Participate, Profit & Celebrate:
Q.: In your opinion, what are the underlying elements driving the M&A deal activity in the defense and government services sectors?
Mr. Lake: There are two major forces that are driving M&A in our sector. The first relates to the fundamental dynamics of our industry. Defense and government spending in general is declining which has only been exacerbated by the budget debates, as well as the ongoing shift in spending priorities and initiatives. Also, due to changing regulations, many large contractors are finding that they need to divest portions of their business. These factors combined are forcing companies to reposition their companies to align with the anticipated flow of defense and government requirements or to be in compliance with government regulations.
The second relates to the availability of and accessibility to capital and in combination with investors seeking out sectors to drive a return on capital. This has resulted in the return of the leveraged loan and the high yield bond markets which makes capital available to the private equity players as well as strategic buyers like Kratos.
Q.: How will the projected reductions in the defense budgets affect mergers and acquisitions?
Mr. Lake: The budget reductions effect M&A in a number of ways. First, big programs such as the F-22, Future Combat System, Ground Combat vehicle, Expeditionary Fighting Vehicle, JSF and many others have been eliminated, curtailed or deferred. As a result, many of the Tier 1 contractors will have to find programs to replace these previously expected revenue streams and one way to replace them is to acquire other companies. Clearly this has already been impacting the industry over the past 12-15 month. Also, acquirers must be very diligent when looking at potential acquisitions to ensure that the Targets programs are mission critical to national security priorities and are well funded.
Q.: Do publically traded companies have unique advantage in pursuing an acquisition strategy?
Mr. Lake: I believe that being public does offer a unique set of advantages some of which are real and some of which are just perceived......but as we know perception is reality. Yes, that means more access to capital but also for certain sellers who believe in the long term success of the combined companies, there is the desire to take stock as consideration in a public company and then profit from the appreciation of the stock. For some, there is still the old fashioned mystique of participating in a publicly traded company.
I also think that track record means just as much as merely being public. The fact that we have successfully executed on our acquisition strategy and consistently closed on deals gives us tremendous credibility as a buyer both in the eyes of the seller but also in the eyes of the bankers bringing the deal to market.
Q.: In your experience what are the differences between buying a publically traded company and private company? Are transactions costs different?
Mr. Lake: I don't think the sourcing changes a great deal because there are a number of very specific industry related bankers that bring us both public and private deals and we know of or have relationships with most of them. By its nature a public company will litigation is becoming much more common place in public company transactions which also is driving up costs across the board.generally have a significant amount of the due diligence documents already available in the public domain whereas private companies often have to go through a very time and management intensive effort to gather data.
Typically, and especially in today's litigious environment, the cost of acquiring a public company is greater than that of a private company. Public companies typically have a fiduciary responsibility to "shop the company extensively" to receive the highest price, and these processes can be very drawn out and expensive. In a stock for stock public company acquisition, fairness opinions are typically required by both the acquirers Board and the Targets Board, which can increase costs and, finally
Q.: How does bolt-in acquisition factor in Kratos corporate growth initiative?
Mr. Lake: Bolt-ins or tuck-ins have been and continue to be a key component of our growth strategy. However, this must be viewed in the context of our overall M&A strategy. First and foremost, all Kratos M&A opportunities must fit into our core National Security focus in specific areas of our operating business. In our defense segment, these business areas include: Weapons Systems support, sustainment & upgrade including Foreign military sales, etc., Information Technology such as network management, software products, cyber security, performance and training and Defense Engineering services such as C5ISR, and range training and support. Finally, in our public safety and securities segment our focus includes solutions that encompasses surveillance system and critical infrastructure.
Q.: How do you go about identifying "tuck-in" prospects and what deals are favored?
Mr. Lake: Our "tuck in" opportunities are focused to align with key industry trends. For example, major new weapons systems are in jeopardy and will either be cut down or cut out. So, we focus on opportunities that extend the useful life of existing legacy systems whether they are weapons, vehicles, tactical shelters, network management systems etc., so called trailing vs. bleeding edge of technology, cyber security and informational assurance as well as in the recently announced $60B of future Foreign Military Sales.
We clearly favor deals driven by our divisional operational management. They know their business area best and what fits in with their operational and tactical tempo; they have to build and sign up for the financial targets which are tied directly to their incentive compensation and since these are "relationship driven", often times these can be "exclusive" opportunities for Kratos.
Q.: How has Kratos acquisition strategy evolved in the past few years?
