This assignment involves the financial statements and SEC filings for the San Diego company Kratos (same Company you looked at for Homework #3).
From the company’s web site or SEC.gov – the filings section, find the Form 10-K for the year ended 12/31/18 that was filed with the SEC on February 28, 2019, the annual filing for the company.
Three questions:
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 30, 2018
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE
ACT OF 1934
Commission file number 001-34460
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
(Exact name of Registrant as specified in its charter )
Delaware
13-3818604
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer Identification No.)
10680 Treena St., Suite 600
San Diego, CA 92131
(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
Name of each exchange on which registered
Common Stock, par value $0.001
The NASDAQ Global Select Market
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No ý
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 (§ 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter)is not contained herein, and will not be contained, to
the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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:
Large accelerated filer ý
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
(Do not check if a smaller reporting company)
Emerging growth company o
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 o No ý
The aggregate market value of the registrant’s voting and non-voting common stock held by non-affiliates as of June 29, 2018, the last business day of the registrant’s most
recently completed second fiscal quarter, was approximately $1,013.2 billion, based on the closing sale price for shares of the registrant’s common stock as reported by the NASDAQ
Global Select Market on such date. This disclosure excludes shares of common stock held by executive officers, directors and stockholders whose individual ownership exceeds 10% of
the common stock outstanding on June 29, 2018 because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive
determination for any other purpose.
As of February 22, 2019, 104,046,886 shares of the registrant’s common stock were outstanding.
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Documents Incorporated by Reference
Items 10, 11, 12, 13 and 14 of Part III of this annual report on Form 10-K incorporate information by reference from the registrant’s definitive proxy
statement to be filed pursuant to Regulation 14A in connection with the registrant’s 2019 Annual Meeting of Stockholders or an amendment to this annual
report on Form 10-K to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year covered by this annual report
on Form 10-K.
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KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 30, 2018
TABLE OF CONTENTS
Page
PART I
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
PART II
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
PART III
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
PART IV
Item 15.
Item 16.
Business
Risk Factors
Unresolved Staff Comments
Properties
Legal Proceedings
Mine Safety Disclosures
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13
33
33
33
33
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Selected Financial Data
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Financial Statements and Supplementary Data
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Controls and Procedures
Other Information
34
36
37
56
56
56
56
57
Directors, Executive Officers and Corporate Governance
Executive Compensation
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Certain Relationships and Related Transactions, and Director Independence
Principal Accounting Fees and Services
57
57
58
58
58
Exhibits, Financial Statement Schedules
Form 10-K Summary
58
62
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All references to “us,” “we,” “our,” the “Company” and “Kratos” refer to Kratos Defense & Security Solutions, Inc., a Delaware corporation, and its
subsidiaries.
FORWARD‑LOOKING STATEMENTS
This Annual Report on Form 10-K (this “Annual 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. The most important risks and uncertainties that could cause our actual results or
achievements to differ materially from the results or achievements expressed in or implied by our forward-looking statements, include, but are not limited to
those specifically addressed in Item 1A “Risk Factors” in this Annual Report, as well as those discussed elsewhere in this Annual Report. These forwardlooking 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.
PART I.
Item 1. Business.
Overview
Kratos is a government contractor at the forefront of the U.S. Department of Defense’s (the “DoD”) recapitalization of strategic weapon systems to
address peer and near peer threats and its related Rapid Innovation Initiatives. Kratos is a leading technology, intellectual property, proprietary product and
system company focused on 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. A key element of our business plan is to make Company-funded investments related
to key platforms, products and systems, so that we own the related intellectual property, providing us designed in, sole and single source positions with our
offerings. We are an industry leader in high performance, jet powered, unmanned aerial drone target systems used to test weapon systems and to train the
warfighter and a provider of high performance unmanned combat aerial systems for force multiplication and amplification. We are also an industry leader in
space and satellite communications, microwave electronics, cyber security/warfare, missile defense, C5ISR (as defined below) and training systems. Our
workforce is primarily engineering and technically oriented with a significant number of employees holding national security clearances. Much of our work
is performed at customer locations, or in a secure facility. Our primary end customers are national and homeland security related agencies. We believe that our
technology, intellectual property, proprietary products and designed-in positions on our customers’ programs, platforms and systems, and our ability to
rapidly develop, demonstrate and field affordable leading technology systems gives us a competitive advantage and creates a high barrier to entry into our
markets. Our entire organization is focused on executing our strategy of becoming the leading technology and intellectual property based company in our
industry.
Industry Update
On February 9, 2018, the Congress approved and the President signed the Bipartisan Budget Act of 2018, which provided that:
1.
2.
3.
4.
spending limits created by the Budget Control Act of 2011 (“BCA”) would be increased by approximately $300 billion over the next two years;
defense spending would be increased by $80 billion in FY (as defined below) 2018 and by $85 billion in the current FY, to approximately $700
billion and $705 billion, respectively;
domestic spending would be increased by $63 billion in FY 2018 and by $68 billion in the current FY; and
Congress would suspend the debt limit through March 2019.
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The Congress and the President also executed a fifth continuing resolution authorization through March 23, 2018, to provide congressional
appropriators the time required to appropriately document and allocate the authorized spending. On March 23, 2018, the President signed the Omnibus
Appropriations Act for FY 2018, which provided $1.3 trillion in discretionary funding for federal agencies. In total for FY 2018, Congress appropriated
approximately $700 billion for national security, including approximately $630 billion for base discretionary funding and approximately $70 billion in
Overseas Contingency Operations (“OCO”) funding. The U.S. Government’s fiscal year (“FY”) ends September 30.
On September 28, 2018, full-year appropriations for FY 2019 were enacted representing over half of discretionary federal spending. For FY 2019,
Congress appropriated approximately $716 billion for national security, including approximately $647 billion for base discretionary funding and
approximately $69 billion in OCO funding. Continuing resolutions provided funding for certain agencies (including NASA and other civil agencies) through
December 21, 2018. On December 22, 2018, U.S. Government agencies that had not yet received full-year appropriations and did not otherwise have funding
entered into a temporary shutdown. On January 25, 2019, a third continuing resolution was enacted, which funded these agencies through February 15, 2019.
On February 15, 2019 a spending bill was enacted to fund these agencies for the remainder of FY 2019. 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 budget environment, including budget caps mandated by the BCA for fiscal years 2020 and 2021, and uncertainty surrounding the debt ceiling
and the appropriations process, remain significant short and long-term risks. Considerable uncertainty exists regarding how future budget and program
decisions will unfold, including the defense spending priorities of the Administration and Congress, what challenges budget reductions (required by the BCA
and otherwise) will present for the defense industry and whether annual appropriations bills for all agencies will be enacted for FY 2020. If annual
appropriations bills are not timely enacted for FY 2020 or beyond, the U.S. Government may again operate under a continuing resolution, restricting new
contract or program starts, presenting resource allocation challenges and placing limitations on some planned program budgets, and we may face another
government shutdown of unknown duration. If a prolonged government shutdown of the DoD were to occur, it could result in program cancellations,
disruptions and/or stop work orders and could limit the U.S. Government’s ability to effectively progress programs and to make timely payments, and our
ability to perform on our U.S. Government contracts and successfully compete for new work.
Additionally, funding for certain programs in which we participate may be reduced, delayed or cancelled, and budget cuts globally could adversely
affect the viability of our subcontractors and suppliers, and our employee base. While we believe that our business is well-positioned in areas that the DoD
and other customers have indicated are areas of focus for future defense spending, the long-term impact of the BCA, other defense spending cuts, challenges
in the appropriations process, the debt ceiling and the ongoing fiscal debates remain uncertain.
Significant delays or reductions in appropriations; long-term funding under a continuing resolution; an extended debt ceiling breach or government
shutdown; and/or future budget and program decisions, among other items, may negatively impact our business and programs and could have a material
adverse effect on our financial position, results of operations and/or cash flows.
Current Reporting Segments
The Company has historically operated in three reportable segments. The Kratos Government Solutions (“KGS”) reportable segment is comprised of
an aggregation of KGS operating segments, including our microwave electronic products, space and satellite communications, modular systems and defense
and rocket support services operating segments. The Unmanned Systems (“US”) reportable segment consists of our unmanned aerial system and unmanned
ground and seaborne system businesses. The Public Safety & Security reportable segment (which was divested in June 2018 and has been classified as
discontinued operations – see Note 8 of the Notes to Consolidated Financial Statements contained within this Annual Report) previously provided
independent integrated solutions for advanced homeland security, public safety, critical infrastructure, and security and surveillance systems for government
and commercial applications.
