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Edited Transcript of KTOS earnings conference call or presentation 6-Nov-18 10:00pm GMT

Q3 2018 Kratos Defense and Security Solutions Inc Earnings Call

SAN DIEGO Nov 19, 2018 (Thomson StreetEvents) -- Edited Transcript of Kratos Defense and Security Solutions Inc earnings conference call or presentation Tuesday, November 6, 2018 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Deanna Hom Lund

Kratos Defense & Security Solutions, Inc. - Executive VP & CFO

* Eric M. DeMarco

Kratos Defense & Security Solutions, Inc. - CEO, President & Director

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Conference Call Participants

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* Gregory Arnold Konrad

Jefferies LLC, Research Division - Equity Analyst

* Joseph Anthony Gomes

NOBLE Capital Markets, Inc., Research Division - Senior Generalist Analyst

* Kenneth George Herbert

Canaccord Genuity Limited, Research Division - MD and Senior Aerospace & Defense Analyst

* Michael Frank Ciarmoli

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

* Michael Roy Crawford

B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst

* Seth Michael Seifman

JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2018 Earnings Conference Call. (Operator Instructions)

As a reminder, this conference call is being recorded.

Joining us today is Mr. Eric DeMarco, President and CEO; and Mrs. Deanna Lund, Executive Vice President and Chief Financial Officer.

I would now turn the call over to Ms. Lund. Ma'am, you may begin.

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. - Executive VP & CFO [2]

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Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solution Third Quarter 2018 Conference Call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer.

Before we begin the substance of today's call, I'd like everyone to please take note of the safe harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today's call.

Today's call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today's press release, we have provided a reconciliation of these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP.

With that, I will now to turn the call over to Eric DeMarco.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [3]

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Thank you, Deanna. Deanna stood in today for Marie, our General Counsel, who has a very bad cold.

Kratos' third quarter reflected the expected continued improvement of our company's financial matrices, our organic growth trajectory and overall performance on our execution. In Q3, Kratos' gross margins, operating margins and EBITDA margins all increased. We generated positive cash flow, and we expect cash flow in Q4 and for 2019 to continue to increase as we transition from the investment mode in our unmanned aerial drone business and as we move towards production. Deanna will provide the details on Kratos' overall third quarter financial performance and our guidance in her prepared remarks.

Kratos' business mix continues to improve favorably as we execute on the plan we communicated to you at the beginning of this year to focus on higher margin programs with better payment terms and liquidity and to deemphasize or not pursue lower-margin opportunities. In Q3, Kratos' bid pipeline increased again up to $6.7 billion, reflecting the significant opportunities that we have and Kratos' alignment with the recently released national security strategy priorities.

In Kratos Unmanned Systems business, our target drone programs performed substantially as expected in Q3, on schedule, on budget and in line with the expected ramps in production, including our large programs with the U.S. Navy, the U.S. Air Force and the U.S. Army. And we are expecting a particularly strong Q4 from our Unmanned Systems business based on current production and execution schedules. These under contract, long-term drone production programs are expected to be key future organic growth drivers for our company.

For Kratos' U.S. Navy SSAT program, we expect a solid Q4, and we expect significantly increased production quantities beginning in the second half of 2019 as we move from Low Rate Initial Production 1 or LRIP 1 to LRIP 2 then to LRIP 3 and then even greater quantities beyond 2020, '21 as we achieve expected full rate SSAT production.

We are also continuing the ramp-up on our U.S. Army target drone programs with increased execution and quantities expected to begin in 2019.

We also expect increasing production with another under contract program beginning in the second half of 2019 as it transitions from LRIP to full-rate production over the next few years.

On our U.S. Air Force AFSAT program, we expect steady execution and production throughout 2019 as a result of AFSAT production year '14, which we recently received sole source, and we also received AFSAT production option years '15 and '16, also sole source, which we expect to execute on in 2020 and 2021.

Internationally, we have now completed negotiations and expect to receive a large new target drone system program award in the next few days with the potential value to Kratos of up to approximately $100 million over the expected

(technical difficulty)

performance. Initial exercises under this new contract award are expected to begin in mid-2019. We are also attracting a number of additional new international target drone programs, which we are hopeful of receiving over the next 18 to 24 months. In Q3, we also received increased funding on a next-generation unmanned aerial target drone programs we are under contract on.

With the global recapitalization of strategic weapon systems and the related requirement to test and evaluate these weapon systems with threat representative targets by the U.S. and our allies, we believe that Kratos' Unmanned Target Drone Systems business is well positioned for sustained future growth, with this business expected to move towards approximately $250 million in annual revenue over the next few years.

