Reports Second Quarter Results

Awarded $95 Million Unmanned Target Contract

A Successful Test and Expansion of Capabilities

$46.7 Million Navy Award

Joe Gomes

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Aerospace & Defense

Kratos Defense & Security Solutions Inc.

<p><strong>Second Quarter 2021 Results</strong></p>
<div>
<div>Kratos revenues increased $34.7 million to $205.1 million for the second quarter from $170.4 million in the same period last year. KGS segment revenue increased $16.4 million due to the contribution from the acquisition of ASC Signal which contributed approximately $11.8 million and organic growth across the microwave products, rocket support, and space and satellite business. The training solutions business decreased by $4.7 million as a result of a reduction in scope of certain international training contracts. Revenues in the US segment increased $18.3 million to $60.3 million for the three months ended June 27, 2021 primarily due to work performed on the SSAT 177 and Valkyrie programs, and due to contributions of approximately $2.1 million from the recent TDI and 5-D Systems acquisitions.</div>
<div> </div>
<div>Product sales increased $39.6 million to $147.1 million in the second quarter of 2021 from $107.5 million in the comparable period last year, primarily as a result of increased production in certain Unmanned Systems drone programs, as well as contribution from ASC Signal. As a percentage of total revenue, product sales were 71.7% in the quarter, as compared to 63.1% in the second quarter of 2020. Service revenues decreased by $4.9 million to $58.0 million in the quarter, primarily related to lower turbine technologies service revenue (which was offset by higher turbine technologies product sales) as well as the previously mentioned reduction in scope of certain international training contracts.</div>
<div> </div>
<div>Gross margin decreased to 25.4% in the second quarter from 27.0% last year. Margins on services increased to 28.8% from 26.6%, due primarily to a more favorable mix of revenues. Margins on products decreased to 24.0% from 27.3%, primarily due to a less favorable mix of certain programs and increased activity in lower margin developmental programs. Margins in the KGS segment decreased to 27.2% from 28.7%, while margins in the US segment decreased to 20.9% from 21.9%.</div>
<div> </div>
<div>SG&amp;A expense increased to $38.2 million, or 18.6% of revenue, compared to $36.0 million, or 21.1% of revenue, in the same period last year. Included in SG&amp;A is an additional $1.8 million of stock compensation expense year-over-year. R&amp;D expenses increased $4.2 million to $10.2 million in the second quarter of 2021 from $6.0 million in the same period last year, with the primary increases in expenses being in the space and satellite communications business. As a percentage of revenues, R&amp;D increased to 5.0% in the second quarter from 3.5% in the comparable period last year. R&amp;D expenses are likely to remain elevated throughout 2021.</div>
<div> </div>
<div>Kratos reported operating income of $3.3 million in the second quarter, compared to $3.0 million last year. Second quarter 2021 operating income was negatively impacted by the $1.8 million increase in stock comp expense, $4.2 million increase in R&amp;D expense, and $1.6 million increase in depreciation expense. Adjusted EBITDA for the quarter was $17.6 million, up from $15.3 million in the second quarter of 2020. Adding back a $0.4 million adverse foreign exchange impact, adjusted EBITDA would have been $18 million in the quarter.&nbsp;&nbsp;</div>
<div> </div>
<div>Kratos reported GAAP net income of $1.1 million, or $0.01 per diluted share, in the quarter, driven by a favorable tax adjustment. In the second quarter last year, the Company reported a net loss of $0.7 million, or a loss of $0.01 per share. On an adjusted basis, the Company reported net income of $7.6 million, or $0.06 per share versus $5.7 million, or $0.05 per share, in the second quarter of 2020.</div>
<div> </div>
<div><strong>Momentum Continuing</strong></div>
<div> </div>
<div>Although COVID pushed a number of Kratos programs to the right, we believe momentum continues to build for the Company both in existing programs and potential new programs. Kratos&#8217; Mako was the first drone to demonstrate the Skyborg ACS compatibility and, along with Valkyrie, is integrating various payloads. We believe this is significant as the DoD has identified 15 potential missions for Skyborg drones. And while the General Atomics Avenger also flew with the ACS system, it remains unclear if the Avenger is General Atomics proposed drone for the program. Boeing meanwhile has gone quiet regarding its BATS drone following its first flight back in the beginning of March. Gremlins continues to move forward, again with a potentially expanded mission scope. Air Wolf, Thanatos, Firejet, and Ghost Works drones continue to see development activity. We anticipate multiple test flights across the range of Kratos drones in the second half.</div>
<div> </div>
<div>Kratos also is awaiting the award of the OBSS (off board sensing station) contracts, of which two are expected in August. OBSS could rival Valkyrie in size of its potential to Kratos. KTT, the Space division, microwave, and rocket systems are all seeing positive momentum.</div>
<div> </div>
<div>The Air Force has communicated that a key focus for the &#8217;23 and through 2027 budget will be the Agile Combat Employment or ACE initiative, which is the ability to operate away from established runways to be runway independent and operate in a manner that presents a very difficult distributed asset and lethality problem for our adversaries. ACE is an evolution of the United States Air Force agile basing concept, which has been identified as a top priority for the Air Force Chief of Staff. And related to the ACE initiative, the customers have made clear that affordability, runway independence and survivability are critical requirements, all of which Kratos drones already demonstrate.&nbsp;     </div>
<div> </div>