On June 11, 2018, we completed the sale of all the issued and outstanding capital stock of Kratos Public Safety & Security Solutions, Inc., a
Delaware corporation and wholly owned subsidiary of the Company (“PSS”), to Securitas Electronic Security, Inc., a Delaware corporation (“Buyer”).
Pursuant to the terms of that certain Stock Purchase Agreement, dated February 28, 2018, by and among Kratos, PSS and the Buyer-, the Buyer agreed to
purchase all of the issued and outstanding capital stock of PSS for a purchase price of $69 million in cash, subject to a closing net working capital adjustment
(the “Transaction”). We are currently in a dispute with the Buyer regarding the closing net working capital adjustment. The amount in dispute is
approximately $8 million. We currently expect to receive approximately $70 million of aggregate net cash proceeds from the Transaction, after taking into
account amounts to be paid by us pursuant to a negotiated transaction services
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agreement between us and the Buyer, receipt of approximately $7.0 million in net working capital retained by the Company, and associated transaction fees
and expenses, excluding the impact of the final settlement and determination of the closing net working capital adjustment. We currently expect that the net
working capital retained by the Company will be collected by the first half of 2019 once certain legacy projects are completed and the project close-out
process has been completed. The Company currently expects to recognize a net break-even on the sale of the Public Safety & Security business once the
aggregate net proceeds described above 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.
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 13 of the Notes to Consolidated Financial Statements
contained within this Annual Report. From a customer and solutions perspective, we view our business as an integrated whole, leveraging skills and assets
wherever possible.
Competitive Strengths
We believe that our intellectual property, proprietary products, and technology are strongly aligned with certain of the highest priority spending
areas of the DoD, and the DoD’s focus on leveraging technology to defeat or deter peer and near-peer adversaries. We also believe that our proven ability to
rapidly design, develop, demonstrate and field leading technology products and systems at an affordable cost differentiates us from our competitors. We
believe that our longstanding customer relationships, and the designed-in position of our systems, technology and products into our customers’ platforms,
programs and systems, provide a unique competitive advantage and position us well for accelerated growth.
Specialized national security focus aligned with mission-critical national security priorities. Continued concerns related to the threats posed by
certain foreign nations, including nations with peer or near peer capabilities have caused the U.S. Government to identify national security as an area of
functional and spending priority. Budget pressures, particularly related to DoD spending, have placed a premium on developing and fielding low-cost, hightechnology solutions to assist in national security missions. While recent budget pressures have at times caused delays in orders for our business, current
budget projections, including the pending fiscal 2020 DoD budget, suggest defense spending will increase over the next few years. The improving outlook
for defense spending is primarily focused on enhanced power projection, warfighting readiness, lethality, and recapitalization of key strategic defense
systems to address peer and near peer threats. Our primary capabilities and areas of focus, listed below, are strongly aligned with the objectives of the U.S.
Government as outlined in the DoD’s Strategic Review Document which was released in 2018:
•
•
•
•
•
•
•
•
•
Unmanned aerial drone, unmanned ground and unmanned seaborne systems
Satellite communications and radio frequency interference detection location and mitigation
Microwave electronics supporting warfare, missile, radar and communication systems
Electronic warfare, attack, missile, and radar systems
Intelligence, surveillance and reconnaissance
Ballistic missile defense systems
Command, control and combat systems
Cyber security and information assurance
Specialized training systems and operational readiness
IP-centric defense company with proprietary products and technology which address critical current and emerging threats faced by U.S. and allied
militaries. As a technology-focused defense company at the forefront of the DoD’s strategy for technology rich and affordable systems, our current and
growing portfolio of proprietary systems, products, solutions, and related intellectual property addresses some of the most critical needs of U.S. and allied
militaries in the fields of unmanned systems, space & satellite communications, microwave electronics, cyber security/warfare, missile defense, combat and
training systems. A key element of our customers’ strategy, and where we have invested significantly, is the development of capabilities and intellectual
property addressing the recent challenges faced by U.S. and allied militaries in Anti-Access and Aerial-Denial (“A2/AD”) environments. This is evidenced by
our significant investment in high-performance Unmanned Aerial Drone System (“UADS”) platforms and technology, which has culminated in a series of
Unmanned Combat Aerial System (“UCAS”) contract wins. Additionally, with our space & satellite and terrestrial ground segment command, control, radio
frequency interference monitoring, geolocation and mitigation products and capabilities, we believe we are well-positioned to capitalize on the 2019 DoD
budget request of $9.3 billion for space investments, a significant portion of which is for the development and protection of U.S. national security space
assets and infrastructure. Accordingly, our proprietary products,
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systems and technologies are developed and refined with the goal of enabling our customers to maintain an advantage over the advanced and constantly
evolving threats of adversaries, at an affordable cost. In many instances, we are one of the few companies that produce the mission-critical technology our
customers require, or we outperformed our peers in a competitive bidding process. We maintain a strategy of internally funding research and development
and owning the intellectual property of many of these high-performance capabilities and systems.
Technology-driven company aligned with and supporting our customers’ increased innovation, technology, and strategic national security
initiatives, with focus on speed and affordability. As the DoD works to increase or maintain its technological advantage over adversaries, it has continued its
efforts to create breakthrough technologies for national security, accelerate innovation to the warfighter, and repurpose current capabilities to create costeffective, disruptive technology advances. With our focus on delivering proven leading edge systems, products and technologies that address the most
critical current and emerging threats, our customers include some of the most technologically advanced organizations of the defense establishment, including
the Defense Innovation Unit (“DIU”) (formerly the Defense Innovation Unit Experimental (“DIUx”)), Defense Advanced Research Projects Agency
(“DARPA”), Air Force Research Laboratory (“AFRL”), the Strategic Capabilities Office (SCO), the Strategic Command (STRATCOM), the National
Aeronautics and Space Administration, the U.S. intelligence community, and other confidential customers. We believe our focus on constant innovation,
capability improvements across our product and solutions portfolio, speed of development, and production and affordability are key differentiators that align
us with and address our customers’ key initiatives.
In-depth understanding of customer missions. We have a reputation for successfully and rapidly designing, developing, demonstrating and fielding
mission-critical products, solutions and services to our customers, at an affordable cost. Our long-term relationships with the U.S. Air Force, U.S. Army, U.S.
Navy and other national security related customers and agencies enable us to develop an in-depth understanding of their missions, problems and technical
requirements. In addition, a substantial number of our employees are located at our customer locations, at secure manufacturing facilities or at critical
infrastructure locations, all of which provides Kratos with valuable strategic insight into our customers’ ongoing missions and future program and mission
requirements. This understanding of our customers’ missions, requirements, and needs, in conjunction with the strategic location of our employees, enables
us to offer technical solutions tailored to our customers’ specific requirements and evolving mission objectives. In addition, once our products are “designed
in” and we are on-site with a customer and providing our products and solutions, we have historically been successful in winning new and recompete
business.
Kratos is one of the industry leaders in high performance, jet powered, unmanned aerial target drone systems which are designed to replicate state of
the art adversarial fighter aircraft, missiles and other threats. Kratos is the sole source or primary unmanned aerial target drone system provider to the U.S. Air
Force, Navy, Army, and numerous allied foreign defense agencies. Leveraging off of this technology, for which Kratos owns the intellectual property, we
made a significant investment over the past six years developing Kratos’ first UCAS, our Unmanned Tactical Aerial Platform (“UTAP-22”), now formally
called “Mako.” After successfully achieving the Mako’s first concept flights at the end of 2015, in 2016 we received a $12.6 million single-award contract to
demonstrate certain payload integration and loyal wingman teaming with manned aircraft in a major military exercise. At the time, this contract was one of
the largest awarded contracts by the DIUx. We are currently under contract with several additional customers related to Kratos’ Mako.
A select sample of Kratos’ other key Unmanned Aerial System (“UAS”) products and contracts includes:
•
In 2017, we successfully advanced to Phase II of the Gremlins program, awarded by DARPA, the U.S. Government’s leader in breakthrough
technologies for national security, teamed with our partner company, Dynetics. In 2018, as part of the Dynetics led team, we were selected
for award on Phase III of the Gremlins program to demonstrate safe and reliable launch and aerial recovery of multiple unmanned drone
system aircraft, capable of employing and recovering diverse distributed payloads in volley quantities.
