Acquisitions

(a) Summary of Recent Acquisitions

Composite Engineering, Inc.

On July 2, 2012, the Company completed the acquisition of Composite Engineering, Inc. (“CEI”) for approximately $164.0 million. The purchase price including an adjustment for working capital and cash to be paid to the CEI shareholders for the 338(h)(10) election includes $135.0 million in cash and 4.0 million shares of the Company's common stock, valued at $5.94 per share on July 2, 2012, or $23.8 million. $10.7 million of the cash paid was placed into an escrow account as security for CEI's indemnification obligations as set forth in the CEI purchase agreement and will be reduced by $1.0 million to pay the working capital adjustment owed to the Company in July 2013. In addition, $2.5 million was paid to retire certain pre-existing CEI debt and settle pre-existing accounts receivable from CEI at its carrying and fair value of $3.0 million. The Company made an election under Section 338(h)(10) of the Internal Revenue Code, which resulted in tax deductible goodwill related to this transaction, and will pay an estimated $1.6 million in additional tax liability incurred by the shareholders of CEI for this election. The Company estimates that the tax deductible goodwill and intangibles, which is subject to change based upon the final fair value of assets acquired and liabilities assumed, will be approximately $140.6 million and can be deducted for federal and California state income taxes over a 15-year period.

In connection with the completion of the CEI transaction, certain CEI personnel entered into long-term employment agreements with the Company. On July 2, 2012, the Company granted restricted stock units ("RSUs") for an aggregate 2.0 million shares of common stock as long-term retention inducement grants to certain employees of CEI who joined Kratos. The RSUs had an estimated value of $11.9 million on the grant date, vest on the fourth anniversary of the closing of the CEI acquisition, or earlier upon the occurrence of certain events, and are being accounted for as compensation expense over such four-year period.

To fund the acquisition of CEI, on May 14, 2012, the Company sold approximately 20.0 million shares of its common stock at a purchase price of $5.00 per share in an underwritten public offering. The Company received gross proceeds of approximately $100.0 million and net proceeds of approximately $97.0 million after deducting underwriting fees and other offering expenses. The Company used the net proceeds from this offering to fund a portion of the purchase price for the acquisition of CEI. In addition, the Company used borrowings of $40.0 million from its revolving line of credit to fund the purchase price of CEI.

CEI is a vertically integrated manufacturer and developer of unmanned aerial target systems and composite structures used for national security programs. Its drones are designed to replicate some of the most lethal aerial threats facing warfighters and strategic assets. CEI's customers include U.S. agencies and foreign governments. CEI is a part of the Kratos Government Solutions ("KGS") segment.

The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by enabling it to strategically expand its strengths in the areas of design, engineering, development, manufacturing and production of unmanned aerial targets, and will also enable the Company to realize significant cross selling opportunities.

The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The following table summarizes the preliminary estimated fair values of the major assets acquired and liabilities assumed (in millions):



Cash	$	8.9
Accounts receivable	9.3
Inventoried costs	12.3
Other current assets	8.9
Property and equipment	8.1
Intangible assets	38.0
Goodwill	104.2
Total assets	189.7
Current liabilities	(25.7		)
Net assets acquired	$	164.0

The goodwill recorded in this transaction is tax deductible.

As of July 2, 2012, the expected fair value of accounts receivable approximated historical cost. The gross accounts receivable was $9.3 million, all of which is expected to be collectible. There was no contingent purchase consideration associated with the acquisition of CEI.

The amounts of revenue and operating loss of CEI included in the Company's condensed consolidated statement of operations and comprehensive income (loss) for the three months ended March 31, 2013 are $25.9 million and $3.2 million, respectively.

Asset Purchase

On December 30, 2011, the Company acquired selected assets of a critical infrastructure security and public safety system integration business (the “Critical Infrastructure Business”) for approximately $18.8 million, which includes a final agreement on the working capital adjustment.

The Critical Infrastructure Business designs, engineers, deploys, manages and maintains specialty security systems at some of the most strategic asset and critical infrastructure locations in the U.S. Additionally, these security systems are typically integrated into command and control system infrastructure or command centers. Approximately 15% of the revenues of the Critical Infrastructure Business are recurring in nature due to the operation, maintenance or sustainment of the security systems once deployed. The Critical Infrastructure Business is part of the Company's Public Safety & Security (“PSS”) segment.

The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by enabling it to strategically expand its strengths in the areas of homeland security solutions and will also enable the Company to realize significant cross selling opportunities and increase its sales of higher margin, fixed price products.