In Kratos' Tactical Drone business area, each program remains on schedule and on budget. Kratos' XQ-58A Valkyrie is currently going through ground safety checks and reviews, with initial flight scheduled to occur within a window we have in the next approximate 90 days. For security-related reasons, I cannot at this time provide any additional information on the specific Valkyrie flight timing. But needless to say, Kratos and our customers are extremely excited as we move towards the initial series of flight demonstrations of this long-range, high-performance strike UAS. Once the Valkyrie successfully executes its series of scheduled demonstration flights, we expect to receive initial unit orders later on in 2019.

For Kratos' Mako, we have completed negotiations on the next phase of this program with our customer set. We expect to be under contract by the end of the year, with the approximate value of this phase ultimately totaling an excess of $20 million to Kratos over an approximate 18-month period. This Mako contract phase has been delayed several months due to the gap and change in leadership at the DIU. But Mr. Michael Brown is now in place as the new DIU Head, and we expect to be rolling again shortly. As a result of this delay, once under contract, we expect our Mako program to begin ramping in Q3, Q4, 2019, continuing into the following year. We are also currently in negotiations with a separate customer for Mako, and we are hoping to be under contract in late 2019 as related to the fiscal 2020 DoD budget.

The Kratos Dynetics Gremlin program remains on schedule for a mid-2019 demonstration, and once successfully demonstrated, we expect initial orders later on in 2019.

As we reported on our last earnings call, Program F has successfully completed its initial under contract demonstration flight series, and additional contract demonstration flights for enhanced capabilities are now planned for the first half of 2019. Once all planned demonstration flights are successfully completed, we expect an initial Project F unit order late in 2019 or early the following year.

We can now also report to you that we expect Project Spartan, which has an extremely high-performance drone we have been working on, which is flying today to be under contract in Q2, Q3 of 2019 for initial demonstration flights.

We have also now begun initial discussions with the customer on what we internally and initially will call Project A and Project Z, with each of these UAS' also now flying today. Project A and Project Z are 2 new tactical system-related opportunities we have been working on for some time now. And we are expected to continue to make progress on each of these going forward, with hopes through an initial contract award late in 2019 or early the following year, also as related to the 2020 budget.

Just last week, we held a facility ribbon-cutting for our new high-performance drone manufacturing site in Oklahoma City. Chairman of the Armed Services Committee, Senator Inhofe, was in attendance as was Congressman Steve Russell, the Governor of Oklahoma, the Mayor of Oklahoma City and many other Oklahoma representatives. I need to specifically mention Oklahoma Governor, Mary Fallin, who has been just an outstanding supporter of Kratos and an advocate for her state. And what we have done and will be doing in Oklahoma would not have occurred without Governor Fallin's leadership, her vision, her encouragement and the support of her entire staff. And we truly thank her for this.

We are tracking for the first Kratos UAS to come off the Oklahoma line in early 2019.

Additionally, and very importantly, we are close to executing a lease on another large, new drone manufacturing facility, which will require custom build-out over the next several months for security-related reasons related to a new tactical program we have recently been successful on, Program [Fanatose], which is expected to have a material financial impact to Kratos beginning in 2020. Due to the restricted nature of this new Kratos program, we are unable to provide any further details at this time.

There have recently been a number of recent publications, which discussed the future of unmanned combat aerial drones, drone swarms, manned/unmanned teaming, including a Barron's article this past weekend, all of which I encourage you to review as I believe these will help frame up the size of the high-performance tactical drone opportunity we are pursuing, which is extremely large, exciting, and it is happening.

As I have just summarized, we expect the next approximate 15 months to be very important for Kratos' tactical drone business, with several important milestones scheduled, with initial orders expected late in 2019 or 2020 and meaningful revenue, profit and cash flow from this business currently forecast to begin in 2020.

We are convinced that Kratos has the right drones at the right time at the right affordable cost to be the leader in the new and forecasted high-growth tactical drone market. And we can literally see the momentum building for high-performance, affordable tactical unmanned aerial drone systems over the past several months.

Kratos Satellite Communication business had a solid third quarter and is expected to have an even stronger Q4, with the space in satellite area of the DoD budget seeing some of the largest increases due to the current threat environment. As you know, the nature of Kratos' Satellite business programs, execution and schedules and the government's fiscal year funding flows result in Kratos' calendar Q3 and our Q4 financial performance for this business to be stronger than our calendar Q1 and Q2. And we are seeing this trend again in 2018, with, as I mentioned, Q4 looking to be particularly strong. And we currently expect to see this trend continue in the future.

Major space programs Kratos supports include WGS, AEHF, SBIRS, MOUS and GPS.