•
In 2016, we were awarded the AFRL Low Cost Attritable Strike Demonstration (“LCASD”) UCAS single-award cost share contract. The
LCASD is an approximately 30 foot by 22 foot unmanned strike aerial drone system. Our customer expects the initial flight of this leading
technology UAS to occur in the first quarter of 2019.
•
We have redeveloped our Air Force Subscale Aerial Target BQM-167 into what we believe to be the highest performance unmanned aircraft
in the world, the U.S. Navy Sub-Sonic Aerial Target (“SSAT”) Drone BQM-177A, with low rate initial production awarded to Kratos in June
2017. In 2018, delivery of the first production aerial targets was made to the U.S. Navy. In addition, our customer, Naval Air Systems
Command (NAVAIR) announced that it expects to award a quantity of up to 60 BQM-177As with deliveries in 2020 and
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2021. We expect the SSAT program to become one of the largest and most important to Kratos in the near term.
•
In 2018, we received a single award $109 million maximum value three year production contract for Air Force Subscale Aerial Target
BQM-167A, with $27 million being initially obligated at the time of award for 30 Lot 14 BQM-167A aerial targets and production support.
•
In 2018, we received a ten-year, sole source, single award framework contract from QinetiQ UK for Kratos’ MQM-178 Firejet aerial targets,
spares, ground support equipment, technical services, and training. In 2018, we were awarded a prime contract for the Aerial Target Systems
2 (ATS-2), Multiple Award Indefinite Delivery Indefinite Quantity (“IDIQ”) Contract with a ceiling value of $93.3 million, and a five year
period of performance.
•
In 2018, we received a sole source, single award multi-year IDIQ contract from Swedish Defence Materiel Administration for our MQM-178
Firejet aerial target aircraft and associated ground support equipment, spares, payloads, components, expendables and support services. The
first order under the three-year IDIQ contract is expected in the first half of 2019. Additionally, there are two three-year exercisable option
periods for a total potential contract performance term of nine years.
We believe that our internally developed and owned intellectual property allows us to provide more capable jet powered, unmanned aircraft,
designed to fly in A2/AD environments and with performance capabilities equal to or greater than fourth generation manned jet fighter aircraft, at an
affordable cost. Kratos’ tactical UAS provide force multiplication and augmentation for manned high performance fighter aircraft. We believe that there are
very few high-performance UAS that are as advanced as our technologies addressing the A2/AD environment, which the DoD has identified as a U.S.
capabilities gap. As such, consistent with the needs and requirements of the U.S. and allied militaries, we believe that our leadership in these types of high
performance unmanned aircraft provides us with a future market opportunity of these types of low-cost, high-performance systems.
We are also an industry leader in ground-based command, control and communications systems for satellites, and a leader in related radio frequency
interference identification, geolocation and mitigation. Our primary customers include the U.S. Air Force, Space Command and other agencies. Our
microwave electronics business products have designed-in positions on critical combat system programs, including Barak, Gripen, Iron Dome, Sling of
David, F-15, F-16, Gripen, and Arrow. Our advanced capabilities in the training systems and solutions market, including for aircraft and combat vehicles,
have allowed us to successfully remain at the forefront of defense industry readiness initiatives. We believe our strategy of internally funding the research and
development of many of our systems, products, solutions and capabilities will continue to solidify our position in high growth markets, such as high
performance UADS, satellite communications, microwave electronics and training systems, and allow us to grow, over the long-term, at a rate greater than that
of the industry.
Diverse base of key contracts with low concentration. Many of our contracts are single-award and/or sole source in nature, where we are the only
awardee by the customer. In many cases, our ability to obtain single award, sole source contracts is due to our intellectual property, proprietary products,
historical performance qualifications, relative experience and affordability. Additionally, as a result of our business development focus on securing key
contracts, we are also a preferred contractor on numerous multi-year, government-wide acquisition contracts (“GWACs”) and multiple award contracts. Our
preferred contractor status provides us with the opportunity to bid on billions of dollars of business each year against a discrete number of other pre-qualified
companies.
We have a highly diverse base of customers and contracts with no contract representing more than 6% of 2018 revenue. Our fixed-price contracts, the
majority of which are production contracts, represent approximately 86% of our 2018 revenue. Our cost-plus-fee contracts and time and materials contracts
represent approximately 9% and 5%, respectively, of our 2018 revenue. We believe our diverse base of key contracts and low reliance on any one contract
provides us with a stable, balanced revenue stream. Our recent major contract awards, including a $93.3 million potential value contract with the U.S. Army’s
Target Management Office (TMO), $30 million in scope increases on multiple training platforms, $109 million maximum value three year production
contract for the Air Force Subscale Aerial Target program, $38.6 million additional task orders awarded on Foreign Military Sales (FMS) to support the Royal
Saudi Naval Forces, $67.5 million single award prime contract to support the Naval Warfare Center, Dahlgren Division Electromagnetic and Sensor Systems
Department through their Radar Systems Division, and multiple space and satellite communications awards have continued to allow us to grow the business
while maintaining a diverse contract base.
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Significant cash flow visibility driven by stable backlog. As of December 30, 2018 and December 31, 2017, our total backlog (see Backlog below)
was approximately $620.7 million and $519.9 million respectively, of which approximately $537.2 million was funded in 2018 and $457.3 million was
funded in 2017. The majority of our sales are from awards issued under long-term contracts, typically three to five years in duration. Our contract backlog
provides visibility into stable future revenue and cash flow over a diverse set of contracts. Importantly, a number of our systems and products are designed-in
on and support long term, multi-year/multi-decade programs, which provides significant operational and financial visibility to our Company.
Highly skilled employees and an experienced management team. We deliver our systems, products and services through a skilled and primarily
engineering and technically oriented workforce of approximately 2,600 employees. Our senior managers have significant experience with U.S. Government
agencies, the U.S. military and U.S. Government contractors. A significant number of Kratos employees hold national security clearances. Members of our
management team have experience growing businesses both organically and through acquisitions and delivering significant value to stakeholders. We
believe that the cumulative experience and differentiated expertise of our personnel in our core focus areas, coupled with our sizable and technically oriented
employee base, allow us to qualify for and bid on larger programs and contracts in a prime contracting role.
Our Strategy
Our strategy is to focus on our core business areas, including unmanned systems, space and satellite communications, cyber security, microwave
electronics, missile defense and training systems, which are closely aligned with the DoD’s mission and funding priorities. We will continue to invest in
differentiating systems, products, technology and intellectual property. We intend to be the leader in rapidly developing, demonstrating and delivering to the
warfighter proven leading technology systems, at an affordable cost.
Internal Growth
We are focused on generating internal growth by capitalizing on our ability to rapidly develop, demonstrate and field leading technology systems
and products at an affordable cost. We will make targeted discretionary investments in mission critical DoD priority areas, including unmanned systems,
space and satellite communications, cyber security, microwave electronics, missile defense and training systems, which have the highest potential for growth
based on recent DoD funding requests, and in which we will retain the intellectual property rights.
Expand technology product, solution and service offerings provided to existing customers. We are focused on expanding the technology, products,
systems and solutions we provide to our current customers by leveraging our strong relationships, technical capabilities, intellectual property and past
performance qualifications as well as by offering a wider range of comprehensive low-cost technology leading and proven products and solutions. In regard
to areas of specialization, our product and solution offerings include the manufacturing of specialized defense electronics; integrated technology solutions
for satellite command, control and communications; specialized high performance UADS and drone aircraft for tactical and threat representation target
purposes; and Unmanned Ground Systems (“UGS”) and Unmanned Seaborne Systems (“USS”). We believe our understanding of customer needs, missions,
requirements and processes, and our ability to rapidly deliver low cost, technology leading systems, products and solutions, position us well for success in
the current national security environment.
Capitalize on current contract base. We are pursuing new program and contract opportunities and awards as we build the business with our
expanding technology base, intellectual property ownership, contract portfolio, and product, solution and service offerings. We are also aggressively
pursuing several national security priority areas, including high performance UADS, satellite communications command, control, communication and signal
monitoring products, microwave electronics for missiles, radars, electronic warfare and communications, cyber security solutions, specialized training
systems, autonomy and artificial intelligence systems, robotics, directed energy systems, hypersonic systems, electromagnetic rail gun systems and next
generation ballistic missile targets. We are also assessing new tactical program areas and platforms to pursue that are consistent with our core capabilities,
technology and intellectual property.
