Kratos Defense & Security Solutions, Inc.: Form 10-Q for the period ended Sep 25, 2022

This Quarterly Report on Form 10-Q (this “Quarterly Report”) contains “forward-looking statements” relating to our future financial performance, the market for our services and our expansion plans and opportunities. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. These forward-looking statements reflect our current beliefs, expectations and projections, are based on assumptions, and are subject to known and unknown risks and uncertainties that could cause our actual results or achievements to differ materially from any future results or achievements expressed in or implied by our forward-looking statements. Many of these factors are beyond our ability to control or predict. As a result, you should not place undue reliance on forward-looking statements. Important risks and uncertainties that could cause our actual results or achievements to differ materially from the results or achievements reflected in our forward-looking statements include, but are not limited to: changes or cutbacks in spending or the appropriation of funding by the Federal Government, including the Department of Defense, or DoD, which could cause delays, cancellations or reductions of key government contracts; bid protests; changes in the scope or timing of our projects; the timing, rescheduling or cancellation of significant customer contracts and agreements; failure by our subcontractors or suppliers to perform their contractual obligations; our failure to meet performance obligations; if the unmanned systems markets do not experience significant growth, or it the products we have developed or will develop do not become programs of record; if we cannot expand our customer base or if our products do not achieve broad acceptance which could impact our ability to achieve our anticipated level of growth; consolidation by or the loss of key customers; risks of adverse regulatory action or litigation; risks associated with debt leverage; failure to successfully achieve our acquisition, integration, cost reduction or divestiture strategies; risks related to security breaches, cybersecurity attacks or other significant disruptions of our information systems; risks related to the new DoD CMMC requirement recently issued by the Pentagon; risks associated with pandemics, epidemics or other public health emergencies, such as the outbreak of coronavirus disease 2019 (“COVID-19”); risks related to unknown defects or errors in our products; risks relating to the ongoing conflict in Ukraine; risks related to continued interest rate increases by the Federal Reserve; and competition in the marketplace, which could reduce revenues and profit margins, as well as the additional risks and uncertainties described in this Quarterly Report on Form 10-Q, in “Item 1A-Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 26, 2021 filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 22, 2022 (the “Form 10-K”), and in other reports that we have filed with the SEC. These forward-looking statements reflect our views and assumptions only as of the date such forward-looking statements are made. Except as required by law, we assume no responsibility for updating any forward-looking statements, whether as a result of new information, future events or otherwise.

All references to “us,” “we,” “our,” the “Company” and “Kratos” refer to Kratos Defense & Security Solutions, Inc., a Delaware corporation, and its subsidiaries.

Overview

Kratos is a government contractor at the forefront of the DoD’s recapitalization of strategic weapon systems to address peer and near peer threats and the DoD’s related Rapid Innovation Initiatives. Kratos is a leading technology, intellectual property, proprietary product and system company focused on the U.S. and its allies’ national security. Kratos is a recognized industry leader in the rapid development, demonstration and fielding of disruptive, transformative and high technology systems and products at an affordable cost. At Kratos, affordability is a technology. Kratos’ primary focus areas are unmanned systems, space and satellite communications, microwave electronics products, cybersecurity/warfare, rocket, hypersonic and missile defense systems, turbine technologies, and Command, Control, Communication, Computing, Combat, Intelligence Surveillance and Reconnaissance (“C5ISR”) Systems and training solutions. 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 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 manufacturing facility. Our primary end customers are national security related agencies. Our entire organization is focused on executing our strategy of being the leading technology and intellectual property based product and system company in our industry.

Industry Update

On March 15, 2022, President Biden signed into law the Fiscal Year 2022 National Security Budget of $782 billion, a 5.6% increase over the previous year. On March 28, 2022, the Biden administration submitted to Congress a proposed fiscal year 2023 Budget Request of $813.3 Billion for National Security (the “Budget Request”), $773 billion of which is for the DoD, a 4% increase above the FY 2022 enacted amount. On September 30, 2022, Congress enacted a Continuing Resolution Authorization (“CRA”) to carry forward the fiscal year 2022 funding levels into fiscal year 2023 while negotiations continue regarding full year appropriations. The CRA also included an additional $12 billion in aid to Ukraine, bringing total appropriations for Ukraine assistance to $39 billion.

The current budget environment, including COVID-19 and Ukraine funding support, heightened levels of inflation, and uncertainty surrounding the debt ceiling and the appropriations process, creates 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 Biden administration and Congress.

We believe continued budget pressures, Continuing Resolution Authorizations (“CRAs”), Federal Government debt ceiling issues, or Federal Government shutdowns would have serious negative consequences for the security of our country and 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 that budget and program decisions made in such an uncertain environment will have long-term implications for our Company and the entire defense industry.

Additionally, funding for certain programs in which we currently participate may be reduced, delayed or cancelled, and budget uncertainty or funding cuts globally could adversely affect the viability of our partners, teammates, subcontractors and suppliers, and our employee base. While we believe that our business is well-positioned in areas that the DoD and other customers indicate are priorities for future defense spending, including in the Budget Request, the short and long-term impact of federal budgetary uncertainty, CRAs, the Budget Control Act of 2011 or similar budgetary restrictions or limitations, other defense spending cuts, including the budget impacts of COVID-19 and the conflict in Ukraine, challenges in the appropriations process, the debt ceiling and the ongoing fiscal debates remain uncertain. Such a challenging federal and DoD budgetary environment may negatively impact our business and programs and could have a material adverse effect on our forecasts, estimates, financial position, results of operations and/or cash flows.

