Kratos buys dronemaker, takes cover

Kratos Defense & Security Solutions Inc. plans to hide out for a while after its acquisition of unmanned aerial target systems maker Composite Engineering Inc.

Management of the San Diego-based defense electronics maker discussed the $155 million acquisition on a conference call Wednesday, May 9.

"The Kratos portfolio is now complete. This will be Kratos' last acquisition for the foreseeable future," Kratos CEO, president and director Eric M. DeMarco said. "We will now be focused solely on integrating and operating the business for organic growth and free cash flow generation."

Terms of the deal, announced Tuesday, call for Kratos to pay $135 million in cash and $20 million in stock for CEI.

Kratos tapped B. Riley & Co. as underwriter for an offering of 20,000 common shares at $5 apiece to raise about $100 million to pay the cash portion of the deal and for other general corporate purposes. The underwriter has a 30-day option to purchase up to 3 million additional shares to cover overallotments, if any. The shares will go to existing institutional investors, DeMarco said.

Private equity shop Oak Investment Partners is injecting $55 million of equity into Kratos to support the stock offering. Oak Investment general partner Bandel L. Carano is a member of the Kratos board.

Kratos will also draw on its recently amended credit agreement for financing. It increased its credit agreement with KeyBank NA to $110 million from $90 million on May 4 and added Cathay Bank as a lender. The interest rate on the increased facility is now LIBOR plus 325 basis points, down from LIBOR plus 375 basis points, said Kratos CFO and executive vice president Deanna Lund on the call.

The deal for CEI is expected to be accretive and should close in the beginning of the third quarter.

The Sacramento, Calif.-based target had $94 million in revenue and adjusted Ebitda of about $16 million for 2011, up from $73.6 million in sales and $5.5 million in Ebitda in 2010. It has about $160 million in backlog.

CEI is being taken at about 7.5 times estimated Ebitda for 2012, according to presentation materials accompanying the call.

Kratos also said it expects to realize $130 million in federal and state tax incentives through the transaction's structure, significantly boosting the target's free cash flow.

CEI makes drones for the U.S. Air Force, U.S. Navy and for other national security agencies. Its products are used in programs involving air-to-air and anti-ship weapons testing. The business was founded in 1959 and employs 400.

Owners Mike and Amy Fournier approached Kratos about a deal in mid-2011, DeMarco said. Kratos already provides the electronic and avionics systems that are on board CEI's aircraft, management explained, as well as systems for its ground control flight stations.

CEI employees will stay on with Kratos; $10 million of Kratos stock paid on the deal is restricted and will vest in four years as a retention incentive.

Kratos, like most defense players over the past few years, has been strengthening its defense technology offerings in response to the changing needs and priorities of the U.S. armed forces. The Department of Defense is focusing more on sophisticated communications and reconnaissance equipment, as opposed to traditional armaments such as ships and tanks.

"We believe that these areas will remain well-funded in the current and expected budgetary environment, as they truly support critical national security missions and priorities," DeMarco said.

In response to this shift, Kratos has been an active acquirer of late. In May 2011 it purchased satellite and space systems company Integral Systems Inc. for about $225 million in cash and stock. Prior to that, in February 2011, Kratos acquired microwave systems business Herley Industries Inc. for $270 million. In October 2010 it bought electronic products business Henry Bros. Electronics Inc. for $45 million. Kratos also bought shelter maker Southside Container & Trailer LLC for $16 million in December 2010.

Jeff McGrath, Chris Oliver, Dominic Aquilina and Stephen Vather at Sagent Advisors LLC advised Kratos. Stephen Perry, Brian Karpiel and Douglas Bartels of Janes Capital Partners advised CEI.

CEI couldn't be reached for comment.

Kratos Defense, founded in 1994, and taking its current name in 2007, has a market capitalization of $165.3 million.

Kratos shares were up 31 cents, or 6.5%, to $5.08, on Wednesday afternoon.