Expand customer and contract base. We are focused on expanding our customer base into areas with significant growth opportunities as indicated
by the FY 2019 DoD budget request and the DoD Strategic Document, by leveraging our technology, intellectual property, proprietary products, capabilities,
industry reputation, long-term customer relationships and diverse contract base. We also believe that our ability to rapidly develop, demonstrate and field
high technology systems and products at an affordable cost is a clear competitive differentiator for our Company. We anticipate that this overall expansion in
our capabilities will enable us both to pursue larger program opportunities, higher value work and to further diversify our revenue base across additional U.S.
Government, international and commercial customers.
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Improve operating margins. We believe that we have opportunities to increase our operating margins and improve profitability by capitalizing on
our corporate infrastructure investments as our business grows, production of our products and systems increases and related revenues increase. We are
proactively focused on continuously improving efficiencies, reducing costs, and concentrating our efforts on operational excellence.
Invest in strategic growth areas. Over the past several years, we have made significant internally funded investments in strategic growth areas
including unmanned tactical aircraft drone systems. Specifically, we have increased internally funded research and development, capital expenditures and
infrastructure investments, including executive management, bid, proposal and new business capture, pursuit and related expenses. We have made these
investments with the intention of developing, demonstrating, fielding and bringing to production high performance jet powered unmanned aerial combat
systems. These investments also allow us to retain the intellectual property rights, design and data packages for these platforms and systems, and to
ultimately secure sole source production positions in these strategic growth areas. Specifically, since 2012, we have invested over $100 million in our UAS
through internally funded research, development and contract design retrofit costs for new platforms under development and capital expenditures for aircraft
and related equipment related to this strategic growth area.
•
We invested in internally funded research, development and capital expenditures to build our own UTAP-22 (Mako) UAS from 2012 to 2015,
and demonstrated the capabilities of the UTAP-22 Mako in a flight demonstration in the fall of 2015. As a result, we were awarded an initial
$12.6 million prime contract from the DIUx for sensor integration and flight demonstration of our UTAP-22 Mako unmanned aerial system the
following year. Under this effort, we integrated certain sensors into our UTAP-22 Mako and participated in a large, complex flight exercise in
2017.
•
We received a $40.8 million single award, cost-share contract from the AFRL for the LCASD. Under the LCASD contract award, we are
designing, developing, and will deliver, demonstrate and test a technical baseline for a high-speed long-range, low-cost limited life-strike UAS.
For our investment, we will retain hard (including two LCASD aircraft) and other assets, and important intellectual property, software, data,
platform and system rights, which we believe will be critically important and valuable over the expected long-term life of this platform,
including with respect to future production opportunities. Our customer expects the initial flight of this leading technology UAS to occur in the
first quarter of 2019.
•
We were awarded one of four prime contract awards from DARPA for the Gremlins program. Under the Gremlins program, DARPA envisions a
swarm of approximately 20 high performance unmanned aerial vehicles that are deployed by an inflight aircraft, and are later recovered,
inflight, by an aircraft. The approximate $3.9 million Phase I contracts were awarded to four competing companies, with the intent to ultimately
down select to one finalist company over a period of approximately 36 months. In 2017, we successfully advanced to Phase II of the Gremlin’s
program, teamed with our partner company Dynetics. In 2018, as part of the Dynetics-led team, we were selected for award on Phase III of the
Gremlins program to demonstrate safe and reliable launch and aerial recovery of multiple unmanned drone system aircraft, capable of
employing and recovering diverse distributed payloads in volley quantities.
Capitalize on corporate infrastructure investments. In recent periods, we have made significant investments in our senior management and
corporate infrastructure related to cyber security threats to our Company, increased and changing regulations we are subject to, and the changing national
security industry environment. These investments also included hiring senior executives with significant experience in the national security industry, hiring
firms to support us on Capitol Hill, Congressionally and with our customers, strengthening our internal controls over financial reporting and accounting staff
in support of increasing public company reporting requirements, expanding our infrastructure in response to increases in cyber security protection and related
regulatory requirements, and expanding our backlog and bid and proposal pipeline. We expect to be allocating additional resources in our pursuit of new,
larger and highly technical prime contract opportunities. We believe our management experience and corporate infrastructure can support a company with a
much larger revenue base than ours. Accordingly, we believe that, to the extent our revenue grows, we will be able to leverage this infrastructure base and
increase our operating margins.
Customers
A representative list of customers in our KGS and US segments during 2018 included the U.S. Air Force, U.S. Army, U.S. Navy, U.S. Marines, Missile
Defense Agency, Space Command, the Department of Homeland Security, the National Aeronautics and Space Administration, FMS, the U.S. Southern
Command, STRATCOM, the Strategic Capabilities Office (SCO), DIU or DIUx, the Rapid Capabilities Offices, the U.S. intelligence community and certain
confidential customers.
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Revenue from the U.S. Government (which includes FMS) includes revenue from contracts for which we are the prime contractor as well as those for
which we are a subcontractor and the ultimate customer is the U.S. Government. Revenues from U.S. Government agency customers in aggregate accounted
for approximately 72%, 75% and 73% of total revenues in 2018, 2017, and 2016, respectively.
Revenues from foreign customers were approximately $114.3 million or 19%, $84.7 million or 14%, and $80.1 million or 15% of total revenue for
the years ended December 30, 2018, December 31, 2017, and December 25, 2016, respectively.
Backlog
Effective January 1, 2018, we adopted the requirements of Accounting Standards Codification 606, Revenue from Contracts with Customers (“ASC
606”), utilizing the modified retrospective method as discussed in Note 1 of the Notes to Consolidated Financial Statements contained within this Annual
Report. Since our adoption of ASC 606, revenues from remaining performance obligations, also referred to as total backlog, are now calculated as the dollar
value of our remaining performance obligations on executed contracts. As of December 30, 2018, our backlog was approximately $620.7 million, of which
$537.2 million was funded. We expect to recognize approximately 66.7% of the remaining total backlog as revenue in 2019, an additional 13.7% in 2020
and the balance thereafter. The adoption of ASC 606 resulted in a reduction of approximately $136.6 million of our total backlog as of December 31, 2017.
Our comparable total backlog balance as of December 31, 2017, applying the requirements under ASC 606, was approximately $519.9 million of which
$457.3 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 the Company is expected 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 IDIQ contracts, only awarded or funded task orders are included for backlog purposes.
We define funded backlog as estimated future revenue under government contracts and task orders for which funding has been appropriated by
Congress and authorized for expenditure by the applicable agency, plus an estimate of the future revenue expected to be realized from commercial contracts
that are under firm orders. Funded backlog does not include the full potential value of the Company’s 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, the Company has reasonable expectations or visibility of what ultimate orders for Kratos’ systems,
products and solutions will be. The Company does 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.
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Employees
As of December 30, 2018, we had a work force of approximately 2,600 full-time, part-time and on-call employees.
Competition
Our market is competitive and includes a number of companies in the U.S. defense and national security industries. Most of the companies that we
compete against have significantly greater financial, technical, marketing and other resources and generate greater revenues than we do. Competition in the
KGS and US segments include tier one, large U.S. Government contractors and system integrators such as Northrop Grumman, Lockheed Martin, General
Dynamics, Raytheon, BAE Systems, L3, and Boeing. While we view other government contractors as competitors, we also team with these same companies in
joint proposals or in the delivery of our products, solutions and services for customers. Tier two competitors include smaller government contractors such as
Mercury Computer, Qinetiq, Cobham, Aerojet Rocketdyne and AAR. Intense competition and long operating cycles are key characteristics of our business
within the defense industry. It is also common in the defense industry for work on major programs to be shared among a number of companies. A company
competing to be a prime contractor or subcontractor on an award may, upon final award of the contract to another competitor, become a subcontractor for the
final prime contractor. It is not unusual to compete for a contract award with a peer company and simultaneously perform as a supplier to or be a customer of
that same competitor on other contracts, or vice versa. The nature of major defense programs, conducted under binding contracts, allows companies that
perform well to benefit from a level of program continuity not frequently found in other industries.