The nature of our operations exposes us to risks associated with pandemics, epidemics or other public health emergencies, including the COVID-19 pandemic. We are a company operating in a “critical infrastructure industry”, as defined by the U.S. Department of Homeland Security. Consistent with federal guidelines and with state and local orders to date, we have continued to operate, including our international operations. Notwithstanding our continued operations, COVID-19 has had and is currently expected to continue to have negative impacts on certain of our operations, workforce, supply chain, vendors, transportation networks and customers, which have reduced certain of our sales and our margins, including as a result of preventative and precautionary measures that we, our suppliers, other businesses and governments are taking. The COVID-19 outbreak is a widespread public health crisis that is adversely affecting the economies and financial markets globally. Any resulting economic downturn could adversely affect demand for our products. The progression of COVID-19 could also negatively impact our business or results of operations through the temporary closure of our operating locations or those of our customers or suppliers.

The ability of our employees and our suppliers’ and customers’ employees to work may be significantly impacted by individuals contracting or being exposed to COVID-19, or as a result of the control measures noted above, which may significantly hamper our production and operations, including throughout the supply chain. On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act, a $2 trillion economic relief bill, was signed into law. Subsequently, on March 11, 2021, the American Rescue Plan Act, a $1.9 trillion economic stimulus bill was enacted.

COVID-19 continues to impact our business in 2022, primarily driven by the emergence of the Omicron variant in late 2021 with a resulting increase in COVID-19 cases in early 2022. COVID-19 has continued to impact our customers, markets and operations, including supply chain disruptions, delays of certain supplier deliveries, difficulties gaining access to certain locations, difficulties gaining access to customers, including instances related to previously scheduled drone and rocket system flights, demonstrations and exercises, and decreased demand requirements of certain of our commercial aero, power and satcom customers. Additionally, customer and contractor-related travel and social distancing restrictions have delayed a number of our target drone, tactical drone and rocket system programs, missions and exercises, and have delayed delivery and execution on certain of our international commercial satcom projects. Despite progress in vaccination efforts, global economic activity remains uncertain and cannot be predicted with confidence. Public health officials and medical professionals have warned that COVID-19 cases may continue to spike due to the Delta, Omicron and other variants. The extent to which COVID-19 may further impact our business depends on future developments, which are highly uncertain and unpredictable, including new information concerning the severity of the outbreak and the effectiveness of actions globally to contain or mitigate its effects.

The current level of uncertainty over the economic, business and operational impacts of COVID-19, including the impact on employee absenteeism, vendor and supply chain and other resources, means the related financial impact cannot be reasonably estimated at this time. Our Condensed Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations reflect estimates and assumptions made by management as of September 25, 2022. Events and changes in circumstances arising after September 25, 2022, including those resulting from the continuing impacts of COVID-19, will be reflected in management’s estimates for future periods.

In addition to the challenges that COVID-19 is presenting to the industry and Kratos, significant adverse supply chain disruptions continue throughout the industry and for the Company, including delays in the receipt and delivery of materials, parts, supplies, etc., which in certain instances and for certain items is significant. In addition, inflation and the related costs of inputs needed to execute the business, including materials, parts, supplies, consultants, subcontractors, vendors, etc. are significantly impacting the costs for Kratos to do business and are significantly adversely impacting our operations, profit margins and financial forecasts. Also, the cost of labor and for the Company’s employees and labor base have also increased significantly, and the ability to hire, obtain and retain employees, is also extremely challenging and is adversely impacting Kratos’ ability to execute its business. There is also a significant industry wide labor shortage, including in the science, technology, engineering, and math discipline areas, and for employees willing and/or able to obtain national security clearances. In addition, recent actions by the Federal Reserve to continue to increase interest rates have impacted our interest expense on our outstanding debt borrowings. Each of these matters and issues are expected to remain for the foreseeable future and to adversely impact the Company’s operations, financial results and financial forecasts.

Reportable Segments

The Company currently operates in two reportable segments. The KGS reportable segment is comprised of an aggregation of KGS operating segments, including our microwave electronics products, space, satellite and cyber, training solutions, C5ISR/modular systems, turbine technologies, and defense and rocket support services operating segments. The US reportable segment consists of our unmanned aerial, unmanned ground, unmanned seaborne and command, control and communications system businesses.

We organize our business segments based primarily on the nature of the products, solutions and services offered. Transactions between segments are negotiated and accounted for under terms and conditions similar to other government and commercial contracts, and these intercompany transactions are eliminated in consolidation. For additional information regarding our reportable segments, see Note 11 of the accompanying Condensed Consolidated Financial Statements. From a customer and solutions perspective, we view our business as an integrated whole, leveraging skills and assets wherever possible.