Mr. Lake: Over the past year you can see that we have had a bias towards products based companies. First, these businesses provide a margin uplift over the traditional services based business. Second, we are not as exposed to the risk of in-sourcing of jobs by the government which has been the trend over the past year or so. Many of these products based businesses support fielded systems that are already deployed and will continue to be used in the foreseeable future since new programs are being eliminated in the current budget cuts. Lastly, but in our case certainly very, very important, we try to take advantage of our $210M net operating loss carry forwards, wherever possible.
Q.: How do you evaluate potential targets and what is your expectation of the acquiree?
Mr. Lake: Fundamentally, all Kratos acquisition opportunities must meet certain key financial, business and management requirements. The target or the transaction must provide us with a market differentiator, discriminator or blocking capability and provide barrier to entry. The acquisition must be immediately accretive to FCF and EPS, and must have a "1+1=3 potential" where the business unit grows along with the target acquire.
We are generally not interested in buying companies so founders can go "sit on the beach". We want active entrepreneurial management who want to grow their business within the context of the broader Kratos network. Also, the deal must have the financial characteristics to meet our lending covenants and also such that we may use the transaction itself as a way to raise money whether it be debt or equity.
Q.: As of recent, there have been several deals in the cyber security. What are the dynamics driving increased deals in this sub-sector, what makes acquisition of Herley a value creator for Kratos?
Mr. Lake: The United States National Security and the Economic Iinfrastructure are more reliant than any other Nations on the Globe. No State Government or Terrorist organization in the world today can compete militarily or technologically with the United States in a "toe to toe" competition. Accordingly, a great potential neutralizer for our adversaries would to be to disrupt the United States Military C4ISR infrastructure, or to compromise our Economic Infrastructure, including stealing out technology via the Cyber realm. Hence, there will be a significant amount of money spent in the United States on both defensive and offensive cyber systems. The Herley acquisition positions Kratos as one of the very few significant Electronic Attack and Electronic Warfare solutions and systems providers in the industry today.
Q.: How important is it to pre-plan and manage the integration process? How is integration process managed at by your team?
Mr. Lake: Pre-planning is very important to the integration process. There are no cookie cutters here. Every deal is very different and the integration plan and process have to take into consideration the culture and personality of the company being acquired. We start very early on identifying what the "hot buttons" are whether its related to key personnel, benefits, back office etc.
The process is managed at two levels. First, the entire Kratos team including the corporate management and division management will make preliminary assessments and establish high priority integration objectives. Generally, the results of this assessment will directly impact both the negotiation of the deal terms as well as the structure of the definitive agreement as it relates to key management, retention plans, operations of the business etc. Second, all of our acquisitions are integrated into a specific division. The division president and their team will further refine the integration plan focusing on a timeline sequencing of integration activities.
Q.: When should a corporation walk away from a potential acquisition? When would Kratos walk away from a deal?
Mr. Lake: We take a great deal of pride in the fact that when we are committed to going down the path of a particular transaction that we have a very high close rate. The single most critical factor contributing to this success rate is our selectivity in the front-end assessment process. We see lots of deal opportunities. We have already identified the key target areas where we are looking to grow through acquisition. So for us, the time to walk away is at the very beginning of the process. If we can't get an exclusive or we think the multiple expectations are too rich, then we will walk away. Because we are so selective up front, we haven't had situations where we find out something in due diligence that is so onerous as to force us to walk away.
Q.: In the past 12 months, Kratos has made series of acquisitions. How have these acquisitions made Kratos a competitive player as well impacted the financial performance?
Mr. Lake: From a business standpoint, the acquisitions that Kratos has recently made has significantly enhanced Kratos capabilities, qualifications and customer reach in targeted areas including; Electronic warfare and Electronic Attack products and solutions, Legacy Military Combat Systems Maintenance Trainers and Sustainment, United States critical infrastructure security and Military Specification (Mil Spec) products and shelters for Unmanned Systems Support, ISR Platform Support and Combat systems.
Kratos today is a clear leader in each of these areas. Financially, as Kratos gains critical mass through both organic growth and acquisitions, we get significant leverage off of our fixed and required public company S.G&A, which is resulting in significant operating income and ebitda profit margin expansion.
Q.: In between closing series of deals, what book are you reading?
Mr. Lake: Frankly, we are so busy these days that the only books I have time to read are the Confidential Information Memorandums on our prospective deals.

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