July 27,
2009
Via EDGAR
U.S.
Securities and Exchange Commission
Division
of Corporation Finance
100 F
Street, NE
Mail Stop
3720
Washington D.C. 20549
Attn: Melissa
Hauber, Senior Staff Accountant
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Re:
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Kratos
Defense & Securities Solutions, Inc.
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Form
10-K for Fiscal Year Ended December 28, 2008
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Filed
March 10, 2009
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Form
10-Q for Fiscal Quarter Ended March 29, 2009
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File
No. 0-27231
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Dear
Ladies and Gentlemen:
On
behalf of Kratos Defense & Security Solutions (the “Company” or “Kratos”),
we are providing this letter in response to the comments raised in the letter
dated July 13, 2009 (the “ Comment Letter ”) from the staff (the “ Staff ”) of
the Securities and Exchange Commission to Ms. Deanna H. Lund, Chief
Financial Officer of the Company. Set forth below are the Company’s responses to
the Staff’s comments. To facilitate your review, the Staff comment, as set forth
in the Comment Letter, is reprinted in italics, numbered to correspond with the
paragraph number assigned in the Comment Letter, and is followed by the
corresponding response from the Company.
Form 10-K for Fiscal Year
Ended December 28, 2008
Note 2. Goodwill
and Other Intangible Assets, page 92
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1.
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Tell
us how you have defined your reporting units, under SFAS 142 and related
guidance.
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In order
to define our reporting units, we took into consideration paragraphs 30 through
36 of SFAS 142 as well as paragraphs 10 through 24 of SFAS 131.
In
accordance with paragraph 30 of FASB Statement No. 142, Goodwill and Intangible
Assets, we assess goodwill for impairment at the reporting unit level,
which is defined as an operating segment or one level below an operating
segment, referred to as a component. We assess whether any components
of our segments constitute a business for which discrete financial information
is available and where segment management regularly reviews the operating
results of that component. Once we have determined the components of the
operating segment we review the economic characteristics of the components to
determine whether these components should be aggregated and deemed a single
reporting unit.
Our
analysis also takes into consideration the relevant provisions, paragraphs 10 –
24 of FASB Statement No. 131,
Disclosures about Segments of an Enterprise and Related Information (FASB
131) in determining our reporting units. In particular, pursuant to the guidance
of paragraph 17 of FASB 131, we aggregate components within an operating segment
that have similar economic characteristics and if the segments are similar in
each of the following areas:
a. The
nature of the products and services
b. The
nature of the production processes
c. The
type or class of customer for their products and services
d. The
methods used to distribute their products or provide their services
e. If
applicable, the nature of the regulatory environment, for example, banking,
insurance, or public utilities.
Based on
the guidance in paragraph 30 of SFAS 142 and paragraphs 10 – 24 of SFAS 131, we
determined our reporting units are the same as our operating segments which are
Public Safety and Security and Government Solutions.
We will
provide the following disclosure in our future filings:
We assess
goodwill for impairment at the reporting unit level, which is defined as an
operating segment or one level below an operating segment, referred to as a
component. We determine our reporting units by fist identifying our operating
segments, and then assess whether any components of these segments constitute a
business for which discrete financial information is available and where segment
management regularly reviews the operating results of that component. We
aggregate components within an operating segment that have similar economic
characteristics. For our December 28, 2008 annual impairment
assessment and our interim test as of February 28, 2009, we identified our
reporting units to be our operating segments which are Government Solutions and
Public Safety and Security.
Note 5. Acquisitions. page
99
Digital Fusion,
Inc.
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2.
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Tell
us and disclose, in future filings, a description of the type and amount
of liabilities assumed and included in the acquisition cost allocation for
costs to exit activities or to involuntarily terminate or relocate
employees of DFI.
