive, to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur. Total backlog can include both funded and unfunded future revenue under government contracts. Total backlog does not include orders for which neither party has performed and which each party has the unilateral right to terminate a wholly unperformed contract without compensating the other party. As such, total backlog generally does not include options for additional performance obligations which have not been executed unless they are considered a material right of the base agreement/contract. For indefinite delivery or indefinite quantity contracts, only awarded or funded task orders are included for backlog purposes.
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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 subsequent appropriation and the procuring agency allocates funding to the contract.
Contracts undertaken by us may extend beyond one year. Accordingly, portions are carried forward from one year to the next as part of backlog. Because many factors affect the scheduling of projects, no assurance can be given as to when revenue will be realized on projects included in our backlog. Although funded backlog represents only business that is considered to be firm, we cannot guarantee that cancellations or scope adjustments will not occur. The majority of funded backlog represents contracts with terms that would entitle us to all or a portion of our costs incurred and potential fees upon cancellation by the customer.
A significant number of the programs that Kratos’ systems, products and solutions support are multi-year/multi-decade in nature. Accordingly, based on historical customer usage or operational tempo, we have reasonable expectations or visibility of what ultimate orders for Kratos’ systems, products and solutions will be. We do not include these expected amounts in its backlog until a related contract award is received.
Management believes that year-to-year comparisons of backlog are not necessarily indicative of future revenues. The actual timing of receipt of revenues, if any, on projects included in backlog could change because many factors affect the scheduling of projects. In addition, cancellations or adjustments to contracts may occur. Backlog is typically subject to large variations from quarter-to-quarter as existing contracts are renewed or new contracts are awarded. Additionally, 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 27, 2020, we had cash and cash equivalents of $374.7 million compared with cash and cash equivalents of $172.6 million as of December 29, 2019, which includes $29.1 million and $24.6 million, respectively, of cash and cash equivalents held by our foreign subsidiaries. We are not presently aware of any restrictions on the repatriation of these funds, however, earnings of these foreign subsidiaries are essentially considered permanently invested in these foreign subsidiaries. If these funds were needed to fund our operations or satisfy obligations in the U.S. they could be repatriated, and their repatriation into the U.S. may cause us to incur additional foreign withholding taxes. We do not currently intend to repatriate these earnings.
Our total long-term debt, including principal due on our 6.5% Notes (as defined below), increased from $295.1 million at December 29, 2019 to $300.5 million at September 27, 2020, due to the amortization of debt issuance costs and approximately $4.8 million in new loans entered into with two banks in Israel during the three months ended September 27, 2020 (as fully described below).
We use our operating cash flow to finance trade accounts receivable, fund necessary increases in inventory, fund capital expenditures, our internal research and development investments and our ongoing operations, service our debt and make strategic acquisitions. Financing trade accounts receivable is necessary because, on average, our customers do not pay us as quickly as we pay our vendors and employees for their goods and services since a number of our receivables are contractually billable and due to us only when certain contractual milestones are achieved. Financing increases in inventory balances is necessary to fulfill shipment requirements to meet delivery schedules of our customers. Cash from continuing operations is primarily derived from our customer contracts in progress and associated changes in working capital components. Our days sales outstanding (“DSO”) have decreased from 134 days as of December 29, 2019 to 124 days at September 27, 2020, primarily reflecting the achievement of certain 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
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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 27, 2020, approximately $11.5 million in unbilled receivables remain outstanding on this project. In addition, we are currently in dispute with an international customer in our US segment over approximately $10.0 million in unbilled receivables outstanding as of September 27, 2020. The dispute concerns the completion of certain system requirements and contractual milestones. Although there could be a delay in billing and collecting amounts due to us under the aforementioned contracts, we have evaluated the present facts of the matters and performed a reassessment of the contractual amounts due and have determined that no adjustment to previously recognized revenue, or the corresponding unbilled receivables, is necessary at September 27, 2020.
A summary of our net cash provided by (used in) operating activities from continuing operations, investing activities from continuing operations, and financing activities from continuing operations and our cash flows from discontinued operations from our condensed consolidated statements of cash flows is as follows (in millions):
| Nine Months Ended | |||||||||||
| September 27, 2020 | September 29, 2019 | ||||||||||
Net cash provided by operating activities from continuing operations | $ | 19.1 | $ | 30.2 | |||||||
Net cash used in investing activities from continuing operations | (66.8) | (35.2) | |||||||||
Net cash provided by financing activities from continuing operations | 248.0 | 2.6 | |||||||||
Net operating cash flows of discontinued operations | 2.1 | 0.8 | |||||||||
Net cash provided by operating activities from continuing operations for the nine months ended September 27, 2020 was impacted by the working capital requirements of, as well as certain investments we are making in, our ballistic missile business and US business.
