Kratos Defense & Security Solutions, Inc.: Form 10-Q for the period ended Jun 25, 2023

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 (“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 25, 2022 filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 23, 2023 (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 technology company in the Defense, National Security and Global markets. Kratos develops, rapidly brings to market and fields transformational technology, products, software and systems at an affordable cost.

Through demonstrated and proven commercial and venture capital backed approaches, including proactive, internally funded research and streamlined development processes and by partnering with similar entrepreneurial entities, Kratos is focused on being first to market, well in advance of the competition which is typically focused on and aligned with government funding cycles and the related extended development and fielding timelines. At Kratos, affordability is a technology, better is the enemy of good enough and ready today, and being first to market with relevant offerings is our key competitive advantage.

Kratos’ primary focus areas are unmanned systems, space and satellite communications, including software products, 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 software and designed-in positions on our customers’ programs, platforms and systems, and our ability to rapidly develop, demonstrate and field affordable leading technology solutions ahead of the competition, 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 and other secured facilities. Our primary end customers are defense and national security related agencies, communications and other global enterprises. Our entire organization is focused on executing our strategy of being the disruptive, affordable, leading technology and intellectual property based product, software and system provider in our markets.

Industry Update

On December 29, 2022, President Biden signed into law the Consolidated Appropriations Act of 2023, a $1.7 trillion spending bill funding the U.S. federal budget for the 2023 federal fiscal year. The funding bill includes a $775.2 billion appropriation for domestic initiatives, a roughly 6% increase in spending for domestic initiatives from the 2022 fiscal year appropriations, with Defense and National Security programs also increasing by approximately 10% to $858 billion. The bill also includes approximately $45 billion for Ukraine and NATO allies. On January 19, 2023, the U.S. reached its $31.4 trillion debt ceiling and, as a result, the U.S. Treasury Department began taking extraordinary special measures to maintain the payment of the U.S. Government’s bills. On June 3, 2023, President Biden signed into law a bill to suspend the debt limit through January 1, 2025.

On July 14, 2023, the U.S. House of Representatives passed its version of a sweeping bill setting Policy for the Department of Defense, the Fiscal 2024 National Defense Authorization Act (“NDAA”), at $886 billion. The vote of 219-210 was largely along party lines, a departure from the typical bipartisan support for a bill that has passed every year since 1961. The Senate passed its version of the NDAA bill on July 27, 2023 at $866 billion and included several significant differences from the previously passed U.S. House of Representative bill. Now, the two chambers, i.e., the House and the Senate, will attempt to negotiate a compromise bill that should come up for a vote later this year. The NDAA is one of the major pieces of legislation Congress passes annually. The NDAA is closely watched by industry and other stakeholders and related interests, as the NDAA typically determines the specific spending outlays and purchases of the Department of Defense and other National Security related Agencies.

The current budget environment, including COVID-19 expenditures, Ukraine funding support, heightened levels of inflation, related supply chain disruption, the appropriations process, continues to create significant short and long-term industry risks. Additionally, with the recent change of party in Congress in 2022, resulting with the Democrats controlling the Senate and the Presidency and the Republicans controlling the House of Representatives, considerable uncertainty exists regarding how future budgets, funding, timing and related program decisions will unfold, including the potential differing defense spending priorities of the Biden administration and of the Congress.

We believe continued budget pressures, (which are expected), Continuing Resolution Authorizations (“CRAs”), (which are also expected), future Federal Government debt ceiling issues, or Federal Government shutdowns could have serious negative consequences for the security of our country and the defense industrial base, including the Company and the related 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 would have long-term implications for our Company and the entire defense industry. Additionally, funding for certain programs, including those 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 customers, partners, teammates, subcontractors, suppliers, and our employee base.

We believe that our business is well-positioned in areas that the U.S. Department of Defense (“DoD”) and other customers indicate are priorities for future defense spending, including those based on the 2022 National Security Strategy document, the 2023 U.S. National Security related budget and NDAA and the recently released fiscal 2024 National Security Budget request and NDAA, and also the related Future Years Defense Program or five year projection of the forces, resources and programs needed to support the DoD’s strategy and operations.

However, due to a divided Congress and Executive Branch, federal budgetary uncertainty, expected CRAs, potential budgetary restrictions or limitations, defense or other spending cuts, including the budgetary impacts of ongoing COVID-19 spending and support for the conflict in Ukraine, challenges in the appropriations process, the debt ceiling issue and ongoing fiscal debates, the short and long term impacts to the industry and to our business remain uncertain.

Such a challenging federal and DoD budgetary environment may negatively impact our customers, business and programs and could have a material adverse effect on our forecasts, estimates, financial position, results of operations and/or cash flows.