We believe that the principal competitive factors in our ability to win new business include our strategy of focusing on priority DoD requirements
and funding areas, our intellectual property, proprietary products, technology and our ability to rapidly develop, demonstrate and deliver systems to the
warfighter at an affordable cost. Also important is our past performance qualifications, customer relationships, domain and technology expertise, the ability
to obtain and replace contract vehicles, the ability to deliver results within budget (time and cost), reputation, accountability, staffing flexibility, and project
management expertise. Additionally, our ability to deliver cost effective systems, products, solutions and services that meet our customers’ requirements is
also a key differentiator.
In the U.S. defense, IT, and services markets, the U.S. Government has stressed competition and affordability in connection with its future
procurement of products and services. This has led to fewer sole source awards, as well as more emphasis on cost competitiveness, with contract awards issued
on a Low Price Technically Acceptable (“LPTA”) basis rather than a best value basis, which has negatively impacted our Defense and Rocket Support
Services (“DRSS”) business in our KGS segment. In addition, competitor bid protests have become more prevalent in the current competitive environment,
resulting in further delay of contract procurement activity.
The majority of our government services business is included in our DRSS business. This cost competitive environment resulted in an impairment in
the carrying value of our DRSS business in the fourth quarter of 2017. Approximately 10% of Kratos’ business for the year ended December 30, 2018 is IT or
government services based. In 2010, Kratos changed its strategy to focus on being a system, product, technology and intellectual property based company
and we deemphasized our focus in our legacy government services businesses. For 2018, our legacy government services business generated revenues of
approximately $59.6 million. See Note 2 of the Notes to Consolidated Financial Statements contained within this Annual Report for further discussion.
Research and Development
We believe that our future success depends upon our ability to continue to rapidly develop new products and services, and enhancements to and
applications for our existing products and services, to be delivered at an affordable cost. Our research and development expenses were $15.6 million, $17.8
million and $13.9 million in 2018, 2017, and 2016, respectively. We intend to continue our focus on research and development as a key strategy for growth,
which will focus on investments in those fields that we believe will offer the greatest opportunity for growth and profitability. Our current primary internal
research and development (“IR&D”) focus areas include satellite communications and signal monitoring, unmanned systems, and electronic products.
Intellectual Property
We believe that our continued success depends in large part on our proprietary technology, the intellectual skills of our employees and the ability of
our employees to continue to innovate. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as confidentiality agreements,
to establish and protect our proprietary rights.
As of December 30, 2018, we held a number of U.S. and foreign patents. We do not consider our business to be materially dependent upon any
individual patent. We will continue to file and pursue patent applications when and where
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appropriate to attempt to protect our rights in our proprietary technologies. We also encourage our employees to continue to invent and develop new
technologies so as to maintain our competitiveness in the marketplace.
We own or have rights to use certain trademarks, service marks and trade names that we use in conjunction with the operation of our business.
Certain of our trademarks have also been registered in selected foreign countries.
Government Regulation
We are subject to various government regulations, including various U.S. Government regulations as a contractor and subcontractor to the agencies
of the U.S. Government. Among the most significant U.S. Government regulations affecting our business are:
•
the Federal Acquisition Regulations and supplemental agency regulations, which comprehensively regulate the formation, administration,
and performance under government contracts;
•
the Truthful Cost or Pricing Data Statute (formerly the Truth in Negotiations Act), which requires certification and disclosure of all cost and
pricing data in connection with contract negotiations;
•
the Cost Accounting Standards, which impose accounting requirements that govern our right to reimbursement under cost-based
government contracts;
•
the Foreign Corrupt Practices Act, which prohibits U.S. companies from providing anything of value to a foreign official to help obtain,
retain or direct business, or obtain any unfair advantages;
•
the False Claims Act and the False Statements Act, which, respectively, impose penalties for payments made on the basis of false facts
provided to the government and impose penalties on the basis of false statements, even if they do not result in a payment; and
•
laws, regulations and executive orders restricting the use and dissemination of information classified for national security purposes and the
exportation of certain products and technical data.
We also need special security clearances to continue working on and advancing certain of our programs and contracts with the U.S. Government.
Classified programs generally will require that we comply with various Executive Orders, federal laws and regulations and customer security requirements
that may include restrictions on how we develop, store, protect and share information, and may require our employees to obtain government clearances.
The nature of the work we do for the federal government may also limit the parties who may invest in or acquire us. Export laws may keep us from
providing potential foreign acquirers with a review of the technical data they would be acquiring. In addition, there are special requirements for foreign
parties who wish to buy or acquire control or influence over companies that control technology or produce goods in the security interests of the U.S. There
may need to be a review under the Exon-Florio provisions of the Defense Production Act. Finally, the government may require a prospective foreign owner to
establish intermediaries to actually run that part of the company that does classified work, and establishing a subsidiary and its separate operation may make
such an acquisition less appealing to such potential acquirers.
In addition, the export from the U.S. of certain of our products may require the issuance of a license by the U.S. Department of Commerce under the
Export Administration Act, as amended, and its implementing regulations as kept in force by the International Emergency Economic Powers Act of 1977, as
amended. Some of our products may require the issuance of a license by the U.S. Department of State under the Arms Export Control Act and its
implementing regulations, which licenses are generally harder to obtain and take longer to obtain than do Export Administration Act licenses.
Our business may require compliance with state or local laws designed to limit the uses of personal user information gathered online or require
online services to establish privacy policies.
Material Availability
We procure critical material, components, products and subsystems from both domestic and global supply partners. These supply sources may be
single sources for certain components and the material provided may have extended lead times. To support our continuing customer needs, we have taken
steps to mitigate sourcing risks. This includes working closely with our suppliers to ensure future material and subsystem availability to support our
manufacturing plans. In some cases, we have elected to stock reserve material to ensure future availability.
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Environmental
Our manufacturing operations are subject to many requirements under environmental laws. In the U.S., the U.S. Environmental Protection Agency
and similar state agencies administer laws that restrict the emission of pollutants into the air, discharges of pollutants into bodies of water and disposal of
pollutants in the ground. Violations of these laws can result in significant civil and criminal penalties and incarceration. The failure to obtain a permit for
certain activities may be a violation of environmental law and subject the owner and operator to civil and criminal sanctions. Most environmental agencies
also have the power to shut down an operation if it is operating in violation of environmental law. U.S. laws also allow citizens to bring private enforcement
actions in some situations. Outside the U.S., the environmental laws and their enforcement vary and may be more burdensome. We have management
programs and processes in place that are intended to minimize the potential for violations of these laws.
Other environmental laws, primarily in the U.S., address the contamination of land and groundwater and require the clean-up of such contamination.
These laws may apply not only to the owner or operator of an on-going business, but also to the owner of land contaminated by a prior owner or operator. In
addition, if a parcel is contaminated by the release of a hazardous substance, such as through its historic use as a disposal site, any person or company that has
contributed to that contamination, whether or not it has a legal interest in the land, may be subject to a requirement to clean up the parcel.
Available Information
We file reports with the Securities and Exchange Commission (“SEC”). We make available on our website under “Investor Relations/Financial
Information/SEC Filings,” free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to
those reports as soon as reasonably practicable after we electronically file such materials with or furnish them to the SEC. Our website address is
www.kratosdefense.com. The SEC also maintains an Internet site that contains our reports, proxy and information statements, and other information at
www.sec.gov.
References to our website and the SEC’s website in this report are provided as a convenience and do not constitute, and should not be viewed as,
incorporation by reference of the information contained on, or available through, such websites. Such information should not be considered a part of this
report, unless otherwise expressly incorporated by reference in this report.
Item 1A. Risk Factors.
You should carefully consider the following risk factors and all other information contained herein as well as the information included in this
Annual Report and other reports and filings made with the SEC in evaluating our business and prospects. Risks and uncertainties, in addition to those we
describe below, that are not presently known to us or that we currently believe are immaterial may also impair our business operations. If any of the
following risks occur, our business and financial results could be harmed and the price of our common stock could decline. You should also refer to the
other information contained in this Annual Report, including our Consolidated Financial Statements and the related Notes.
Risks Related to Our Business
The U.S. Government provides a significant portion of our revenue, and our business could be adversely affected by changes in the fiscal policies of the U.S.
Government and governmental entities.
