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Spruce Point – Kratos Defense & Security Solutions, Inc (KTOS) Has Up 75% Downside

Spruce Issues Update And Strong Sell Opinion On Kratos Defense & Security Solutions, Inc (Nasdaq: KTOS) Post Q1 Results

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Executive Summary

Spruce Point Capital Management has issued a critical update report on Kratos Defense & Security Solutions, Inc. (Nasdsq: KTOS) ("Kratos" or "the Company") following the Company's Q1 2018 results issued late last week.

Spruce Point has conducted a critical forensic analysis of the Company's financial guidance, 10-Q filing, and conference call disclosures. We believe the current management has issued a potentially deceptive revision to its continuing free cash flow guidance, and left clues to suggest its cash balances are not accurately stated.

As a result of our investigative analysis, we continue to reiterate caution and a "Strong Sell" opinion on Kratos. It is easy to justify 45% - 75% downside risk.

Our update will detail the following issues:

  1. Adjusted for a change in revenue accounting principle, Kratos Q1 revenues missed expectations by 6%
  2. Kratos operating income performance was aided by unexplained decline in depreciation (notably in its promoted Unmanned Systems (drone) segment), despite a material ramp in capex
  3. Kratos Q2’2018 revenue guidance of $140 to $150m also fell short of expectations for $154 million
  4. In a potentially deceptive manner, Kratos reduced its normalized free cash flow guidance for 2018 by 36% to 58%
  5. New anomalies in Kratos financials call into question the accuracy of Its cash balances
  6. Kratos trades at an irrational 160x 2018 free cash flow despite revenue disappointments, a new high in DSO, and evidence that suggests management is using deceptive free cash flow forecasts
  7. Kratos would be worthless if given an industry free cash flow multiple. Giving them the benefit of the doubt, it is very easy to justify 45% to 75% downside risk ($3.15 to $6.30/sh)
    1. Adjusted for a change in revenue accounting principle, Kratos Q1 revenues missed expectations by 6%
    2. Kratos operating income performance was aided by unexplained decline in depreciation (notably in its promoted Unmanned Systems (drone) segment), despite a material ramp in capex
    3. Kratos Q2’2018 revenue guidance of $140 to $150m also fell short of expectations for $154 million
    4. In a potentially deceptive manner, Kratos reduced its normalized free cash flow guidance for 2018 by 36% to 58%
    5. New anomalies in Kratos financials call into question the accuracy of Its cash balances
    6. Kratos trades at an irrational 160x 2018 free cash flow despite revenue disappointments, a new high in DSO, and evidence that suggests management is using deceptive free cash flow forecasts
    7. Kratos would be worthless if given an industry free cash flow multiple. Giving them the benefit of the doubt, it is very easy to justify 45% to 75% downside risk ($3.15 to $6.30/sh)

Kratos Q1 Result In A Large Revenue Miss Pro Forma For Revenue Accounting Change

Pay very close attention to Kratos results for Q1’2018 which benefited from the adoption of ASU 2014-09 relating to revenue recognition. In Kratos’ 10-K Annual Report filed in Feb 2018, it said it did not expect the accounting change to be material, yet given footnote disclosure in the recently filed 10-Q, the impact was very material – 4x larger to revenues. Instead of a fractional miss to revenue expectations, Kratos missed expectations by approximately 6%.

Kratos also offered Q2’18 revenue guidance of $140 to $150m vs. $154m – suggesting further disappointment

Kratos on New Revenue Accounting Change (2017 10-K, F-17, Feb 28, 2018): “Based upon an assessment of material active contracts as of December 31, 2017, the Company has determined that the impact on the results of operations and cash flows upon adoption are not material. The Company also does not expect the impact in the periods after adoption to be material.….The Company expects the cumulative effect of adopting ASU 2014-09 to result in an increase in revenue of less than $2 million and an increase in operating income of less than $2 million. These changes principally reflect the impact of converting contracts applying the units-of-delivery under the old revenue guidance to the cost-to-cost method of accounting. The cumulative effect of adoption of the new revenue guidance will be recognized as an increase in contract assets, a reduction in inventoried costs, an increase in contract liabilities and a net decrease in accumulated deficit as of January 1, 2018.”