Net cash used in investing activities from continuing operations for the nine months ended September 27, 2020 is comprised of the acquisitions of ASC Signal, TDI and Optimized Performance Machining, Inc., a payment due under the FTT acquisition agreement, and capital expenditures, which 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. Net cash used in investing activities from continuing operations for the nine months ended September 29, 2019 is comprised of the acquisition of FTT and capital expenditures, which 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. During the nine months ended September 27, 2020, capital expenditures of approximately $11.3 million were incurred in our US business, primarily related to our unmanned combat target initiative. We expect our capital expenditures for our calendar year 2020 to continue to be significant for investments we are making, specifically in our US business totaling approximately $18 to $23 million, including approximately $13 to $16 million for capital aerial targets and related support equipment.
Net cash provided by financing activities from continuing operations was $248.0 million for the nine months ended September 27, 2020 and consisted primarily of net proceeds of $240.4 million from our recently completed equity offering of approximately 15.5 million shares of common stock. Net cash provided by financing activities from continuing operations was $2.6 million for the nine months ended September 29, 2019.
The net operating cash flows of discontinued operations for the nine months ended September 27, 2020 is substantially related to approximately $3.1 million collected on amounts due related to the legacy projects retained by us following the sale our PSS business unit partially offset by the loss from operations from our discontinued PSS business unit of $0.8 million.
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Contractual Obligations and Commitments
Issuance of 6.5% Senior Secured Notes due 2025
In November 2017, we issued and sold $300 million aggregate principal amount of 6.5% Senior Secured Notes due 2025 (the “6.5% Notes”) in a private placement conducted pursuant to Rule 144A and Regulation S under the Securities Act of 1933, as amended. We incurred debt issuance costs of $6.6 million associated with the 6.5% Notes. We utilized the net proceeds from the sale of the 6.5% Notes, as well as cash from its recent equity offering to extinguish the outstanding 7.00% Senior Secured Notes due in 2019 (the “7% Notes”). The total reacquisition price of the 7% Notes was $385.2 million, including a $12.0 million call premium, and $0.3 million of accrued interest.
The 6.5% Notes are governed by the Indenture, dated as of November 20, 2017 (the “Indenture”), among the Company, our existing and future domestic subsidiaries parties thereto (the “Subsidiary Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent. A Subsidiary Guarantor can be released from its guarantee if (a) all of the capital stock issued by such Subsidiary Guarantor or all or substantially all of the assets of such Subsidiary Guarantor are sold or otherwise disposed of; (b) we designate such Subsidiary Guarantor as an Unrestricted Subsidiary (as defined in the Indenture); (c) we exercise our legal defeasance option or our covenant defeasance option; or (d) upon satisfaction and discharge of the Indenture or payment in full in cash of the principal of, premium, if any, and accrued and unpaid interest on the 6.5% Notes.
The 6.5% Notes bear interest at a rate of 6.5% per year from the date of original issuance or from the most recent payment date on which interest has been paid or provided for. Interest on the 6.5% Notes is payable in arrears on May 30 and November 30 of each year, beginning on May 30, 2018. The 6.5% Notes are fully and unconditionally guaranteed by the Subsidiary Guarantors.
The 6.5% Notes and the guarantees (as set forth in the Indenture) are our senior secured obligations and are equal in right of payment with all other senior obligations of the Subsidiary Guarantors’ existing and future secured debt to the extent of the assets securing that secured debt. Our obligations under the 6.5% Notes are secured by a first priority lien on substantially all of our assets and the assets of the Subsidiary Guarantors, except with respect to accounts receivable, inventory, deposit accounts, securities accounts, cash, securities and general intangibles (other than intellectual property), on which the holders of the 6.5% Notes have a second priority lien, junior to the lien securing our obligations under the Credit Agreement (as defined below).