We continue to be affected by various unfavorable macroeconomic conditions including significant adverse supply chain disruptions that continue throughout the industry and for us, and related 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 increased costs of inputs needed to execute our business, including materials, parts, supplies, consultants, subcontractors, vendors, etc. have significantly increased our business costs and have significantly adversely impacted our operations, profit margins and financial forecasts.

Also, the cost of labor for the Company’s employees and labor base has also increased significantly and current challenges in hiring, obtaining and retaining employees, including those employees requiring National Security clearances, is adversely impacting Kratos’ ability to execute its business and is a primary operational and execution challenge for Kratos. There is also a significant industry wide labor shortage, including in the Science, Technology, Engineering, and Math (STEM) discipline areas, also including for employees willing and/or able to obtain National Security clearances, and for high level manufacturing and production disciplines.

In addition, recent actions by the Federal Reserve to increase interest rates have impacted our interest expense on our outstanding debt borrowings and the related cost of executing Kratos’ business. Each of these matters and issues are expected to continue for the foreseeable future and are expected to continue 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 June 25, 2023 to the Three Months Ended June 26, 2022

Revenues. Revenues by operating segment for the three months ended June 25, 2023 and June 26, 2022 are as follows (dollars in millions):

Revenues increased $32.7 million to $256.9 million for the three months ended June 25, 2023 from $224.2 million for the three months ended June 26, 2022. Revenues in our KGS segment increased $37.0 million primarily due to the contribution of $9.0 million in increased revenues from the recent acquisition of SRI’s Engineering Division (“SRE”), a net increase of $18.0 million in our C5ISR, turbine technologies, microwave electronics products, defense and rocket support and training solutions businesses, and an increase of $10.0 million in our space and satellite communications business. Revenues in our US segment decreased $4.3 million to $52.1 million for the three months ended June 25, 2023, primarily due to reduced tactical drone activity as a result of timing of program contract awards as compared to the three months ended June 26, 2022.

Product sales increased $7.8 million to $153.2 million for the three months ended June 25, 2023 from $145.4 million for the three months ended June 26, 2022, primarily as a result of increased production in our KGS segment, offset partially by decreased volume in our US segment. As a percentage of total consolidated revenues, product sales were 59.6% for the three months ended June 25, 2023 as compared to 64.9% for the three months ended June 26, 2022. Service revenues increased by $24.9 million to $103.7 million for the three months ended June 25, 2023 from $78.8 million for the three months ended June 26, 2022, primarily as a result of the recent SRE acquisition and a change in mix of revenues.

Cost of Revenues. Cost of revenues increased $26.6 million to $193.0 million for the three months ended June 25, 2023 from $166.4 million for the three months ended June 26, 2022. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.

Gross Margin. Gross margin decreased to 24.9% for the three months ended June 25, 2023 from 25.8% for the three months ended June 26, 2022. Margins on services decreased to 22.9% for the three months ended June 25, 2023 from 28.7% for the three months ended June 26, 2022. Margins on products increased to 26.2% for the three months ended June 25, 2023 from 24.2% for the three months end June 26, 2022. Margins in the KGS segment decreased to 26.0% for the three months ended June 25, 2023 from 27.8% for the three months ended June 26, 2022, primarily due to a less favorable mix of revenues. Margins in the US segment increased to 20.3% for the three months ended June 25, 2023 from 19.7% for the three months ended June 26, 2022, primarily due to a more favorable mix of products produced and shipped in the three months ended June 25, 2023.

Selling, General and Administrative (“SG&A”) Expenses. SG&A expenses increased $2.8 million to $47.3 million for the three months ended June 25, 2023 from $44.5 million for the three months ended June 26, 2022. As a percentage of revenues, SG&A decreased to 18.4% at June 25, 2023 from 19.8% at June 26, 2022. Included in SG&A was the impact of the recent SRE acquisition.

Research and Development (“R&D”) Expenses. R&D expenses increased $0.7 million to $9.9 million for the three months ended June 25, 2023 from $9.2 million for the three months ended June 26, 2022, primarily due to increased development efforts in our space and satellite communications business. As a percentage of revenues, R&D decreased to 3.9% for the three months ended June 25, 2023 from 4.1% for the three months ended June 26, 2022. 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 decreased to $0.0 million from $5.9 million for the three months ended June 25, 2023 and June 26, 2022, respectively, primarily related to a $5.5 million litigation charge recorded in the three months ended June 26, 2022 resulting from the settlement of a dispute with an international customer in our US segment.

Total Other Expense, Net. Total other expense, net increased to $4.9 million from $2.9 million for the three months ended June 25, 2023 and June 26, 2022, respectively. This increase in expense of $2.0 million was primarily related to an increase in interest expense of $2.4 million in the three months ended June 26, 2022 resulting from an increase in interest rates.