Comparison of Results for the Three Months Ended September 25, 2022 to the Three Months Ended September 26, 2021

Revenues. Revenues by operating segment for the three months ended September 25, 2022 and September 26, 2021 are as follows (dollars in millions):

Revenues increased $28.0 million to $228.6 million for the three months ended September 25, 2022 from $200.6 million for the three months ended September 26, 2021. Revenues in our KGS segment increased $39.3 million primarily due to the contribution of $30.2 million in revenues from the recent acquisitions of Cosmic, CTT and SRE, and an increase of $13.6 million in our C5ISR, defense and rocket support services, turbine technologies, and microwave electronics products businesses, offset partially by a reduction of $2.8 million in our training solutions business and a reduction of approximately $1.8 million due to the wind-down of a federal services satellite contract. Revenues in our US segment decreased $11.3 million to $50.0 million for the three months ended September 25, 2022, primarily due to a reduction in tactical drone programs as a result of timing of program contract awards as compared to the three months ended September 26, 2021.

Product sales decreased $9.0 million to $140.0 million for the three months ended September 25, 2022 from $149.0 million for the three months ended September 26, 2021, primarily as a result of decreased production in our US segment, offset partially by increases in our KGS segment. As a percentage of total revenue, product sales were 61.2% for the three months ended September 25, 2022 as compared to 74.3% for the three months ended September 26, 2021. Service revenues increased by $37.0 million to $88.6 million for the three months ended September 25, 2022 from $51.6 million for the three months ended September 26, 2021, primarily as a result of the recent Cosmic and SRE acquisitions.

Cost of Revenues. Cost of revenues increased $33.7 million to $173.7 million for the three months ended September 25, 2022 from $140.0 million for the three months ended September 26, 2021. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.

Gross Margin. Gross margin decreased to 24.0% for the three months ended September 25, 2022 from 30.2% for the three months ended September 26, 2021. Margins on services decreased to 26.5% for the three months ended September 25, 2022 from 31.2% for the three months ended September 26, 2021. Margins on products decreased to 22.4% for the three months ended September 25, 2022 from 29.9% for the three months end September 26, 2021. Margins in the KGS segment decreased to 24.7% for the three months ended September 25, 2022 from 34.3% for the three months ended September 26, 2021, primarily due to a less favorable mix of revenues, as well as due to a $4.5 million impact to cost of sales related to certain non-recoverable costs, including rate and cost growth items, resulting from the inability to hire the required planned direct labor base both internally and by the Company’s subcontractors to execute on its backlog, due to a continuing challenging environment in both hiring and retaining skilled manufacturing personnel, including an approximately $3.4 million impact to the Company’s C5ISR business, and non-recoverable indirect cost rate growth resulting from a smaller than planned direct labor base due to delays in customer program execution and awards in the Company’s Training Solutions business of approximately $1.1 million. Margins in the US segment increased to 21.4% for the three months ended September 25, 2022 from 20.9% for the three months ended September 26, 2021, primarily due to a more favorable mix of products produced and shipped in the three months ended September 25, 2022.

Selling, General and Administrative (“SG&A”) Expenses. SG&A expenses increased $6.7 million to $48.5 million for the three months ended September 25, 2022 from $41.8 million for the three months ended September 26, 2021. As a percentage of revenues, SG&A increased to 21.2% at September 25, 2022 from 20.8% at September 26, 2021. Included in SG&A was the impact of the recent CTT, Cosmic and SRE acquisitions and an increase of $0.2 million in the US segment primarily related to increased headcount. In addition, $1.9 million impact to SG&A is related to the non-recoverable indirect cost rate growth in the Company’s Training Solutions business for the three months ended September 25, 2022. Amortization expense of purchase intangibles increased from $1.1 million for the three months ended September 26, 2021 to $3.0 million for the three months ended September 25, 2022, reflecting the recent acquisitions.

Research and Development (“R&D”) Expenses. R&D expenses increased $1.6 million to $9.6 million for the three months ended September 25, 2022 from $8.0 million for the three months ended September 26, 2021, primarily due to increased development efforts in our Unmanned Systems business of $1.0 million. As a percentage of revenues, R&D increased to 4.2% for the three months ended September 25, 2022 from 4.0% for the three months ended September 26, 2021. R&D expenses are made by the Company, typically in conjunction with our customers, for the Company to achieve a “first to market” position with our products or technology. We also invest in R&D expenses to achieve market leading “designed in” positions on major programs, platforms or systems.

Restructuring Expenses and Other. Restructuring expenses and other increased to $0.2 million from $0.0 million for the three months ended September 25, 2022 and September 26, 2021, respectively.

Total Other Expense, Net. Total other expense, net decreased to $5.2 million from $5.9 million for the three months ended September 25, 2022 and September 26, 2021, respectively. The decrease in expense of $0.7 million was primarily related to a reduction in interest expense of $1.7 million as a result of our debt refinancing in February of 2022, offset by an increase in expense of $1.2 million related to foreign transaction losses.