Kratos' Training Systems business continued solid performance in Q3, which is expected to continue in Q4 and in the next year as a result of major program wins we have received, including MCAT, AVET/NATS, KC-46 and RSN/FMS.

Kratos' Microwave Electronics business, similar to prior years, is expected to have a particularly strong Q4 as we execute, complete and deliver on multiple under contract programs. Programs Kratos' Microwave Electronics business support included F-15, F-16, Gripen, BARAK, Arrow, Iron Dome and Magic Wand.

Kratos' Rocket Support and Ballistic Missile Targets business also had a solid Q3 as we execute on a number of missile defense-related programs. Since we last spoke with you, Kratos' ballistic missile targets had, had a number of successful missile defense-related missions, including intercepts, certain of which have been highly publicized, including a video of Kratos' BMD targets systems in action. I encourage you to take a look at these videos.

We are currently tracking multiple, new missile defense-related opportunities, which, if we are successful receiving, are expected to be important contributors to Kratos' growth and financial performance beginning in Q3, Q4 of '19.

In our Rocket Support business, we are also pursuing certain hypersonic opportunities, which we are hopeful of being successful on and receiving new contract awards in Q2 and Q3 of next year.

Similar to Kratos' Unmanned Aerial Drone System business and our BMD targets and Hypersonic business, Kratos' competitive differentiators include our intellectual property or proprietary system positioning, our prudent ability to rapidly develop, demonstrate and field technologically advanced systems all in affordable cost.

Kratos' C5ISR Modular Systems business had a particularly strong Q3, also driven by the global recapitalization of strategic weapon systems, and 2019 is currently shaping up to be another solid year based on our current bid proposal on opportunity pipeline. Major programs Kratos' C5ISR business supports includes Patriot, FAAD, CBRNE, SBIRS, SHORAD and CPP. As we mentioned on the last quarter's call, in Q3, we exited our Modular Systems division's non-C5ISR business, closed the facility and reduced staff in order to increase profit margins and cash flow, which will result in reduced revenues in Q3 and Q4 2018 but in higher-margin rates.

In Kratos' Traditional Government Services business, we've recently received an approximate $60 million 5-year radar system contract award, which we expect to begin ramping in Q2, Q3 of '19. This recent contract award is expected to help stabilize this business, which, as you know, has been declining over the past several quarters.

Related to Kratos' plan to deemphasize or not accept lower margin contracts are contracts with unacceptable payment terms. There are 2 specific recent instances where Kratos could have executed these contracts months ago. But certain terms were not acceptable, and as a result, we were not willing to move forward. One of these is now under contract. And the other, we have just reached agreement on and expect to be under contract by the end of this year. Having ultimately reached terms on both of these were acceptable to our company. The delays in contract award on these 2 large programs will impact Kratos' Q4 revenue slightly and our Q1 '19 due to the related delays in execution, but we are forecasting to be caught back up and on the original plan for these programs by Q2, Q3 next year.

The global threat environment, including peer and near peer threats, is increasing. And as a result, the recapitalization of strategic weapon systems by the U.S. and our allies to deal with these threats, as I have mentioned before, is underway. Kratos' core businesses include Unmanned Aerial Drone Systems, Satellite Communications, Training Systems, C5ISR Systems and Microwave Electronics. And they are well positioned for this environment in addressing these threats.

Additionally, Kratos is recognized as the affordable alternative system provider in our core business areas, and affordability does and will continue to matter and be a competitive differentiator for Kratos, and our customers routinely communicate this to us.

Kratos is on a solid and, we believe, sustainable organic revenue profit and cash flow growth trajectory as a result of the investments we have previously made, which are now substantially complete, the long-term under contract programs we have successfully received over the past several years as a result of these investments and that we expect to continue to receive going forward.

We want to thank our employees, customers and all of our stakeholders in being instrumental in building Kratos into the company that it is today.

Deanna?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. - Executive VP & CFO [4]

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Thank you, Eric.

Kratos' third quarter 2018 revenues of $159.4 million, up 1.5% from third quarter '17 revenues of $157.1 million, were at the upper end of the range of our estimate of $150 million to $160 million. And our adjusted EBITDA of $16.7 million or 10.5% adjusted EBITDA margin exceeded our forecast of $12 million to $14 million. Additionally, Kratos' adjusted EPS of $0.08 per share also exceeded our forecast of $0.02 to $0.04 per share for the quarter.