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As of
December 28, 2008 the cost allocation for DFI did not include any liabilities
for costs to exit activities or to involuntarily terminate or relocate
employees. Subsequent to the initial cost allocation presented in the
Form 10-K for the year ended December 28, 2008, the Company has determined that
no such costs would be incurred. As a result, no subsequent liabilities for
these expenses have been accrued and the Company believes no disclosure is
required.
Form 10-Q for Fiscal Quarter
Ended March 29, 2009
Management’s Discussion and
Analysis of Financial Condition and Results of Operations, page
31
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3.
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We
note that you took significant goodwill impairment charges in the fourth
quarter of fiscal 2008 and the first quarter of 2009. You state at page 44
of the Form 10-K that you believe the charge does not effect your normal
business operations. In addition, you state at page 36 of the Form 10-Q
that the most recent charge is primarily driven by adverse equity market
conditions. We believe that you should expand your MD&A to discuss
your expectations regarding your future operating results and liquidity in
light of taking an impairment charge. You should clearly explain to your
investors, if true, that you expect that historical operating results will
not be indicative of future operating results. You should also discuss the
primary drivers in your assumptions that resulted in the goodwill
impairment charge. For instance, did you significantly reduce projected
future revenues or net cash flows or increase the discount rates? In
addition, discuss whether and when you considered a recovery of the
economy in your cash flow
projections.
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We will
provide the following disclosure in our future filings:
The
impairment charge is primarily driven by adverse equity market conditions that
caused a decrease in current market multiples and our average stock price as of
February 28, 2009, compared with the impairment test performed as of
December 28, 2008. In our analysis, we use the income
approach and validate its reasonableness by considering our market
capitalization based upon an average of our stock price for a period prior to
and subsequent to the date we perform our analysis. The average market price of
our stock as of February 28, 2009 was $0.78 which equates to a 39% drop in our
average stock price and corresponding market capitalization from December 28,
2008 which had an average stock price of $1.29. We reconcile the fair value of
our reporting units which is calculated using the income approach to our market
capitalization. As a result of this reconciliation, it was noted that investors
were requiring a higher rate of return, and therefore, our discount factor which
is based upon an estimated market participant weighted average cost of capital
(WACC) increased 300 basis points from 14% in our year end impairment test in
2008 as compared to 17% in our 2009 first quarter interim impairment test. This
change was the key factor contributing to the $41.3 million goodwill impairment
charge that we recorded in the first quarter of 2009.
Our
forecasts of growth rates and operating margins had not changed as of February
28, 2009 as compared to the forecasts which were used as of December 28, 2008.
Our historical growth rates and operating results are not indicative of our
future growth rates and operating results as a consequence of our transformation
of the Company from a commercial wireless service provider to a U.S. government
defense contractor. The decline in revenues on a pro forma basis after
considering recent acquisitions, which was expected by us, is primarily due to
the impact of the conversion of our work as a prime contractor under certain
legacy small business awards to that of a subcontractor. This change resulted in
an award of an overall smaller portion of the entire project as the contracts
were recompeted and the original term of the small business contracts were
completed. The conversion of work as a prime to a subcontractor related to
legacy small business contracts awarded to acquired companies is not uncommon in
the government defense contractor industry for companies that have been
acquisitive. Our projected growth rates take into consideration this anticipated
impact on small business awards. Our contracts are long term in nature and are
supported by significant backlog. Because our contracts are of a long term
nature, a majority of our receivables are with agencies within the U. S.
government or we are a subcontractor to a customer whose receivables are with
the agencies within the U.S. government, we are not subject to significant short
term changes in operating cash flow. Moreover, because of the nature of
our current business we do not have significant capital expenditure
requirements. Additionally, our contract base is highly diversified and
the loss of any one contract would not impact revenues by more than 3%. In
addition, we did not assume a recovery of the global or national economy in our
cash flow projections in either analysis.
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4.
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We
note that goodwill accounted for 43% of total assets as of March 29, 2009.