Kratos Defense & Security Solutions, Inc (KTOS)

Operating Margin Improvement By Questionable Depreciation Decline

Kratos is touting its significant improvement in operating income, and specifically its improved performance in its hyped Unmanned Systems (US or drone) business. However, digging beneath the surface we find an unexplained decline in depreciation and amortization year-over-year. (1) The biggest percentage decline of 50% was in Unmanned Systems segment. This result makes little sense given that Capex is now running higher than depreciation, and the majority of the Capex is focused on growing the Unmanned System business. The result is unlikely to be explained by the divestiture of PSS which carried very little depreciation and amortization expense.

Kratos Defense & Security Solutions, Inc (KTOS)

Downgrading Kratos On Reduction in Continuing Free Cash Flow Guidance

Pay very close attention to Kratos new guidance disclosure. Kratos added one sentence that discloses that cash flow forecasts include $7m of working capital proceeds from the sale of its Public Safety and Security business. This is a non-recurring source of cash flow and should not be factored into the forward valuation of its share price. On a continuing basis, Kratos continuing free cash flow guidance is a meager $5 to $12m

New disclosure last week in Kratos Q1’18 Press Release: “Kratos is also affirming its full year 2018 financial guidance of positive cash flow generation from operations of $35 to $45 million, including the expected collection of net working capital proceeds of the PSS business retained by Kratos.

The disclosure was absent from Kratos prior Q4’17 press release when 2018 guidance was offered

Kratos Adjusted 2018E Free Cash Flow From Continuing Operations

Kratos Defense & Security Solutions, Inc (KTOS)

CFO Potentially Misleading Kratos Investors And Analysts About The PSS Sale Impact?

The CFO of Kratos explicitly stated last quarter that guidance excluded results of PSS. Furthermore, when asked directly by an analyst and given the opportunity to provide clarity about the working capital assumptions behind the forecast, she still failed to mention that the cash flow guidance included $7m from the PSS divestiture. We believe this is a material omission.

CFO Lund on Q4’17 Call (Feb 2018): “Accordingly today we are providing initial guidance for the first quarter and full-year 2018 reflecting PSS as a discontinued operation. Kratos' PSS business was forecast to achieve full-year 2018 revenues and adjusted EBITDA before corporate overhead of approximately $140 to $159 and $9 million to $12 million respectively. PSS generated full-year 2017 revenues and adjusted EBITDA excluding the allocated corporate overhead cost of $149 million and $6.9 million respectively. As the result of the pending sale Kratos' Q1 2018 and full-year financial guidance provided today excludes PSS as those all other financial information covered.”

Analyst Herbert Q4’17 Call (Feb 2018): “Eric and Deanna, I really appreciate all the detail. I just wonder Deanna really I mean the guidance calls very significant improvement in cash from operations and free cash flow for the full- year. I know you went through some of this, but how will you characterize maybe the risk to that 40 million in cash from operations at the midpoint for 2018? And maybe just a little more detail on specifically, what you assume working capital and some of the other key pieces to provide?

CFO Lund Response To Herbert Fails To Address PSS: “So some of the rest are there is some flight milestones that need to occur on some of the Unmanned programs which just doing part arrange time to get on to certain ranges that Ken delayed that milestones so that's one of the risks some of the other ones we don’t really see as risky because they are just really hitting certain performance metrics that are in our control which obviously that the flights on range time those are not totally in our control. From a working capital requirement prospective we do expect some use in working capital as we continue to grow the business but that some of that is offset in the cash flow guidance that we given with some of that milestone that we do expect and to collect. Some of these milestones are milestones we had expected in the second half of '17 and they have moved into '18 to some of them we do expect to see some in the first half of '18.”

Article by Spruce Point Capital Management

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