Provision (Benefit) for Income Taxes from Continuing Operations. The income tax benefit from continuing operations for the three months ended September 25, 2022 was $0.8 million and the income tax expense from continuing operations for the three months ended September 26, 2021 was $5.7 million. For the three months ended September 25, 2022, the Company has utilized the discrete effective tax rate method. The discrete method is applied when it is not possible to reliably estimate our full year effective tax rate due to significant permanent differences in relation to pre-tax book income, resulting in significant variability to our effective tax rate. For the three months ended September 26, 2021, the income tax expense was a function of the estimated effective tax rate for the year. The estimated effective tax rate is driven by estimated foreign taxes, estimated federal and state taxes, permanent book/tax differences, and the projected income or loss for the year.

Loss from Discontinued Operations. The loss from discontinued operations was $0.0 million for the three months ended September 25, 2022. The loss from discontinued operations was $0.8 million for the three months ended September 26, 2021, primarily reflecting costs related to the ongoing closing net working capital adjustment dispute with the buyer of the Kratos Public Safety & Security Solutions, Inc. (“PSS”) business.

Comparison of Results for the Nine Months Ended September 25, 2022 to the Nine Months Ended September 26, 2021

Revenues. Revenues by operating segment for the nine months ended September 25, 2022 and September 26, 2021 are as follows (dollars in millions):

Revenues increased $49.1 million to $649.0 million for the nine months ended September 25, 2022 from $599.9 million for the nine months ended September 26, 2021. Revenues in our KGS segment increased $67.6 million, primarily due to the contribution of $66.4 million in revenues from the recent Cosmic, CTT and SRE acquisitions, increased revenues in our space, satellite and cyber business of $5.5 million, increases in our defense and rocket support services and turbine technologies businesses of $9.8 million, and increases in our C5ISR businesses of $4.9 million, partially offset by an $18.6 million reduction in our training solutions business, resulting primarily from the completion of training solutions contracts. Revenues in our US segment decreased $18.5 million to $159.0 million for the nine months ended September 25, 2022 primarily due to a reduction in tactical drone based revenues, including as a result of timing of program contract awards, as compared to the nine months ended September 26, 2021.

Product sales decreased $19.3 million to $413.7 million for the nine months ended September 25, 2022 from $433.0 million for the nine months ended September 26, 2021, primarily as a result of decreased production activity in our US segment and reductions in our training solutions business. As a percentage of total revenue, product sales were 63.7% for the nine months ended September 25, 2022 as compared to 72.2% for the nine months ended September 26, 2021. Service revenues increased by $68.4 million to $235.3 million for the nine months ended September 25, 2022 from $166.9 million for the nine months ended September 26, 2021. The increase was primarily a result of the recent Cosmic and SRE acquisitions.

Cost of Revenues. Cost of revenues increased $48.1 million to $484.4 million for the nine months ended September 25, 2022 from $436.3 million for the nine months ended September 26, 2021. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.

Gross Margin. Gross margin decreased to 25.4% for the nine months ended September 25, 2022 from 27.3% for the nine months ended September 26, 2021. Margins on services decreased to 27.2% for the nine months ended September 25, 2022 from 28.5% for the nine months ended September 26, 2021. Margins on product sales decreased to 24.3% for the nine months ended September 25, 2022 from 26.8% for the nine months ended September 26, 2021. Margins in the KGS segment decreased to 26.9% for the nine months ended September 25, 2022 from 29.9% for the nine months ended September 26, 2021 due to a less favorable mix of revenues, as well as due to a $4.5 million impact to cost of sales related to certain non-recoverable costs, including rate and cost growth items, resulting from the inability to hire the required planned direct labor base both internally and by the Company’s subcontractors to execute on its backlog, due to a continuing challenging environment in both hiring and retaining skilled manufacturing personnel, including an approximately $3.4 million impact to the Company’s C5ISR business , and non-recoverable indirect cost rate growth resulting from a smaller than planned direct labor base due to delays in customer program execution and awards in the Company’s Training Solutions business of approximately $1.1 million. Margins in the US segment decreased to 20.5% for the nine months ended September 25, 2022, from 21.1% for the nine months ended September 26, 2021, primarily due to a less favorable mix of products produced and shipped during the nine months ended September 25, 2022.

SG&A Expenses. SG&A expenses were $136.3 million for the nine months ended September 25, 2022 and $117.9 million for the nine months ended September 26, 2021. As a percentage of revenues, SG&A increased to 21.0% at September 25, 2022, from 19.7% at September 26, 2021. Included in SG&A, was an increase of $0.7 million of stock compensation expense from $19.2 million for the nine months ended September 26, 2021 to $19.9 million for the nine months ended September 25, 2022 as well as increased SG&A expenses related to the recent acquisitions of CTT, Cosmic and SRE. In addition, $1.9 million impact to SG&A is related to the non-recoverable indirect cost rate growth in the Company’s Training Solutions business for the nine months ended September 25, 2022. Amortization expense of purchase intangibles increased from $3.7 million for the nine months ended September 26, 2021 to $6.3 million for the nine months ended September 25, 2022, reflecting the recent acquisitions.

R&D Expenses. R&D expenses were $28.0 million for the nine months ended September 25, 2022 and $26.2 million for the nine months ended September 26, 2021, with the primary increases in expenses in our US segment. As a percentage of revenues, R&D decreased to 4.3% for the nine months ended September 25, 2022 from 4.4% for the nine months ended September 26, 2021.