The 6.5% Notes will be redeemable, in whole or in part, at any time on or after November 30, 2020 at the respective redemption prices specified in the Indenture. In addition, we may redeem up to 40% of the 6.5% Notes before November 30, 2020 with the net proceeds of certain equity offerings. We may also redeem some or all of the 6.5% Notes before November 30, 2020 at a redemption price of 100% of the principal amount thereof plus accrued and unpaid interest, to, but excluding, the redemption date, if any, plus a “make whole” premium. In addition, during each 12-month period commencing on the issue date and ending on or prior to November 30, 2020, we may redeem up to 10% of the original aggregate principal amount of the 6.5% Notes issued under the Indenture at a redemption price of 103.000% of the principal amount thereof, plus accrued and unpaid interest, to, but excluding, the date of redemption, if any. We may also be required to make an offer to purchase the 6.5% Notes upon a change of control and certain sales of its assets.
The Indenture contains covenants limiting, among other things, our ability and the Subsidiary Guarantors’ ability to: (a) pay dividends on or make distributions or repurchase or redeem our capital stock or make other restricted payments; (b) incur additional debt and guarantee debt; (c) prepay, redeem or repurchase certain debt; (d) issue certain preferred stock or similar equity securities; (e) make loans and investments; (f) sell assets; (g) incur liens; (h) consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; (i) enter into transactions with affiliates; and (j) enter into agreements restricting our ability and certain of its subsidiaries’ ability to pay dividends. These covenants are subject to a number of exceptions. As of September 27, 2020, we were in compliance with the covenants contained in the Indenture governing the 6.5% Notes.
The terms of the Indenture require that the net cash proceeds from asset dispositions be either utilized to (i) repay or prepay amounts outstanding under the Credit Agreement unless such amounts are reinvested in similar collateral, (ii) permanently reduce other indebtedness, (iii) make an investment in assets that replace the collateral of the 6.5% Notes or (iv) a combination of (i), (ii) and (iii). To the extent there are any remaining net proceeds from the asset disposition after application of (i), (ii) and (iii), such amounts are required to be utilized to repurchase the 6.5% Notes at par.
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The Indenture also provides for events of default which, if any such event occurs, would permit or require the principal, premium, if any, interest, if any, and any other monetary obligations on all the then-outstanding 6.5% Notes to become or to be declared due and payable immediately.
As of September 27, 2020, there was $300.0 million of 6.5% Notes outstanding.
Other Indebtedness
Credit and Security Agreement
On November 20, 2017, we entered into an amended and restated credit and security agreement (the “Credit Agreement”), with the lenders from time to time party thereto, SunTrust Bank, as Agent (the “Agent”), PNC Bank, National Association (“PNC Bank”), as Joint Lead Arranger and Documentation Agent, and SunTrust Robinson Humphrey, Inc. (“SunTrust”), as Joint Lead Arranger and Sole Book Runner. The Credit Agreement 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 as described therein), 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 obligations under the Credit Agreement are secured by (i) a first priority lien on our accounts receivable, inventory, deposit accounts, securities accounts, cash, securities and general intangibles (other than intellectual property)and (ii) a second priority lien, junior to the lien securing our 6.5% Notes, on all of our other assets.
Borrowings under the revolving credit facility may take the form of a base rate revolving loan, Eurodollar revolving loan or swingline loan. Base rate revolving loans and swingline loans 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 prime lending rate, as in effect at such time, (ii) the federal funds rate, as in effect at such time, plus 0.50% per annum and (iii) the Adjusted LIBO Rate (as defined in the Credit Agreement) determined at such time for an interest period of one month, plus 1.00% per annum. Eurodollar revolving 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 LIBO Rate. The Applicable Margin varies between 1.00%-1.50% for base rate revolving loans and swingline loans and 2.00%-2.50% for Eurodollar loans, and is based on several factors including our then-existing borrowing base and the lenders’ total commitment amount and revolving credit exposure. The calculation of our borrowing base takes into account several items relating to us and our subsidiaries, including amounts due and owing under billed and unbilled accounts receivable, then held eligible raw materials inventory, work-in-process inventory, and applicable reserves.
As of September 27, 2020, there were no borrowings outstanding on the Credit Agreement and $6.1 million was outstanding on letters of credit, resulting in net borrowing base availability of $69.1 million. We were in compliance with the financial covenants of the Credit Agreement and its amendments as of September 27, 2020.
Israel Debt
During August 2020, we entered into two 5-year term loans with two banks in Israel representing an aggregate principal amount of approximately $4.8 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 is paid by the State of Israel with subsequent interest and principal payments due monthly commencing in August 2021. We intend to repay these loans at the end of the first year.
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 the 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, in the future, 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.