We note that revenues have declined (on a pro forma basis after
considering recent acquisitions) and you continue to report operating
losses. As a result of your impairment tests of your reporting units as of
December 28, 2008 and February 28, 2009, you determined that a portion of
your goodwill balance was not impaired. In light of the significance of
your goodwill balance and your impairment charge, we expect robust and
comprehensive disclosure in your critical accounting policies regarding
your impairment testing policy. This disclosure should provide investors
with sufficient information about management’s insights and assumptions
with regard to the recoverability of goodwill. Specifically, we believe
you should provide the following
information:
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·
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Provide
a more detailed description of the steps you perform to review goodwill
for recoverability.
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Describe
the nature of the valuation techniques and the significant estimates and
assumptions you employed to determine the fair value of your reporting
unites in your impairment analysis. For example, you should disclose the
discount rate and how it was determined, including your consideration of
any market risk premiums. In this regard, it is unclear to us why your
determination of the weighted average cost of capital, as described at
page 59 of your Form 10-K, does not consider data of market participants,
as represented by comparable
companies.
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In
addition, we believe your disclosure should address your estimates of future
cash flows as follows:
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a)
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Provide
a discussion of your projected growth rates as compared to historical
growth.
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b)
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Discuss
reasons for the differences between projected and historical rates and the
effect of the current economic conditions on your
assumptions.
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c)
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Provide
a sensitivity analysis for your most recent impairment test. Disclose the
impact of reasonable likely changes in each of your significant
assumptions.
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·
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Describe
changes to the assumptions and methodologies, if any, since your last
annual impairment test.
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As
discussed above in our response to question 3, the key assumption that changed
in our impairment test as of February 28, 2009 as compared to our last annual
impairment test was an increase in the discount rate of 3%, from 14% in our
annual impairment test to 17% in our impairment test as of February 28, 2009. We
will disclose the change in this assumption in our MD&A as discussed
above.
We will
provide the following disclosure in our critical accounting policies in our
future filings:
We
perform impairment tests for goodwill as of the last day of our fiscal year, or
when evidence of potential impairment exists. When it is determined that
impairment has occurred, a charge to operations is recorded. In order
to test for potential impairment, we use the income approach, specifically the
discounted cash flow (DCF) method, to derive the fair value of each of our
reporting units and in order to validate the reasonableness of the income
approach, we consider the market approach, which estimates the fair value of our
reporting units based upon comparable market prices to validate the
reasonableness of the implied multiples from the income approach. We also
consider our market capitalization based upon an average of our stock price
prior to and subsequent to the date we perform our analysis and reconcile the
fair value of our reporting units to our market capitalization assuming a
control premium.
In
applying the income approach to our impairment test for goodwill, we make
assumptions about the amount and timing of future expected cash flows, terminal
growth rates, appropriate discount rates, and the control premium a controlling
shareholder could be expected to pay:
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The
timing of future cash flows within our DCF analysis is based on our most
recent forecasts and other estimates. Our historical growth rates and
operating results are not indicative of our projected growth rates and
operating results as a consequence of our acquisitions and divestitures
and the transformation of the Company from a commercial wireless service
provider to a U.S. government defense contractor. The decline
in revenues on a pro forma basis after considering recent acquisitions,
which was expected by us, is primarily due to the impact of the conversion
of our work as a prime contractor under certain legacy small business
awards to that of a subcontractor. This change resulted in an award of an
overall smaller portion of the entire project as the contracts were
recompeted and the original term of the small business contracts were
completed. The conversion of work as a prime to a subcontractor related to
legacy small business contracts awarded to the acquired companies is not
uncommon in the government defense contractor industry for companies that
have been acquisitive. Our projected growth rates take into consideration
this anticipated impact on small business
awards.