Restructuring Expenses and Other. Restructuring expenses and other increased to $6.4 million for the nine months ended September 25, 2022 from $0.2 million for the nine months ended September 26, 2021, primarily as a result of the $5.5 million litigation charge related to the settlement of a dispute with an international customer in our US segment.

Total Other Expense, Net. Total other expense, net, increased to $26.9 million from $17.3 million for the nine months ended September 25, 2022 and September 26, 2021, respectively. The increase in expense of $9.6 million was primarily related to the $13.0 million loss on the extinguishment of our Senior Secured Notes which was partially offset by a reduction in interest expense of $4.7 million as a result of the reduced rate on our new debt.

Benefit for Income Taxes from Continuing Operations. The income tax benefit from continuing operations for the nine months ended September 25, 2022 and September 26, 2021 was $4.6 million and $0.6 million, respectively. For the nine months ended September 25, 2022, the Company has utilized the discrete effective tax rate method. The discrete method is applied when it is not possible to reliably estimate our full year effective tax rate due to significant permanent differences in relation to pre-tax book income, resulting in significant variability to our estimated effective tax rate. For the nine months ended September 26, 2021, a $2.7 million tax benefit was recorded resulting from the federal and state tax implications of stock-based compensation in the form of restricted stock units. The remaining $2.1 million expense was a function of the estimated effective tax rate for the year. The estimated effective tax rate is driven by estimated foreign taxes, estimated federal and state taxes, permanent book/tax differences, and the projected income or loss for the year.

Income (Loss) from Discontinued Operations. The income from discontinued operations was $0.7 million for the nine months ended September 25, 2022, and includes a $0.9 million benefit as a result of the release of an indemnification liability following the lapse of the statute of limitations associated with a potential tax liability that was recorded in 2019 as part of the sale of PSS. The loss from discontinued operations was $1.1 million for the nine months ended September 26, 2021, primarily reflecting the work performed in relation to outstanding tasks on legacy projects retained by us following the sale of PSS, as well as costs related to the ongoing closing net working capital adjustment dispute with the buyer of the PSS business.

Backlog

On September 25, 2022, we had approximately $1,068.9 million of total backlog, of which $696.1 million was funded. We expect to recognize approximately 20% of the remaining total backlog as revenue in fiscal year 2022, an additional 39% in fiscal year 2023 and the balance thereafter. Our comparable total backlog balance as of September 26, 2021, was approximately $839.1 million, of which $618.0 million was funded. Backlog as of September 25, 2022 as compared to September 26, 2021 has increased primarily as a result of contract awards in our C5ISR, Space, Satellite and Cyber, Turbine Technologies and Unmanned Systems businesses, and to a lesser degree due to the impact of the acquisitions of Cosmic, CTT and SRE, which contributed approximately $102.2 million as of September 25, 2022.

Total backlog is our estimate of the amount of revenue expected to be realized over the remaining life of awarded contracts and task orders that we have in hand as of the measurement date. Total backlog can include award fees, incentive fees, or other variable consideration estimated based on the most likely amount we expect to be entitled to receive, to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur. Total backlog can include both funded and unfunded future revenue under government contracts. Total backlog does not include orders for which neither party has performed and which each party has the unilateral right to terminate a wholly unperformed contract without compensating the other party. As such, total backlog generally does not include options for additional performance obligations which have not been executed unless they are considered a material right of the base agreement/contract. For indefinite delivery or indefinite quantity contracts, only awarded or funded task orders are included for backlog purposes.

We define funded backlog as estimated future revenue under government contracts and task orders for which funding has been appropriated by Congress and authorized for expenditure by the applicable agency, plus an estimate of the future revenue expected to be realized from commercial contracts that are under firm orders. Funded backlog does not include the full potential value of our contracts because Congress often appropriates funds to be used by an agency for a particular program of a contract on a yearly or quarterly basis even though the contract may call for performance over a number of years. As a result, contracts typically are only partially funded at any point during their term, and all or some of the work to be performed under the contracts may remain unfunded unless and until Congress makes a 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 or if revenue will be realized on projects included in our backlog. Although funded backlog represents only business that is considered to be firm, we cannot guarantee that cancellations or scope adjustments will not occur. The majority of funded backlog represents contracts with terms that would entitle us to all or a portion of our costs incurred and potential fees upon cancellation by the customer.

A significant number of the programs that Kratos’ systems, products and solutions support are multi-year/multi-decade in nature. Accordingly, based on historical customer usage or operational tempo, we have reasonable expectations or visibility of what ultimate orders for Kratos’ systems, products and solutions will be. We do not include these expected amounts in our backlog until a related contract award is received.

Management believes that year-to-year comparisons of backlog are not necessarily indicative of future revenues. The actual timing of receipt of revenues, if any, on projects included in backlog could change because many factors affect the scheduling of projects. In addition, cancellations or adjustments to contracts may occur. Backlog is typically subject to large variations from quarter-to-quarter as existing contracts are renewed or new contracts are awarded. Additionally, all U.S. Government contracts included in backlog, whether or not funded, may be terminated at the convenience of the U.S. Government.