Our third quarter year-over-year consolidated organic revenue growth was driven by growth of 9.2% in our KGS segment, primarily reflecting demand in our Satellite Communications and Training Systems businesses. Revenues in our Unmanned Systems segment reflected the current year expected production schedule, which was down 20% from the prior year due to the timing of the production ramp, which occurred in the third quarter of 2017 and which included the initiation of Low-Rate Initial Production of our SSAT aerial target and in international target program. As Eric mentioned earlier, we expect the production ramp in the fourth quarter to increase in our Unmanned Systems segment and our full year 2018 Unmanned Systems revenues to be substantially greater than the prior year.

In the third quarter, KGS generated revenues of $126.1 million, adjusted EBITDA of $14.1 million and operating income of $11 million, all which were up from the prior year comparable revenues of $115.5 million, adjusted EBITDA of $6.4 million and operating income of $1.4 million, reflecting the growth primarily in the Satellite Communications and Training Systems businesses as well as margin improvement in our Modular Systems business.

From an accounting standpoint, Kratos was required to adopt a new revenue recognition practice beginning January 1 of this year, which can affect the timing of revenue recognition for certain contracts. The impact of this new accounting standard was approximately $5.3 million on Kratos' third quarter 2018 revenues.

Operating income of $10.1 million in the third quarter of '18 increased year-over-year from $100,000 in the third quarter of '17, an increase sequentially from $2.6 million in the second quarter of 2018. These improvements were driven by a more favorable mix of revenues, which positively impacted gross margins, with margins increasing to 27.7% in the third quarter of '18 from 23.7% in the third quarter of '17 and includes the deemphasis of lower-margin opportunities that Eric mentioned previously. The increase in gross margins was accompanied with the reduction of SG&A expenses, reflecting the impact of cost reduction actions we have taken.

On a year-over-year basis, our Q3 '18 adjusted EBITDA increased 47.8% or $5.4 million from $11.3 million in the third quarter of '17 up to $16.7 million in the third quarter of '18. Our adjusted EBITDA for the third quarter is from continuing operations and excludes noncash stock compensation costs of $1.7 million and severance-related costs of $100,000.

On a GAAP basis, net income for the third quarter was $1.7 million, which includes income from discontinued operations of $300,000 and includes a tax provision of $3.4 million, primarily reflecting tax expense for foreign jurisdictions and for states for which we cannot utilize our NOLs. As mentioned on our previous call, we currently expect to recognize an approximate net breakeven position on the sale of PSS after current estimates of working capital adjustments, changes in retained net assets or other adjustments. Any future changes to the working capital adjustments or the retained net assets and the completion of those related projects will be selected in those future periods.

Moving on to the balance sheet and liquidity. Our cash balance was $187.2 million plus $300,000 in restricted cash at September 30. At quarter-end, we had 0 amount outstanding on our bank line of credit and $5.3 million of letters of credit outstanding. Debt outstanding was $294 million at quarter-end, and net debt was $106.5 million. Our LTM, or last 12-month, adjusted EBITDA was $58.4 million with a net leverage ratio of 1.82 to 1. Cash flow generated from continuing operations for the third quarter was $14 million, which includes the use of approximately $1.4 million of internal noncapital expense related to development cost related to the LCASD program.

Capital expenditures were $6.9 million, including approximately $3.7 million related to the Unmanned Systems division, primarily reflecting the 2 LCASD Kratos-owned aircraft and related equipment that we are building, and we expect this capital effort to be substantially complete in the fourth quarter this year.

Our free cash flow from operations for the quarter was $7.1 million, reflecting the $14 million of cash flow generated from operations, less the capital expenditures of $6.9 million. After reflecting the final payment of $2.9 million for acquired satellite communications technology, free cash flow was approximately $3.2 million.

On accounts receivable. DSOs decreased from 137 days at the end of the second quarter to 129 days at the end of the third quarter as certain of the milestone payments we were expecting were collected during the quarter. Our DSOs include long-term delivery projects, where we invoice amounts at the completion of certain milestones and/or final delivery of products, and we are forecasting a number of billing milestones to be achieved and paid upon completion of contractual milestones in the fourth quarter of the year.

Our contract mix for the quarter was 84% of revenues generated from fixed price contracts, 11% from cost plus fixed fee contracts and 5% generated from time and material contracts. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 76%, including revenues generated from contracts with the DoD, non-DoD federal government agencies and FMS or foreign military sales contracts. We generated 8% from commercial customers and 16% from foreign customers.

Backlog at third quarter-end was $571.7 million, with $528.1 million funded and $43.6 million unfunded. And our book-to-bill ratio was 1.4 to 1 for the third quarter and 1 to 1 for the last 12 months ended September 30.