Provision (Benefit) for Income Taxes from Continuing Operations. The income tax expense from continuing operations for the three months ended June 25, 2023 and June 26, 2022 was $2.4 million and $0.5 million, respectively. For the three months ended June 25, 2023 and June 26, 2022, the Company 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.

Comparison of Results for the Six Months Ended June 25, 2023 to the Six Months Ended June 26, 2022

Revenues. Revenues by operating segment for the six months ended June 25, 2023 and June 26, 2022 are as follows (dollars in millions):

Revenues increased $68.3 million to $488.7 million for the six months ended June 25, 2023 from $420.4 million for the six months ended June 26, 2022. Revenues in our KGS segment increased $77.2 million, primarily due to the net increased contribution of $21.0 million in revenues from the recent acquisition of SRI’s Engineering Division (“SRE”), a net increase of $30.7 million in our C5ISR, turbine technologies, microwave electronics products and defense and rocket support businesses, and an increase of $26.3 million in our space and satellite communications business, offset partially by a reduction of $0.8 million in our training solutions business. Revenues in our US segment decreased $8.9 million to $100.1 million for the six months ended June 25, 2023 primarily due to a reduction in tactical drone based revenues as a result of timing of program contract awards, as compared to the six months ended June 26, 2022.

Product sales increased $19.7 million to $293.4 million for the six months ended June 25, 2023 from $273.7 million for the six months ended June 26, 2022, primarily as a result of increased production activity in our KGS segment, offset partially by decreased volume in our US segment. As a percentage of total revenue, product sales were 60.0% for the six months ended June 25, 2023 as compared to 65.1% for the six months ended June 26, 2022. Service revenues increased by $48.6 million to $195.3 million for the six months ended June 25, 2023 from $146.7 million for the six months ended June 26, 2022. The increase was primarily a result of the recent Cosmic and SRE acquisitions.

Cost of Revenues. Cost of revenues increased $54.7 million to $365.4 million for the six months ended June 25, 2023 from $310.7 million for the six months ended June 26, 2022. The increase in cost of revenues was primarily a result of the increase in revenues discussed above.

Gross Margin. Gross margin decreased to 25.2% for the six months ended June 25, 2023 from 26.1% for the six months ended June 26, 2022. Margins on services decreased to 24.1% for the six months ended June 25, 2023 from 27.7% for the six months ended June 26, 2022. Margins on product sales increased to 26.0% for the six months ended June 25, 2023 from 25.2% for the six months ended June 26, 2022. Margins in the KGS segment decreased to 26.6% for the six months ended June 25, 2023 from 28.2% for the six months ended June 26, 2022 primarily due to a less favorable mix of revenues. Margins in the US segment decreased to 20.0% for the six months ended June 25, 2023 from 20.1% for the six months ended June 26, 2022.

SG&A Expenses. SG&A expenses were $95.1 million for the six months ended June 25, 2023 and $87.8 million for the six months ended June 26, 2022. As a percentage of revenues, SG&A decreased to 19.5% at June 25, 2023, from 20.9% at June 26, 2022.

R&D Expenses. R&D expenses were $20.1 million for the six months ended June 25, 2023 and $18.4 million for the six months ended June 26, 2022, with the primary increases in expenses in our space and satellite communications business. As a percentage of revenues, R&D expenses decreased to 4.1% for the six months ended June 25, 2023 from 4.4% for the six months ended June 26, 2022.

Restructuring Expenses and Other. Restructuring expenses and other decreased to $0.9 million for the six months ended June 25, 2023 from $6.2 million for the six months ended June 26, 2022, 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 during the six months ended June 26, 2022.

Total Other Expense, Net. Total other expense, net decreased to $10.5 million for the six months ended June 25, 2023 from $21.7 million for the six months ended June 26, 2022. The decrease in expense of $11.2 million was primarily related to the $13.0 million loss on the extinguishment of our Senior Secured Notes during the six months ended June 26, 2022 which was partially offset by an increase in interest expense of $2.1 million during the six months ended June 25, 2023 resulting from increased interest rates.

Provision (Benefit) for Income Taxes from Continuing Operations. The income tax expense from continuing operations for the six months ended June 25, 2023 was $3.1 million and the income tax benefit for the six months ended June 26, 2022 was $3.8 million. For the six months ended June 25, 2023 and June 26, 2022, the Company 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.