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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. 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.
Effective December 30, 2019, we adopted the requirements of ASC 326, Measurement of Credit Losses on Financial Instruments, as discussed in Note 1 to the accompanying Condensed Consolidated Financial Statements. Other than the adoption of ASC 326, there have been no significant changes to our “Critical Accounting Policies or Estimates” as compared to the significant accounting policies described in the Form 10-K.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Since December 29, 2019, there have been no material changes in the quantitative or qualitative aspects of our market risk profile. For additional information regarding the Company’s exposure to certain market risks, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” included in the 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 27, 2020.
Changes in Internal Control Over Financial Reporting
We operate under the COSO (Committee of Sponsoring Organizations) 2013 Framework. There was no change in our internal control over financial reporting during the three months ended September 27, 2020 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
See Note 15 of the Notes to the 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, as well as the risk factors disclosed in Item 1A. to Part I of the 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, there have been no material changes in our risk factors as previously disclosed.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Mine Safety Disclosures.
Not applicable.
Item 5. Other Information.
None.
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Item 6. Exhibits.
| Incorporated by Reference | ||||||||||||||||||||||||||||||||
| Exhibit Number | Exhibit Description | Form | Filing Date/ Period End Date | Exhibit | Filed- Furnished Herewith | |||||||||||||||||||||||||||
| 2.1#* | 10-Q | 05/10/2018 (001-34460) | 2.2 | |||||||||||||||||||||||||||||
| 2.2#* | 10-Q | 05/08/2019 (001-34460) | 2.3 | |||||||||||||||||||||||||||||
| 3.1 | 10-K | 02/27/2017 (001-34460) | 3.1 | |||||||||||||||||||||||||||||
| 3.2 | 10-K | 02/27/2017 (001-34460) | 3.2 | |||||||||||||||||||||||||||||
| 4.1 | 10-K | 02/27/2017 (001-34460) | 4.1 | |||||||||||||||||||||||||||||
| 4.2 | 8-K | 11/21/2017 (001-34460) | 4.1 | |||||||||||||||||||||||||||||
| 4.3 | 10-K | 02/28/2018 (001-34460) | 4.5 | |||||||||||||||||||||||||||||
| 31.1 | * | |||||||||||||||||||||||||||||||
| 31.2 | * | |||||||||||||||||||||||||||||||
| 32.1 | * | |||||||||||||||||||||||||||||||
| 32.2 | * | |||||||||||||||||||||||||||||||
| 101.INS | * | |||||||||||||||||||||||||||||||
| 101.SCH | * | |||||||||||||||||||||||||||||||
| 101.CAL | * | |||||||||||||||||||||||||||||||
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| Incorporated by Reference | ||||||||||||||||||||||||||||||||
| Exhibit Number | Exhibit Description | Form | Filing Date/ Period End Date | Exhibit | Filed- Furnished Herewith | |||||||||||||||||||||||||||
| 101.DEF | * | |||||||||||||||||||||||||||||||
| 101.LAB | * | |||||||||||||||||||||||||||||||
| 101.PRE | * | |||||||||||||||||||||||||||||||
| 104 | Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101) | * | ||||||||||||||||||||||||||||||
# Certain schedules and exhibits referenced in this document have been omitted in accordance with Item 601(b)(2) of Regulation S-K. A copy of any omitted schedule and/or exhibit will be furnished supplementally to the Securities and Exchange Commission upon request.
* Certain confidential information contained in this Exhibit has been omitted because it is both (i) not material and (ii) would be competitively harmful if publicly disclosed.
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SIGNATURES
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.
| KRATOS DEFENSE & SECURITY SOLUTIONS, INC. | |||||||||||
| By: | /s/ ERIC M. DEMARCO | ||||||||||
| Eric M. DeMarco | |||||||||||
| Chief Executive Officer, President | |||||||||||
| (Principal Executive Officer) | |||||||||||
| By: | /s/ DEANNA H. LUND, CPA | ||||||||||
| Deanna H. Lund | |||||||||||
| Executive Vice President, Chief Financial Officer | |||||||||||
| (Principal Financial Officer) | |||||||||||
| By: | /s/ MARIA CERVANTES DE BURGREEN, CPA | ||||||||||
| Maria Cervantes de Burgreen | |||||||||||
| Vice President and Corporate Controller | |||||||||||
| (Principal Accounting Officer) | |||||||||||
| Date: | October 29, 2020 | ||||||||||
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