Liquidity and Capital Resources

As of September 25, 2022, we had cash and cash equivalents of $125.2 million compared with cash and cash equivalents of $349.4 million as of December 26, 2021, which includes $19.8 million and $29.4 million, respectively, of cash and cash equivalents held by our foreign subsidiaries. We are not presently aware of any restrictions on the repatriation of these funds, however, earnings of these foreign subsidiaries are essentially considered permanently invested in these foreign subsidiaries. If these funds were needed to fund our operations or satisfy obligations in the United States they could be repatriated, and their repatriation into the United States may cause us to incur additional foreign withholding taxes. We do not currently intend to repatriate these earnings.

Our total long-term debt increased from $296.7 million at December 26, 2021 to $297.3 million at September 25, 2022. Under the New Credit Facility, on February 18, 2022, we completed the refinancing of our outstanding $90 million revolving credit facility and $300 million of Senior Secured Notes, with a new 5-year $200 million Revolving Credit Facility and 5-year $200 million Term Loan A. We incurred debt issuance costs of $3.2 million associated with the New Credit Facility. We have drawn approximately $200 million under the Term Loan A and $100 million on the new Revolving Credit Facility, with $100 million remaining in borrowing capacity, less $8.0 million for outstanding letters of credit (as more fully described in Note 10 of the accompanying Condensed Consolidated Financial Statements).

On February 18, 2022, the proceeds of $300 million from the New Credit Facility, along with cash funded by us for the 3.25% call premium to redeem the Company’s outstanding Senior Secured Notes, plus accrued interest, was distributed to the trustee for redemption of the Senior Secured Notes. The redemption of the outstanding $300 million of Senior Secured Notes closed on March 14, 2022, for an amount of cash equal to 103.25% of the principal amount thereof plus accrued and unpaid interest thereon. We incurred a loss on the extinguishment of debt of $9.8 million related to the call premium on the Senior Secured Notes and the write-off of $3.2 million of unamortized debt issuance costs resulting in a total loss on extinguishment of debt of $13.0 million.

We use our operating cash flow to finance trade accounts receivable, fund necessary increases in inventory including increasing inventory stock levels and advance buys in larger lot sizes to gain pricing benefits where possible, in order to mitigate the impact of supply chain disruptions and price increases, fund internal investments of engineering costs, fund capital expenditures, our internal research and development investments and our ongoing operations, service our debt, enhance our security infrastructure, including cyber security infrastructure, and make strategic acquisitions. Financing trade accounts receivable is necessary because, on average, our customers do not pay us as quickly as we pay our vendors and employees for their goods and services because a number of our receivables are contractually billable and due to us only when certain contractual milestones are achieved. Financing increases in inventory balances are necessary to fulfill shipment requirements to meet delivery schedules of our customers. These financing requirements have increased and have recently negatively impacted our operating cash flows due to actions we have taken to advance inventory purchases in an attempt to mitigate supply chain disruptions and to bolster our inventory levels. For the nine months ended September 25, 2022, approximately $28.0 million of operating cash flow was used to fund inventory purchases. Cash from continuing operations is primarily derived from our customer contracts in progress and associated changes in working capital components. Our days sales outstanding (“DSO”) have decreased from 128 days as of December 26, 2021 to 120 days at September 25, 2022, primarily reflecting outstanding contractual billing milestones. Our DSOs are impacted by the achievement of contractual billing milestones such as equipment shipments and deliveries on certain products, and for certain flight requirements that must be fulfilled on certain aerial target programs, or final billings which are not due until completion on certain projects, and therefore we are unable to contractually bill for amounts outstanding related to those milestones at this time.

In November 2019, a large training solutions program was terminated for convenience (“T for C”), by the customer. Under a T for C, a contractor is entitled to seek specified costs through a termination settlement process including (1) the contract price for completed supplies and services accepted by the government but not previously paid for; (2) the cost incurred in the performance of work terminated plus a reasonable profit on those costs; and (3) and its costs incurred in settling with subcontractors and preparing and settling the termination proposal. However, we will not be able to collect the total withheld amounts until the settlement terms of the T for C have been negotiated and agreed to with the customer. At September 25, 2022, approximately $4.8 million in unbilled receivables remain outstanding on this project. In March 2022, we agreed, together with the customer, to a litigation settlement of $6.0 million for a portion of the amounts outstanding on this project, which was collected in July 2022. The remaining unbilled balance of $4.8 million is subject to negotiation and settlement with the customer.

We were also in dispute with an international customer in our US segment concerning the completion of certain system requirements and contractual milestones related to a contract the Company acquired with the acquisition of CEi in 2012. In June 2022, the parties entered into a settlement agreement to resolve their dispute and to resolve all claims and counterclaims, and we are currently in the process of implementing the terms of the settlement agreement. The Company recorded a $5.5 million litigation settlement charge in the quarter ended June 26, 2022, with a remaining $5.6 million carrying value of assets on the balance sheet as of September 25, 2022 which are expected to be settled by the end of the year. During the quarter ended September 25, 2022, we paid approximately $3.7 million related to the settlement.

