Kratos increases debt, but says main strategy is 'build the company'

By Paul Deckelman

New York, Jan. 18 - Kratos Defense & Security Solutions, Inc. has more than doubled its debt level in the past year - but the San Diego-based high-tech defense contractor is apparently not worried.

"Our strategy is to build the company," declared Kratos' president and chief executive officer, Eric DeMarco, to participants at BOCEMb, Noble Financial Capital Markets' annual equity conference in Hollywood, Fla., on Wednesday. His assertion came while discussing the company's debt and capital structure.

DeMarco said that another part of the strategy is to "obviously generate value along the way through organic growth and through smart acquisitions."

Add-on deals swell debt

As of the end of the company's fiscal third quarter on Sept. 25 - fourth-quarter numbers aren't out yet - Kratos had $625 million of debt on its books, all of it in the form of 10% senior secured notes due 2017. Kratos sold the original $225 million tranche of those bonds at par in May 2010 and then increased that in a pair of add-on deals.

Last March, it sold $285 million of the bonds, pricing them at 107 to yield 8½%. In July, it sold an additional $115 million at 105 to yield 8.88%.

That brought the total amount of the notes outstanding to $625 million. DeMarco said such funding "is permanent capital. This is enabling us the flexibility to execute our strategy and move forward."

In each case, proceeds from those bond deals were used to fund acquisitions of other companies making complementary products and systems.

Proceeds from the original tranche were used to complete the company's acquisition of Gichner Holdings, Inc. for $133 million as well as to refinance existing debt and for general corporate purposes. The March 2011 deal helped to fund the $270 million acquisition of Herley Industries, Inc., and July's add-on proceeds were used to defray the cash portion of its $241 million cash-and-stock acquisition of Integral Systems, Inc.

Amend and extend

The company had no other outstanding debt on its books at the end of the fiscal third quarter.

Last July, roughly concurrently with the bond deal and the closing of the Integral Systems acquisition, Kratos also amended and extended its revolving credit facility, pushing the 2011 maturity out to 2016 and upsizing the facility to $65 million from $35 million previously.

Pricing was raised to between 300 and 315 basis points over Libor from the Libor-plus 225 bps rate on the expiring 2007 facility. There were no borrowings outstanding at that time.

The amended facility also included an accordion feature allowing Kratos to expand the credit line to $100 million; in November, it exercised that option to up the size of the revolver to $90 million from $65 million.

Acquisitions are accretive

While the additional debt raised the company's interest costs - during the fiscal third quarter, it paid $15 million, versus $13.1 million the quarter before, reflecting the impact of the latest add-on deal, and versus the $6.7 million it had paid during the fiscal first quarter, before either of last-year's two add-ons - the acquisitions funded by the debt also increased company revenues, earnings and cash flow.

Adjusted EBITDA rose to $29.5 million at the end of the fiscal third quarter, versus $22.7 million in the second quarter, before Integral Systems was a part of the company, and versus $12.6 million in the first quarter, before either Herley Industries or Integral was a part of Kratos.

DeMarco said that Kratos is "looking to generate next year somewhere between $1.50 and $2.00 per share of free cash flow after debt service on 32.4 million shares. The business is a significant cash flow generator."

The company had $110 million of cash at the end of the fiscal third quarter, for a net debt figure of $515 million and a net leverage ratio of 4.1 times.

Not afraid of defense cuts

The company's primary customer is the U.S. Department of Defense. It also gets significant sales from the Department of Homeland Security and from non-federal agencies looking to beef up their own anti-terrorist surveillance capacities, including the operators of such facilities as the Port of Long Beach in California and of Kennedy Airport and the Metropolitan Transportation Authority in New York.

DeMarco said that Kratos is in a good position, as either the sole producer or perhaps one of only two or three such producers, of the kind of high-tech security, communications, surveillance and, in the case of the Pentagon, weapons systems that its customers are seeking to buy.

He said that even with the fears of looming defense cutbacks, high-tech defense spending would still continue to be a huge market and said that the recently announced realignment of national defense priorities would play to the company's strengths.

For instance, he said that even a worst-case scenario cutting defense outlays to $482 billion from over half a trillion dollars now would still leave defense funded at the same level it held in 2007.

And he added that "from an acquisition standpoint, we're going to stay opportunistic if we see things that make sense, that fit in exactly to our [strategic] thesis and the newly announced national defense doctrine."

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