In fiscal 2018, 2017 and 2016, we generated 72%, 75% and 73%, respectively, of our total revenues from contracts with the U.S. Government
(including all branches of the U.S. military and FMS), either as a prime contractor or a subcontractor. We expect to continue to derive most of our revenues
from work performed under U.S. Government contracts. See the Industry Update section in Item 1 “Business” contained within this Annual Report for a
discussion of the current budgetary and funding constraints on U.S. Government spending and legislation enacted to reduce the U.S. federal deficit. As a
result, we have experienced and expect to continue to experience reduced or delayed awards on some of our programs, with a related negative impact to our
revenues, earnings and cash flows. Competitor bid protests also have become more prevalent in the current competitive environment resulting from decreased
government spending, which has led to further contract award delays. In addition, any future changes to the fiscal policies of the U.S. Government and
foreign governmental entities may decrease overall government funding for defense and homeland security, result in delays in the procurement of our
products and services due to lack of funding, cause the U.S. Government and government agencies to reduce their purchases under existing contracts, or
cause them to exercise their rights to terminate contracts at-will or to abstain from exercising options to renew contracts, any of which would have an adverse
effect on our business, financial condition, results of operations and/or cash flows.
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Significant delays or reductions in appropriations for our programs and U.S. Government funding more broadly may negatively impact our business and
programs and could have a material adverse effect on our financial position, results of operations and/or cash flows.
U.S. Government programs are subject to annual congressional budget authorization and appropriation processes. For many programs, Congress
appropriates funds on a fiscal year basis even though the program performance period may extend over several years. Consequently, programs are often
partially funded initially and additional funds are committed only as Congress makes further appropriations. If we incur costs in excess of funds obligated on
a contract, we may be at risk for reimbursement of those costs unless and until additional funds are obligated to the contract. We cannot predict the extent to
which total funding and/or funding for individual programs will be included, increased or reduced as part of the annual budget process ultimately approved
by Congress and the President or in separate supplemental appropriations or continuing resolutions, as applicable. Laws and plans adopted by the U.S.
Government relating to, along with pressures on and uncertainty surrounding the federal budget, potential changes in priorities and defense spending levels,
sequestration, the appropriations process, use of continuing resolutions (with restrictions, e.g., on new starts) and the permissible federal debt limit, could
adversely affect the funding for individual programs and delay purchasing or payment decisions by our customers. In the event government funding for our
significant programs becomes unavailable, or is reduced or delayed, or planned orders are reduced, our contract or subcontract under such programs may be
terminated or adjusted by the U.S. Government or the prime contractor.
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 our programs in particular.
The budget environment, including budget caps mandated by the BCA for fiscal years 2020 and 2021, and uncertainty surrounding the debt ceiling
and the appropriations process, remain significant short and long-term risks. Considerable uncertainty exists regarding how future budget and program
decisions will unfold, including the defense spending priorities of the Administration and Congress, what challenges budget reductions (required by the BCA
and otherwise) will present for the defense industry and whether annual appropriations bills for all agencies will be enacted for FY 2020. If annual
appropriations bills are not timely enacted for FY 2020 or beyond, the U.S. Government may again operate under a continuing resolution, restricting new
contract or program starts, presenting resource allocation challenges and placing limitations on some planned program budgets, and we may face another
government shutdown of unknown duration. If a prolonged government shutdown of the DoD were to occur, it could result in program cancellations,
disruptions and/or stop work orders and could limit the U.S. Government’s ability to effectively progress programs and to make timely payments, and our
ability to perform on our U.S. Government contracts and successfully compete for new work.
We believe continued budget pressures would have serious negative consequences for the security of our country, the defense industrial base,
including the Company, and the customers, employees, suppliers, investors, and communities that rely on companies in the defense industrial base. It is
likely budget and program decisions made in this environment would have long-term implications for us and the entire defense industry.
Additionally, funding for certain programs in which we participate may be reduced, delayed or cancelled, and budget cuts globally could adversely
affect the viability of our subcontractors and suppliers, and our employee base. While we believe that our business is well-positioned in areas that the DoD
and other customers have indicated are areas of focus for future defense spending, the long-term impact of the BCA, other defense spending cuts, challenges
in the appropriations process, the debt ceiling and the ongoing fiscal debates remain uncertain.
Significant delays or reductions in appropriations; long-term funding under a continuing resolution; an extended debt ceiling breach or government
shutdown; and/or future budget and program decisions, among other items, may negatively impact our business and programs and could have a material
adverse effect on our financial position, results of operations and/or cash flows.
If we fail to establish and maintain important relationships with government agencies and prime contractors, our ability to successfully maintain and
develop new business may be adversely affected.
Our reputation and relationship with the U.S. Government, and in particular with the agencies of the DoD and the U.S. intelligence community, are
key factors in maintaining and developing new business opportunities. In addition, we often act as a subcontractor or in “teaming” arrangements in which we
and other contractors bid together on particular contracts or programs for the U.S. Government or government agencies. We expect to continue to depend on
relationships with other prime contractors for a portion of our revenue for the foreseeable future. Negative press reports regarding conflicts of interest, poor
contract performance, employee misconduct, information security breaches or other aspects of our business, regardless of
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accuracy, could harm our reputation. Additionally, as a subcontractor or team member, we often lack control over fulfillment of a contract, and poor
performance on the contract could tarnish our reputation, even when we perform as required. As a result, we may be unable to successfully maintain our
relationships with government agencies or prime contractors, and any failure to do so could adversely affect our ability to maintain our existing business and
compete successfully for new business.
Many of our contracts contain performance obligations that require innovative design capabilities, are technologically complex, require state-of-the-art
manufacturing expertise, or are dependent upon factors not wholly within our control. Failure to meet these obligations could adversely affect our
profitability and future prospects. Early termination of client contracts or contract penalties could adversely affect our results of operations.
We design, develop, and manufacture technologically advanced and innovative products and services, which are applied by our customers in a
variety of environments. Problems and delays in development or delivery as a result of issues with respect to design, technology, licensing and intellectual
property rights, labor, inability to achieve learning curve assumptions, manufacturing materials or components could prevent us from meeting requirements.
Either we or the customer may generally terminate a contract as a result of a material uncured breach by the other. If we breach a contract or fail to perform in
accordance with contractual service levels, delivery schedules, performance specifications, or other contractual requirements set forth therein, the other party
thereto may terminate such contract for default, and we may be required to refund money previously paid to us by the customer or to pay penalties or other
damages. Even if we have not breached, we may deal with various situations from time to time that may result in the amendment or termination of a contract.
These steps can result in significant current period charges and/or reductions in current or future revenue. Other factors that may affect revenue and
profitability include inaccurate cost estimates, design issues, unforeseen costs and expenses not covered by insurance or indemnification from the customer,
diversion of management focus in responding to unforeseen problems, and loss of follow-on work.
If our subcontractors or suppliers fail to perform their contractual obligations, our performance and reputation as a contractor and our ability to obtain
future business could suffer.
As a prime contractor, we often rely upon other companies as subcontractors to perform work we are obligated to perform for our customers. As we
secure more work under certain of our contracts, we expect to require an increasing level of support from subcontractors that provide complementary and
supplementary services to our offerings. We are responsible for the work performed by our subcontractors, even though in some cases we have limited
involvement in that work. If one or more of our subcontractors fails to satisfactorily perform the agreed-upon services on a timely basis or violates U.S.
Government contracting policies, laws or regulations, our ability to perform our obligations as a prime contractor or meet our customers’ expectations may be
compromised. In extreme cases, performance or other deficiencies on the part of our subcontractors could result in a customer terminating our contract for
default. A termination for default could expose us to liability, including liability for the agency’s costs of re-procurement, could damage our reputation and
could hurt our ability to compete for future contracts.
We also are required to procure certain materials and parts from supply sources approved by the U.S. Government. The inability of a supplier to meet
our needs or the appearance of counterfeit parts in our products could have a material adverse effect on our financial position, results of operations or cash
flows.
Our earnings and profitability depend, in part, on subcontractor and supplier performance and product availability.
We rely on other companies to provide major components for our products. For instance, we build the airframe, electronics and flight control systems
for our unmanned aerial systems. We rely on our suppliers to provide the engines and parachutes for landing the aircraft. Disruptions or performance problems
caused by our subcontractors and suppliers, or a misalignment between our contractual obligations to our customers and our agreements with our
subcontractors and suppliers, could have an adverse effect on our ability to meet our commitments to customers.