A summary of our net cash provided by (used in) operating activities from continuing operations, investing activities from continuing operations, and financing activities from continuing operations and our cash flows from discontinued operations from our condensed consolidated statements of cash flows is as follows (in millions):

Net cash used in operating activities from continuing operations was $32.3 million for the nine months ended September 25, 2022. Net cash used in operating activities from continuing operations was primarily a result of the net loss of $28.3 million. Net cash provided by operating activities from continuing operations was $34.6 million for the nine months ended September 26, 2021, primarily a result of the net income of $2.0 million, stock compensation, depreciation, amortization and other noncash charges of $45.1 million and changes of $12.5 million in net working capital accounts.

Net cash used in investing activities from continuing operations for the nine months ended September 25, 2022 is comprised of cash paid for acquisitions, net of cash acquired of $132.2 million, and $34.8 million in capital expenditures. Cash used for acquisitions included $74.0 million related to the acquisition of the assets of SRE, $37.5 million related to the acquisition of Cosmic, $15.3 million for the remaining purchase price due on the acquisition of CTT, and a $5.4 million payment due under the acquisition agreement for KTT Core, of which we purchased a controlling interest in February 2019. Net cash used in investing activities from continuing operations for the nine months ended September 26, 2021 is comprised of a payment due under the KTT Core acquisition agreement and capital expenditures, which were partially offset by insurance proceeds. Capital expenditures consist primarily of investments in machinery, computer hardware and software and improvement of our physical properties in order to maintain suitable conditions in which to conduct our business, including enhancements for secure facilities required for contracts we have been awarded or expect to be awarded, and include investments we are making to build capital aerial targets and related support equipment. During the nine months ended September 25, 2022, capital expenditures of approximately $18.6 million were incurred in our US business, primarily related to our unmanned combat target initiative. We expect our capital expenditures for our fiscal year 2022 to continue to be significant for investments we are making, specifically in our US business totaling approximately $25 to $28 million, including approximately $18 to $20 million for capital aerial targets and related support equipment.

Net cash used in financing activities from continuing operations was $21.4 million for the nine months ended September 25, 2022 and included $309.8 million used to redeem our $300 million of Senior Secured Notes including the call premium of $9.8 million, debt issuance costs of $3.2 million, payroll withholding taxes paid from vested restricted stock traded for taxes of $12.3 million and payments made on financing lease obligations of $1.0 million. These uses were partially offset by $300.0 million in proceeds from our New Credit Facility (partially offset by a $1.2 million principal payment on June 30, 2022) and employee stock purchase plan receipts of $6.1 million. Net cash used in financing activities from continuing operations was $9.0 million for the nine months ended September 26, 2021, and consisted primarily of repayment of our Israel debt of $5.1 million, payroll withholding taxes paid from vested restricted stock traded for taxes of $9.1 million and payments made on financing lease obligations of $0.7 million offset by employee stock purchase plan receipts of $5.9 million.

The net operating cash flows of discontinued operations for the nine months ended September 25, 2022 was a use of $0.3 million. The net operating cash flows of discontinued operations for the nine months ended September 26, 2021 was a use of $1.1 million.

Contractual Obligations and Commitments

New Credit Facility

Under the New Credit Facility, on February 18, 2022, the Company completed the refinancing of its outstanding $90 million revolving credit facility and $300 million Senior Secured Notes, with a new 5-year $200 million Revolving Credit Facility and 5-year $200 million Term Loan A. The Company incurred debt issuance costs of $3.2 million associated with the New Credit Facility. The Company has drawn approximately $200 million under the Term Loan A (partially offset by a $1.2 million principal payment on June 30, 2022) and $100 million on the new Revolving Credit Facility, with $100 million remaining in borrowing capacity, less $8.0 million for outstanding letters of credit.

On February 18, 2022, the proceeds of $300 million from the New Credit Facility along with cash funded by the Company for the 3.25% call premium to redeem the Company’s outstanding Senior Secured Notes, plus accrued interest, was distributed to the trustee for redemption of the Senior Secured Notes. The redemption of the Company’s outstanding $300 million 6.5% Senior Secured Notes due November 2025 closed on March 14, 2022, for an amount of cash equal to 103.25% of the principal amount thereof plus accrued and unpaid interest thereon. The Company incurred a loss on the extinguishment of debt of $9.8 million related to the call premium on the Senior Secured Notes and the write-off of $3.2 million of unamortized debt issuance costs resulting in a total loss on extinguishment of debt of $13.0 million.

The New Credit Facility is governed by a Credit Agreement (the “Credit Agreement”), which establishes the 5-year senior secured credit facility which is comprised of the $200 million Revolving Credit Facility (which includes sub-facilities for the incurrence of up to $10.0 million of swingline loans and the issuance of up to $50.0 million of Letters of Credit) and the $200 million Term Loan A. The Credit Agreement contemplates uncommitted incremental credit facilities of up to $200 million (which amount would be reduced by the aggregate amount of any and all incremental credit facilities actually established under the Credit Agreement) plus additional uncommitted incremental capacity subject to a limitation based on the Company’s pro forma total net leverage ratio (including any such additional uncommitted incremental capacity).