Backlog

On June 25, 2023, we had approximately $1,157.3 million of total backlog, of which $863.9 million was funded. We expect to recognize approximately 39% of the remaining total backlog as revenue in fiscal year 2023, an additional 32% in fiscal year 2024 and the balance thereafter. Our comparable total backlog balance as of June 26, 2022, was approximately $1,050.2 million, of which $713.6 million was funded. Backlog as of June 25, 2023 as compared to June 26, 2022 has increased primarily as a result of contract awards in our Space, Satellite and Cyber, Turbine Technologies, Microwave Technologies and Unmanned Systems businesses.

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 June 25, 2023, we had cash and cash equivalents of $48.2 million compared with cash and cash equivalents of $81.3 million as of December 25, 2022, which includes $23.6 million and $18.9 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 decreased from $257.5 million at December 25, 2022 to $236.8 million at June 25, 2023. 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. As of June 25, 2023, the Company made $5.0 million of principal payments on Term Loan A, and has net amounts outstanding of approximately $43.0 million under the new Revolving Credit Facility, with approximately $157.0 million remaining in borrowing capacity, less $13.6 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, and to fund advanced inventory purchases to mitigate supply chain disruptions. 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 six months ended June 25, 2023, approximately $20.0 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 134 days as of December 25, 2022 to 120 days at June 25, 2023, 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 June 25, 2023, 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 which is included in restructuring expenses and other in the year ended December 25, 2022.

A summary of our net cash 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 $2.1 million for the six months ended June 25, 2023. Net cash used in operating activities from continuing operations for the six months ended June 25, 2023 was primarily a result of the net loss of $6.2 million and changes in net working capital accounts of $30.9 million partially offset by noncash charges $35.2 million which includes stock compensation, depreciation and amortization. Net cash used in operating activities from continuing operations was $29.5 million for the six months ended June 26, 2022 as a result of the net loss of $20.3 million and changes in net working capital accounts of $60.3 million, which was partially offset by noncash charges totaling $51.8 million.

Net cash used in investing activities from continuing operations for the six months ended June 25, 2023 is comprised of $18.9 million in capital expenditures partially offset by receipt of $8.3 million of proceeds from the sale of Valkyries which had been previously built as capital assets as they were produced ahead of government contract award. During the six months ended June 25, 2023, capital expenditures of approximately $8.2 million were incurred in our US business, primarily related to our unmanned tactical initiative. We expect our capital expenditures for our fiscal year 2023 to continue to be significant for investments we are making, specifically in our US business totaling approximately $20 to $25 million. The Company made the decision in the first quarter of 2023 to move forward with its second serial production run of 12 next generation Valkyries. The total estimated amount related to production of Valkyries ahead of government contract award, including the first and second production run, is $10 to $15 million of the estimated 2023 capital expenditures for the US business. Net cash used in investing activities from continuing operations for the six months ended June 26, 2022 is comprised of cash paid for acquisitions, net of cash acquired of $131.9 million, and $21.9 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 $5.1 million payment due under the acquisition agreement for KTT Core, of which we purchased a controlling interest in February 2019.

Net cash used in financing activities from continuing operations was $20.8 million for the six months ended June 25, 2023, which included $2.5 million of principal payments on our $200 million Term Loan A and a $51.0 million payment (partially offset by a $34.0 million draw) on the new Revolving Credit Facility, payroll withholding taxes paid from vested restricted stock traded for taxes of $3.4 million and payments made on financing lease obligations of $0.8 million. These uses were partially offset by employee stock purchase plan receipts of $2.9 million. Net cash used in financing activities from continuing operations was $22.2 million for the six months ended June 26, 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 $11.5 million and payments made on financing lease obligations of $0.6 million. These uses were partially offset by $300.0 million in proceeds from our New Credit Facility and employee stock purchase plan receipts of $2.9 million.

The net operating cash flows of discontinued operations for the six months ended June 25, 2023 was a use of $0.1 million. The net operating cash flows of discontinued operations for the six months ended June 26, 2022 was a use of $0.4 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 $3.3 million associated with the New Credit Facility. As of June 25, 2023, the Company made $5.0 million of principal payments on Term Loan A. As of June 25, 2023, the Company has net amounts outstanding of approximately $43.0 million under the new Revolving Credit Facility, with approximately $157.0 million remaining in borrowing capacity, less $13.6 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.

On April 28, 2023, the Company entered into an interest rate swap contract to hedge U.S. dollar-one month Term SOFR in order to fix the interest rate movements associated with the Company’s Term Loan A. The initial hedge amount was $195.0 million and amortizes in accordance with Term Loan A. The swap is at a fixed rate one-month term SOFR of 3.721% and settles monthly on the last day of each calendar month. The swap has an effective date of May 1, 2023 and terminates on May 1, 2026.

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 June 25, 2023.

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.

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 25, 2022, 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 June 25, 2023.

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 June 25, 2023 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.