Our ability to perform our obligations on time could be adversely affected if one or more of our subcontractors or suppliers were unable to provide
the agreed-upon products or materials or perform the agreed-upon services in a timely, compliant and cost-effective manner or otherwise to meet the
requirements of the contract. Changes in economic conditions, including changes in defense budgets or credit availability, or other changes impacting a
subcontractor or supplier (including changes in ownership or operations) could adversely affect the financial stability of our subcontractors and suppliers
and/or their ability to perform. The inability of our suppliers to perform, or their inability to perform adequately, could also result in the need for us to
transition to alternate suppliers, which could result in significant incremental cost and delay or the need for us to provide other resources to support our
existing suppliers.
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In connection with our U.S. Government contracts, we are required to procure certain materials, components and parts from supply sources approved
by the customer. We also are facing increased and changing regulatory requirements, many of which apply to our subcontractors and suppliers. In some cases,
there may be only one supplier for certain components. If a sole source supplier cannot meet our needs or is otherwise unavailable, we may be unable to find a
suitable alternative.
Our procurement practices are intended to reduce the likelihood of our procurement of counterfeit, unauthorized or otherwise non-compliant parts or
materials. We rely on our subcontractors and suppliers to comply with applicable laws and regulations, including regarding the parts or materials we procure
from them; in some circumstances, we rely on certifications provided by our subcontractors and suppliers regarding their compliance. We also rely on our
subcontractors and suppliers to effectively mitigate the risk of cyber and security threats or other disruptions with respect to the products and components
they deliver to us and the information entrusted to them by us or our customers.
If we are unable to procure, or experience significant delays in subcontractor or supplier deliveries of, needed materials, components, intellectual
property or parts; if our subcontractors or suppliers do not comply with all applicable laws and regulations; if the certifications we receive from them are
inaccurate; or if what we receive is counterfeit or otherwise improper, it could have a material adverse effect on our financial position, results of operations
and/or cash flows.
We face intense competition from many competitors that have greater resources than we do, which could result in price reductions, reduced profitability or
loss of market share.
We operate in highly competitive markets and generally encounter intense competition to win contracts from many other firms, including mid-tier
federal contractors with specialized capabilities, large defense contractors and IT service providers. Competition in our markets may increase as a result of a
number of factors, such as the entrance of new or larger competitors, including those formed through alliances or consolidation, or the reduction in the overall
number of government contracts. We may also face competition from prime contractors for whom we currently serve as subcontractors or teammates if those
prime contractors choose to offer customer services of the type that we are currently providing. In addition, we may face competition from our subcontractors
who, from time-to-time, seek to obtain prime contractor status on contracts for which they currently serve as a subcontractor to us.
Many of our competitors have greater financial, technical, marketing and public relations resources, larger customer bases and greater brand or name
recognition than we do. Such competitors may be able to utilize their substantially greater resources and economies of scale to, among other things:
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divert sales from us by winning very large‑scale government contracts, a risk that is enhanced by the recent trend in government
procurement practices to bundle services into larger contracts and the recent trend of making award determinations on a LPTA basis;
divert sales from us by the award of government contracts to our competitors who may be willing to bid at substantially lower prices;
force us to charge lower prices; or
adversely affect our relationships with current customers, including our ability to continue to win competitively awarded engagements in
which we are the incumbent.
In the event that the market for products in our US segment expands, we expect that competition will intensify as additional competitors enter the
market and current competitors expand their product lines. In order to secure contracts successfully when competing with larger, well-financed companies, we
may be forced to agree to contractual terms that provide for lower aggregate payments to us over the life of the contract, which could adversely affect our
margins. In addition, larger diversified competitors serving as prime contractors may be able to supply underlying products and services from affiliated
entities, which would prevent us from competing for subcontracting opportunities on these contracts. If we lose business to our competitors or are forced to
lower our prices, our revenue and operating profits could decline.
Our business is dependent upon our ability to keep pace with the latest technological changes.
The market for our services is characterized by rapid change and technological improvements. Failure to respond in a timely and cost-effective way
to these technological developments would result in serious harm to our business and operating results. We have derived, and we expect to continue to
derive, a substantial portion of our revenues from providing innovative engineering services and technical solutions that are based upon today’s leading
technologies and that are capable of adapting to future technologies. As a result, our success will depend, in part, on our ability to develop and market service
offerings that respond in a timely manner to the technological advances of our customers, evolving industry standards and changing customer preferences.
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We believe that, in order to remain competitive in the future, we will need to continue to invest significant financial resources to develop new
offerings and technologies or to adapt or modify our existing offerings and technologies, including through internal research and development, acquisitions
and joint ventures or other teaming arrangements. These expenditures could divert our attention and resources from other projects, and we cannot be sure that
these expenditures will ultimately lead to the timely development of new offerings and technologies or identification of and expansion into new markets.
Due to the design complexity of our products, we may, in the future, experience delays in completing the development and introduction of new products.
Any delays could result in increased costs of development or deflect resources from other projects. In addition, there can be no assurance that the market for
our products will develop or continue to expand or that we will be successful in newly identified markets as we currently anticipate. The failure of our
technology to gain market acceptance could significantly reduce our revenues and harm our business. Furthermore, we cannot be sure that our competitors
will not develop competing technologies that gain market acceptance in advance of our products.
Additionally, the possibility exists that our competitors might develop new technology or offerings that might cause our existing technology and
offerings to become obsolete. If we fail in our new product development efforts or our products or services fail to achieve market acceptance more rapidly as
compared to our competitors, our ability to procure new contracts could be negatively impacted, which could negatively impact our results of operations and
financial condition.
If the UAS and UGS markets do not experience significant growth, if we cannot expand our customer base or if our products do not achieve broad
acceptance, then we may not be able to achieve our anticipated level of growth.
For the fiscal year ended December 30, 2018, our US segment accounted for 21.5% of our total revenue. We cannot accurately predict the future
growth rate or size of this market. Demand for our products may not increase, or may decrease, either generally or in specific markets, for particular types of
products or during particular time periods. There are only a limited number of programs under which the U.S. military, our primary customer, is currently
funding the development or purchase of our UAS and UGS products. Although we are seeking to expand our US customer base to include foreign
governments, domestic non-military agencies and commercial customers, we cannot assure that our efforts will be successful. The expansion of the UAS and
UGS markets in general, and the market for our products in particular, depends on a number of factors, including the following:
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customer satisfaction with these types of systems as solutions;
the cost, performance and reliability of our products and products offered by our competitors;
customer perceptions regarding the effectiveness and value of these types of systems;
limitations on our ability to market our US products and services outside the U.S. due to U.S.
government regulations; and
marketing efforts and publicity regarding these types of systems.
Even if UAS and UGS gain wide market acceptance in general, our specific products may not adequately address market requirements or may not
gain market acceptance. If these types of systems generally, or our products specifically, do not gain wide market acceptance, then we may not be able to
achieve our anticipated level of growth and our revenue and results of operations may suffer.
Loss of our General Services Administration (“GSA”) contracts or GWACs could impair our ability to attract new business.
We are a prime contractor under several GSA contracts and GWAC vehicles. We believe that our ability to provide services under these contracts
will continue to be important to our business because of the multiple opportunities for new engagements each contract provides. If we were to lose our
position as prime contractor on one or more of these contracts, we could lose substantial revenues and our operating results could suffer. GSA contracts and
other GWACs typically have a one or two-year initial term with multiple options exercisable at the government customer’s discretion to extend the contract
for one or more years. We cannot be assured that our government customers will continue to exercise the options remaining on our current contracts, nor can
we be assured that our future customers will exercise options on any contracts we may receive in the future.
Government contracts differ materially from standard commercial contracts, involve competitive bidding and may be subject to cancellation or delay
without penalty.
Government contracts frequently include provisions that are not standard in private commercial transactions and are subject to laws and regulations
that give the U.S. Government rights and remedies not typically found in commercial contracts, including provisions permitting the U.S. Government to:
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terminate our existing contracts;
reduce potential future income from our existing contracts;
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modify some of the terms and conditions in our existing contracts;
suspend or permanently prohibit us from doing business with the U.S. Government or with any specific government agency;
impose fines and penalties;
subject us to criminal prosecution;
suspend work under existing multiple year contracts and related task orders if the necessary funds are not appropriated by Congress;
decline to exercise an option to extend an existing multiple year contract; and
claim rights in technologies and systems invented, developed or produced by us.