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The
current economic conditions have negatively impacted our Public Safety and
Security reporting unit’s projected growth rates and cash flows as customers
have delayed or cancelled capital expenditures related to the systems we
provide. However, this reporting unit has no goodwill, it is significantly
smaller than our Government Solutions segment (for the quarter ended March 28,
2009, it generated 11.3% of our total consolidated revenues) and our goodwill
impairment analysis is not materially affected by changes in the expected cash
flows for this reporting unit. Current economic conditions have currently not
significantly impacted our estimates of cash flows in our Government Solutions
reporting unit which primarily provides services to the federal government and
primarily the DOD. Our contracts are long term in nature and are supported by
significant backlog. Because our contracts are of a long term nature, a majority
of our receivables are with agencies within the U. S. government or we are a
subcontractor to a customer whose receivables are with the agencies within the
U.S. government, we are not subject to significant short term changes in
operating cash flow. As a result of our current business model, we do not
have significant capital expenditure requirements. Additionally, our
contract base is highly diversified and the loss of any one contract would not
impact annual revenues by more than 3%.
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The
terminal growth rate is used to calculate the value of cash flows beyond
the last projected period in our DCF analysis and reflects our best
estimates for stable, perpetual growth of our reporting
units.
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We
use estimates of market participant weighted average cost of capital
(WACC) as a basis for determining the discount rates to apply to our
reporting units’ future expected cash flows. The significant
assumptions within our WACC are: (a) equity risk premium, (b) beta, (c)
size premium adjustments, (d) cost of debt, and (e) capital structure
assumptions. In addition, we use a company specific risk adjustment which
is a subjective adjustment that, by its very nature does not include
market related data, but instead examines the prospects of the reporting
unit relative to the broader industry to determine if there are specific
factors which may make it more “risky” relative to the
industry.
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We
use an estimated control premium in reconciling the aggregate value of our
reporting units to our market capitalization. As discussed in Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible
Assets, (SFAS 142), control premiums may effectively cause a
company’s aggregate fair value of its reporting unit(s) to exceed its
current market capitalization due to the ability of a controlling
shareholder to benefit from synergies and other intangible assets that
arise from such control. As a result, the measurement of fair value of an
entity with a collection of assets and liabilities that operate together
to produce cash flows is different from the fair value measurement of that
entity’s individual securities, hence, the reason a control premium is
paid.
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To test
the sensitivity of our results to other outcomes that were reasonably likely to
occur, we sensitized our forecasts for changes to revenue growth rates and
operating margins, discount rates and long-term growth rates. None of these
sensitized forecasts resulted in different conclusions with respect to goodwill
impairment.
Our
methodology for evaluating goodwill and intangibles for impairment is consistent
with the methodology we have used in prior periods.
As a
result of the assumptions used in our analyses, several factors could result in
impairment of our $110.2 million goodwill and $29.3 million long-lived
intangibles in future periods, including but not limited to:
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a
decline in our stock price and resulting market capitalization, if we
determine the decline is sustained and is indicative of a reduction in the
fair value below the carrying value of our government solutions reporting
unit;
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decreases
in available government funding, including budgetary constraints affecting
federal government spending generally, or specific departments or
agencies;
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changes
in federal government programs or requirements, including the increased
use of small business providers;
and
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our
failure to reach our internal forecasts could impact our ability to
achieve our forecasted levels of cash flows and reduce the estimated
discounted value of our reporting
units.
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It is not
possible at this time to determine if an impairment charge would result from
these factors, or, if it does, whether such charge would be
material.
* * * *
In
addition, the Company hereby acknowledges that:
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the
Company is responsible for the adequacy and accuracy of the disclosure in
the filings;
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staff
comments or changes to disclosure in response to staff comments do not
foreclose the Commission from taking any action with respect to the
filings; and
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the
Company may not assert staff comments as a defense in any proceeding
initiated by the Commission or any person under the federal securities
laws of the United States.
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If you have any questions with respect
to the foregoing, please contact me at (858) 812-7322.
Regards,
/s/ Deanna H.
Lund
Deanna H.
Lund
Executive
Vice President, Chief Financial Officer
cc: Donald
Williams, Grant Thornton
Scott M. Stanton, Morrison &
Foerster