<div>To highlight some contracts awarded since the end of the first quarter, Kratos received an $85.9 million contract award, with a $60.7M base and two options totaling approximately $25.3M, from the U.S. Army to support the Army Ground Aerial Target Control System, including software updating, cyber security inspections and installation of replacement parts. The Company also received more than $30 million to support space-related U.S. national security efforts. The follow-on awards are to previous contracts, implementing advanced technologies to provide better system performance.&nbsp;</div>
<div> </div>
<div>The Company&nbsp;received multiple awards totaling more than $46 million to support Space Domain Awareness (SDA) efforts. Kratos is&nbsp;leveraging the technology behind its OpenSpace software platform to help satellite ground systems quickly adapt to changing conditions. Notably, Kratos has delivered products supporting the satellite industry&#8217;s movement toward virtualized ground systems to over 30 customers around the globe. These included products in Kratos&#8217; quantum and SpectralNet lines, both of which are part of its OpenSpace family of dynamic, virtual ground solutions. Kratos Space and Satellite business experienced a 1.3 to 1.0 book-to-bill in the second quarter and with&nbsp;Kratos supporting approximately 80% of the world&#8217;s satellite providers, Kratos has the relationships, existing installed base, and the past performance qualifications, to see significant new demand for its software based open space systems, in our view.</div>
<div> </div>
<div>KTT is another growth opportunity. Kratos is breaking the cost curve on turbojet and turbofans engines. Depending on the engine, costs could be three, four, five times less costly than today&#8217;s alternatives. Kratos is hopeful of a KTT award in the second half of 2021 that could be in the multiple tens of millions of dollars range.</div>
<div> </div>
<div><strong>Favorable National Security Budget</strong>     </div>
</div>
<div> </div>
<div>In spite of concerns following the Biden win in the Presidential election last year, the Biden Administration in May submitted a proposed budget for the year beginning October 2021 that included $753 billion for National Security funding, including $715 billion for the DoD. While this is a slight decrease from the Trump Administration&#8217;s $722 billion DoD request, it is not the worst case scenario others were fearing.&nbsp; We view these requests favorably for Kratos. In addition, the FY 2022 National Security budget includes a focus on research and development for new technologies to address peer and near peer threats. The FY 2022 budget request prioritizes defense research and development, test and evaluation funding to invest in breakthrough technologies that are also focused on innovation and the development of next generation defense capabilities. All of these are in Kratos&#8217; wheelhouse, in our opinion.</div>
<div> </div>
<div> Notably, the Senate Armed Services Committee recently authorized $201.6 million for the Skyborg program, including an increase of $75 million specifically called out for the purchase of Valkyrie aircraft. It also authorized $125 million to accelerate the use of unmanned aircraft as augmented adversary support, a new market opportunity for Kratos.</div>
<div> </div>
<div><strong>Capital Structure and Liquidity</strong>   </div>
<div> </div>
<div>Kratos ended the quarter with $369.3 million of cash on the balance sheet. Long-term debt was $300.3 million. The Company had $64.4 million available under its credit lines at quarter&#8217;s end. The Company should have sufficient cash to fund any transition to full rate production in its programs, in our view. We do not expect Kratos to seek out any significant acquisitions at this time.</div>
<div> </div>
<div> During the first six months of 2021, Kratos generated $22.0 million of cash, an $11.2 million increase over the same period last year. Driven by a $6 million increase in capital expenditures year-over-year, cash used in investing activities was $26.7 million in the first half of 2021, although down from the $29.5 million used in the same period last year which included $15.5 million for acquisitions. Kratos used $6.4 million in financing activities compared to a source of $241.5 million last year which included the sale of equity. Net net, Kratos used $12.2 million of cash in the first six months of 2021. For the full year, management expects operating cash flow to be in the $23-$28 million range, with a net use of cash in the $30-$40 million range driven by higher capital expenditures.</div>
<div> </div>
<div><strong>Projections</strong></div>
<div> </div>
<div>We believe Kratos will have a strong second half of 2021, although it will be weighted towards the fourth quarter. While there are some wildcards, such as a return to COVID restrictions and potential supply chain interruptions, the second half results are already in backlog so are not dependent upon winning additional business.</div>
<div> </div>
<div>For the third quarter, we are now projecting revenue of $205 million, down from our prior estimate of $215 million. Adjusted EBITDA is now at $19 million, down from our prior $23.5 million estimate, and adjusted EPS is projected at $0.07, down from a previous $0.11. In the third quarter of 2020, Kratos had revenue of $202 million, adjusted EBITDA of $24.6 million, and adjusted EPS of $0.14. However, given our expectation of a strong fourth quarter with improving margins, our full year revenue estimate is $839 million, compared to our prior $844 million, adjusted EBITDA is projected to be $85.7 million up from $84.1 million previously, and our full year adjusted EPS estimate is $0.33 versus our prior $0.29. In 2020, Kratos reported full year revenue of $747.7 million, adjusted EBITDA of $78.5 million, and adjusted EPS of $0.39.</div>


Kratos Defense & Security Solutions Inc. (KTOS)

Solid 2Q21 Sets Up A Strong 2H21

Fundamental Analysis:

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Reports Second Quarter Results (KTOS)

Awarded $95 Million Unmanned Target Contract (KTOS)

A Successful Test and Expansion of Capabilities (KTOS)

$46.7 Million Navy Award (KTOS)

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