In addition, government contracts are frequently awarded only after formal competitive bidding processes, which have been and may continue to be
protracted and typically impose provisions that permit cancellation in the event that necessary funds are unavailable to the government agency. Competitive
procurements impose substantial costs and managerial time and effort in order to prepare bids and proposals for contracts that may not be awarded to us. In
many cases, unsuccessful bidders for government contracts are provided the opportunity to formally protest certain contract awards through various agencies,
administrative and judicial channels. We have experienced an increase in competitor bid protests on contracts on which we were the successful bidder due to
the competitive environment resulting from decreased government spending. In addition, we have formally protested procurement awards in which we were
not the initial successful bidder, but believed that the source selection process was flawed. The protest process may substantially delay a successful bidder’s
contract performance, result in cancellation of the contract award entirely and distract management. We may not be awarded contracts for which we bid, and
substantial delays or cancellation of purchases may follow our successful bids as a result of such protests. We believe that this environment of protracted
competitive bidding processes and competitor bid protests will continue.
Certain of our government contracts also contain “organizational conflict of interest” clauses that could limit our ability to compete for certain
related follow-on contracts. For example, when we work on the design of a particular solution, we may be precluded from competing for the contract to install
that solution. While we actively monitor our contracts to avoid these conflicts, we cannot guarantee that we will be able to avoid all organizational conflict
of interest issues.
We may not receive the full amounts estimated under the contracts in our backlog, which could reduce our revenue in future periods below the levels
anticipated. This makes backlog an uncertain indicator of future operating results.
Backlog is typically subject to large variations from quarter to quarter and comparisons of backlog from period to period are not necessarily
indicative of future revenues. The contracts comprising our backlog may not result in actual revenue in any particular period or at all, and the actual revenue
from such contracts may differ from our backlog estimates. The timing of receipt of revenues, if any, on projects included in backlog could change because
many factors affect the scheduling of projects. Cancellation of or adjustments to contracts may occur. Additionally, all U.S. Government contracts included in
backlog, whether or not funded, may be terminated at the convenience of the U.S. Government. The failure to realize all amounts in our backlog could
adversely affect our revenues and gross margins. As a result, our funded, unfunded and total backlog as of any particular date may not be an accurate
indicator of our future earnings.
A preference for minority-owned, small and small disadvantaged businesses could impact our ability to be a prime contractor and limit our opportunity to
work as a subcontractor on certain governmental procurements.
As a result of the Small Business Administration (“SBA”) set-aside program, the federal government may decide to restrict certain procurements only
to bidders that qualify as minority-owned, small, or small disadvantaged businesses. As a result, we would not be eligible to perform as a prime contractor on
those programs and in general would be restricted to no more than 49% of the work as a subcontractor on those programs. An increase in the amount of
procurements under the SBA set-aside program may impact our ability to bid on new procurements as a prime contractor, limit our opportunity to work as a
subcontractor or restrict our ability to compete on incumbent work that is placed in the set-aside program.
U.S. Government in-sourcing could result in loss of business opportunities and personnel.
The U.S. Government has continued to reduce the percentage of contracted services in favor of more federal employees through an initiative called
“in-sourcing.” Over time, in-sourcing could have an adverse effect on our business, financial condition and results of operations. Specifically, as a result of
in-sourcing government procurements for services could be fewer and smaller in the future. In addition, work we currently perform could be in-sourced by the
federal government and, as a result, our revenues could be reduced. Moreover, our employees could also be hired by the government. This loss of our
employees would necessitate the need to retain and train new employees. Accordingly, the effect of in-sourcing or the
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continuation of in-sourcing at a faster-than-expected rate could have an adverse effect on our business, financial condition, and results of operations.
Our business could be negatively impacted by security threats, including cyber security threats, and other disruptions.
Many of the systems we develop, install and maintain involve managing and protecting information involved in intelligence, national security and
other sensitive or classified U.S. Government functions. We face various security threats, including cyber security threats, to gain unauthorized access to this
sensitive information. Such threats can come from external as well as internal sources. We also face threats to the safety of our directors, officers, and
employees; threats to the security of our facilities and infrastructure; and threats from terrorist acts. Although we utilize various procedures and controls to
monitor these threats and mitigate our exposure to such threats, there can be no assurance that these procedures and controls will be sufficient in preventing
security threats from materializing. If any of these events were to materialize, they could lead to the loss of sensitive information, critical infrastructure,
personnel or capabilities essential to our operations and prevent us from being eligible for further work on sensitive or classified systems for U.S. Government
customers. Further, any losses we incur from such a security breach could exceed the policy limits under our errors and omissions and product liability
insurance. Any losses we incur, any damage to our reputation or any limitations on our eligibility for additional work resulting from a security breach could
materially reduce our revenue and could have a material adverse effect on our business, financial condition and results of operations.
Cybersecurity attacks in particular are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to data,
and other electronic security breaches that could lead to disruptions in mission critical systems, unauthorized release of confidential or otherwise protected
information and corruption of data. We have experienced cybersecurity attacks and may experience them in the future. These events could damage our
reputation and lead to financial losses from remedial actions, loss of business, loss of proprietary and trade secret information or potential liability.
If we experience systems or service failure, our reputation could be harmed and our customers could assert claims against us for damages or refunds.
We create, implement and maintain IT solutions that are often critical to our customers’ operations. We have experienced, and may in the future
experience, some systems and service failures, schedule or delivery delays and other problems in connection with our work. If we experience these problems,
we may:
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lose revenue due to adverse customer reaction;
be required to provide additional services to a customer at no charge;
cause customers to postpone, cancel or fail to renew contracts;
receive negative publicity, which could damage our reputation and adversely affect our ability to attract or retain customers; and
suffer claims for substantial damages.
We cannot ensure that provisions in our customer contracts will be legally sufficient to protect us if we are sued.
In addition, our errors and omissions and product liability insurance coverage may not be adequate, may not continue to be available on reasonable
terms or in sufficient amounts to cover one or more large claims, or the insurer may disclaim coverage as to some types of future claims. The successful
assertion of any large claim against us could seriously harm our business. Even if not successful, these claims may result in significant legal and other costs,
be a distraction to our management and harm our reputation.
Our products are complex and could have unknown defects or errors, which may increase our costs, harm our reputation with customers, give rise to costly
litigation, or divert our resources from other purposes.
Our products, including but not limited to unmanned vehicles, aerial targets, UAS and ballistic missile targets, are extremely complex and must
operate successfully with complex products from other vendors. Despite testing, our products have contained defects and errors and may in the future contain
defects or errors, or experience performance problems when first introduced, when new versions or enhancements are released, or even after these products
have been used by our customers for a period of time. These problems could result in expensive and time-consuming design modifications or warranty
charges, delays in the introduction of new products or enhancements, significant increases in our service and maintenance costs, diversion of our personnel’s
attention from our product development efforts, exposure to liability for damages, damaged customer relationships, and harm to our reputation, any of which
could materially harm our results of operations. In addition, increased development and warranty costs could be substantial and could reduce our operating
margins.
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The existence of any defects, errors, or failures in our products or the misuse of our products could also lead to lawsuits against us, result in injury,
death, or property damage, and significantly damage our reputation and support for our products in general.
Although we maintain insurance policies, we cannot provide assurance that this insurance will be adequate to protect us from all material judgments
and expenses related to potential future claims or that these levels of insurance will be available in the future at economical prices or at all. A successful
liability claim could result in substantial cost to us. Even if we are fully insured as it relates to a claim, the claim could nevertheless diminish our brand and
divert management’s attention and resources, which could have a negative impact on our business, financial condition, and results of operations.
Due to the volatile and flammable nature of certain components of our products and equipment, fires or explosions may
disrupt our business or cause significant injuries, which could adversely affect our financial results.
The development and manufacture of certain of our products involves the handling of a variety of explosive and flammable materials as well as high
power equipment. From time to time, these activities may result in incidents that could cause us to temporarily shut down or otherwise disrupt some
manufacturing processes, causing production delays and resulting in liability for workplace injuries and/or fatalities. We have safety and loss prevention
programs that require detailed reviews of process changes and new operations, along with routine safety audits of operations involving explosive materials,
to mitigate such incidents, as well as a variety of insurance policies. However, we cannot ensure that we will not experience such incidents in the future or
that any such incidents will not result in production delays or otherwise have a material adverse effect on our business and financial condition.
Our financial results may vary significantly from quarter to quarter.
We expect our…
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