Borrowings under the revolving credit facility and the term loan credit facility may take the form of base rate loans or SOFR loans. Base rate loans under the Credit Agreement will bear interest at a rate per annum equal to the sum of the Applicable Margin (as defined in the Credit Agreement) from time to time in effect plus the highest of (i) the Agent’s(as defined in the Credit Agreement) prime lending rate, as in effect at such time, (ii) the Federal Funds Rate (as defined in the Credit Agreement), as in effect at such time, plus 0.50%, (iii) the Adjusted Term SOFR (as defined in the Credit Agreement) for a one-month tenor in effect on such day, plus 1.00% and (iv) 1.00%. SOFR loans will bear interest a rate per annum equal to the sum of the Applicable Margin from time to time in effect plus the Adjusted Term SOFR for an Interest Period (as defined in the Credit Agreement) selected by the Company of one, three or six months. The Applicable Margin varies between 1.25% and 2.25% per annum for SOFR loans and between 0.25% and 1.25% per annum for base rate loans, and is based on the Company’s total net leverage ratio from time to time.

Mandatory amortization on the Term Loan A is 2.5% in each of the first and second years and 5.0% in each of the third, fourth and fifth years, with the remaining outstanding balance due at maturity. The Credit Agreement contains certain covenants, which include, but are not limited to, restrictions on indebtedness, liens, fundamental changes, restricted payments, asset sales, and investments, and places limits on various other payments. The Company was in compliance with the covenants contained in the Credit Agreement as of September 25, 2022.

6.5% Senior Secured Notes due 2025

In November 2017, the Company issued and sold $300 million aggregate principal amount of Senior Secured Notes due 2025 in a private placement conducted pursuant to Rule 144A and Regulation S under the Securities Act of 1933, as amended. The Company incurred debt issuance costs of $6.6 million associated with the Senior Secured Notes. The Senior Secured Notes were redeemed on March 14, 2022.

Other Indebtedness

Credit and Security Agreement

On November 20, 2017, the Company entered into the amended and restated credit and security agreement (the “Credit and Security Agreement”), which established a five-year senior secured revolving credit facility in the aggregate principal amount of $90.0 million (subject to a potential increase of the aggregate principal amount to $115.0 million, subject to the agent’s and applicable lenders’ approval), consisting of a subline for letters of credit in an amount not to exceed $50.0 million, as well as a swingline loan in an aggregate principal amount at any time outstanding not to exceed $10.0 million. The Credit and Security Agreement was replaced by the New Credit Facility on February 18, 2022.

Israel Debt

During August 2020, the Company entered into two 5-year term loans with two banks in Israel representing an aggregate principal amount of approximately $5.1 million. These loans were subsidized by the State of Israel as part of a COVID-19 relief package with interest at Israeli NIS prime interest, plus a margin of 1.5%. The first year of interest was paid by the State of Israel with subsequent interest and principal payments due monthly, commencing in August 2021. The Company repaid all amounts outstanding under this debt in the third quarter of fiscal year 2021.

5-D Systems Loan

In connection with the acquisition of 5-D Systems, the Company assumed a loan in the amount of approximately $0.5 million with an interest rate of 1.0% that had been obtained under the Small Business Administration Paycheck Protection Program as part of a COVID-19 relief package. Payment of interest and principal was due monthly with the balance due in April 2022. The sellers of 5-D Systems applied for forgiveness of this loan, the application was accepted and the loan was forgiven in July 2021.

Other Liquidity Matters

We believe that our cash on hand, together with funds available under the Credit Agreement and cash expected to be generated from operating activities, will be sufficient to fund our anticipated working capital and other cash needs for at least the next 12 months. As discussed below and in Part I, Item 1A, “Risk Factors” of our Annual Report on Form 10-K, our quarterly and annual operating results have fluctuated in the past and may vary in the future due to a variety of factors, many of which are external to our control. If the conditions in our industry deteriorate or our customers cancel or postpone projects or if we are unable to sufficiently increase our revenues or further reduce our expenses, we may experience a significant long-term negative impact to our financial results and cash flows from operations. In such a situation, we could fall out of compliance with our financial and other covenants, which, if not waived, could limit our liquidity and capital resources.

Critical Accounting Principles and Estimates

The foregoing discussion of our financial condition and results of operations is based on the Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. The preparation of these Condensed Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, and the related disclosures of contingencies. We base these estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates.

There have been no significant changes to our “Critical Accounting Policies or Estimates” as compared to the significant accounting policies described in our Annual Report on Form 10-K.

Since December 26, 2021, there have been no material changes in the quantitative or qualitative aspects of our market risk profile. For additional information regarding our exposure to certain market risks, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” included in our Annual Report on Form 10-K.

Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) promulgated under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report.

Based on the foregoing, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of September 25, 2022.

Changes in Internal Control Over Financial Reporting

We operate under the Committee of Sponsoring Organizations 2013 Framework. There was no change in our internal control over financial reporting during the three months ended September 25, 2022 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

In evaluating us and our common stock, we urge you to carefully consider the risks and other information in this Quarterly Report on Form 10-Q, as well as the risk factors disclosed in Item 1A. to Part I of our Annual Report on Form 10-K, and other reports that we have filed with the SEC. Any of the risks discussed in such reports, as well as additional risks and uncertainties not currently known to us or that we currently deem immaterial, could materially and adversely affect our results of operations, financial condition or prospects. During the period covered by this Quarterly Report on Form 10-Q, there have been no material changes in our risk factors as previously disclosed.