The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The following table summarizes the estimated fair values of the major assets acquired and liabilities assumed (in millions):



Accounts receivable	$	23.4
Other assets	0.5
Intangible assets	2.0
Goodwill	2.6
Total assets	28.5
Current liabilities	(9.7		)
Net assets acquired	$	18.8

The goodwill recorded in this transaction is tax deductible.

As of December 30, 2011, the expected fair value of accounts receivable approximated historical cost. The gross accounts receivable was $24.4 million, of which approximately $1.0 million is not expected to be collectible.

Due to the integration of the Critical Infrastructure Business with the Company's existing PSS business it is impractical to estimate the amounts of revenue and operating income (loss) included in the Company's condensed consolidated statement of operations and comprehensive income (loss).

In accordance with FASB Accounting Standards Codification ("ASC") Topic 805, Business Combinations (“Topic 805”), the allocation of the purchase price for the Company’s acquisition of CEI is subject to adjustment during the measurement period after the respective closing dates when additional information on asset and liability valuations becomes available. The above estimated fair values of assets acquired and liabilities assumed of CEI are provisional and are based on the information that was available as of the acquisition date to estimate the fair value of assets acquired and liabilities assumed. Measurement period adjustments reflect new information obtained about facts and circumstances that existed as of the acquisition date. The Company believes that such information provides a reasonable basis for estimating the fair values of assets acquired and liabilities assumed, but the Company is waiting for additional information necessary to finalize those fair values. The Company has not finalized its valuation of certain assets and liabilities recorded in connection with this transaction, including contingent liabilities and deferred taxes. Thus, the provisional measurements recorded are subject to change. Any changes will be recorded as adjustments to the fair value of those assets and liabilities, and residual amounts will be allocated to goodwill. The final valuation adjustments may also require adjustment to the condensed consolidated statements of operations and comprehensive income (loss).

Pro Forma Financial Information

The following tables summarize the supplemental condensed consolidated statements of operations information on an unaudited pro forma basis as if the acquisition of CEI occurred on December 26, 2011 and include adjustments that were directly attributable to the transaction or were not expected to have a continuing impact on the Company. The acquisition of CEI is included in the results of operations for the three months ended March 31, 2013. There are no material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings for 2012. The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transaction been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future (all amounts except per share amounts are in millions):



	For the Three Months Ended March 25, 2012
Pro forma revenues	$	232.4
Pro forma net loss before tax	(9.4		)
Pro forma net loss	(5.3		)
Net loss attributable to the registrant	(2.5		)
Basic and diluted pro forma loss per share	$	(0.09	)

The pro forma financial information reflects acquisition related expenses incurred, pro forma adjustments for the additional amortization associated with finite-lived intangible assets acquired, additional incremental interest expense, stock compensation related to the RSUs granted in the CEI transaction, and the related tax expense.

These adjustments are as follows (in millions):



	For the Three Months Ended March 25, 2012
Intangible amortization	$	4.0
Net change in stock compensation expense	$	0.7
Increase in weighted average common shares outstanding for shares issued and not already included in the weighted average common shares outstanding	24.0

Contingent Acquisition Consideration

In connection with certain acquisitions, the Company has agreed to make additional future payments to the seller contingent upon achievement of specific performance-based milestones by the acquired entities. Pursuant to the provisions of Topic 805, the Company will re-measure these liabilities each reporting period and record changes in the fair value in its condensed consolidated statement of operations and comprehensive income (loss). Increases or decreases in the fair value of the contingent consideration liability, which is measured as the present value of expected future cash flows, a Level 3 measurement in the fair value hierarchy (Level 3 hierarchy as defined by ASC Topic 820, Fair Value Measurements and Disclosures (“Topic 820”)), can result from changes in discount periods and rates, as well as changes in the estimates on the achievement of the performance-based milestones.

Contingent acquisition consideration as of March 31, 2013, which is related to the DEI Services Corporation ("DEI") acquisition, is summarized in the following table (in millions):



Balance as of December 30, 2012	$	2.1
Cash payments and adjustments	—
Balance as of March 31, 2013	$	2.1

As of March 31, 2013, the $2.1 million of contingent acquisition consideration is reflected in other current liabilities in the condensed consolidated balance sheet.

Pursuant to the terms of the agreement and plan of merger with DEI Services Corporation entered into on August 9, 2010 (“the DEI Agreement”), upon achievement of certain cash receipts, revenue, EBITDA and backlog amounts in 2010, 2011 and 2012, the Company will be obligated to pay certain additional contingent consideration (the “DEI Contingent Consideration”). The Company has paid $2.9 million related to the DEI Contingent Consideration, of which $2.5 million was paid in April 2012. As of March 31, 2013, the undiscounted amount of future DEI Contingent Consideration that is payable by the Company under the DEI Agreement is $2.1 million, which was paid in April of 2013.