Today, we are providing fourth quarter revenue guidance of $182 million to $192 million, adjusted EBITDA guidance of $13 million to $17 million and adjusted EPS guidance of $0.03 to [$0.07] per share. (Sic-see press release "$0.06") We are adjusting Kratos' full year 2018 revenue guidance to $635 million to $645 million and adjusted EBITDA to $56 million to $60 million and adjusted EPS guidance to $0.18 to $0.21 per share. We expect operating cash flow for the fourth quarter to be in the range of $12 million to $22 million, with capital expenditures in the range of $4 million to $8 million and free cash flow from operations of $8 million to $14 million for the fourth quarter. For full year 2018, we expect our capital expenditures to be in the range of $22 million to $25 million for FY '18, with approximately $13 million to $16 million related to our Unmanned Systems business.

We expect our estimated cash taxes to be approximately $2.5 million to $3.5 million for FY '18 and expect the impact of tax reform to be fairly insignificant to our estimated cash taxes due to our over $330 million net operating loss positions.

We are adjusting our full year cash flow from operations guidance to reflect a delay in the expected collection of net working capital proceeds of the PSS business retained by Kratos, which we now expect in the first half of 2019 adjusted to $27 million to $37 million and free cash flow of $5 million to $12 million for the year.

Consistent with our past practice, we will be providing Kratos' 2019 financial guidance, along with our Q4 and full year 2018 report. When we do provide our initial 2019 guidance, we expect revenue, adjusted EBITDA, cash flow and EPS to all be significantly increased over 2018 as Kratos' organic growth trajectory continues and as we expect Kratos' 2019 quarterly trajectory to be similar to 2018, with Q1 being the lowest and similar to what we guided to for Q1 '18, with Q2, Q3 and Q4 of '19 each increasing and being significantly higher than Q1.

Eric?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [5]

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Thank you, Deanna.

We'll now turn it back over to the moderator for any questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) First question that I have is from Ken Herbert of Canaccord.

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Kenneth George Herbert, Canaccord Genuity Limited, Research Division - MD and Senior Aerospace & Defense Analyst [2]

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Yes, I just wanted to first -- Eric, you went through a number of new potential programs on the tactical side. Just a high-level question. As you look at some of the increase sort of -- you cautioned around what the ultimate fiscal '20 defense budget could like. I know it's a fairly tight range. But have you seen any sort of incremental risk to timing on Project A, Z, Spartan or any other new contracts or maybe the existing portfolio with the -- with sort of the increased concern around how fiscal '20 could ultimately look in terms of defense spending?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [3]

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We are actually seeing an increased interest across the board because of the affordability of the drones. And also, Ken, as you know, our drones, they're leading edge. They're not bleeding edge. And the fact that they're leading edge, they're proven. For the most part, they're flying today or what else what we're doing are derivatives of what we're flying today. It significantly reduces risks and schedule in our customers' mind, which also obviously ties into cost and affordability. And so we are seeing things accelerate, and we are seeing the expectations for those outyears accelerate as our customers want quantities deployed, quantities of weapons deployed.

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Kenneth George Herbert, Canaccord Genuity Limited, Research Division - MD and Senior Aerospace & Defense Analyst [4]

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And I know your overall sort of bid pipeline has grown. But can you provide any sort of additional detail on the new tactical opportunities, just even at a high level in terms of the potential revenue upside?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [5]

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The -- Ken, if one believes that 2, 3, 4, 5 years from now there will be high-performance manned -- unmanned drones accompanying the manned aircraft, which I do and which is why I encourage people to look at some of the articles I mentioned, this is happening, and it is happening in a big way. And the ones I can talk about, I'm talking about. The other ones for the last couple of years, as you know, we've been shut down on a lot of information. It is happening, and we believe this is going to be substantially bigger than our Targets business. And you heard what I said about that today, and that is growing very rapidly, and it's going to continue to address the global threats on the exercise weapon systems.

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Kenneth George Herbert, Canaccord Genuity Limited, Research Division - MD and Senior Aerospace & Defense Analyst [6]

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Okay. Great. That's helpful. And just one final one, Deanna. The reduction in the free cash flow guide this year, about $7 million, is that all attributable to the working capital proceeds sort of delay on receipt there? Or is there anything else going on?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. - Executive VP & CFO [7]

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Yes. It's all attributed to that, and we originally expected it in the fourth quarter. It's now moving to this first half of '19.

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Operator [8]

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Next question is coming from Mike Crawford of FBR.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [9]

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B. Riley FBR. So Eric, you mentioned this other new tactical program that will result in new building, yet another new production facility. And I think you said there will be a material impact in 2020. Without going into details of that program, can you talk about what sort of investment we might expect in that, given the way that you've retained proprietary data rights to things like the Valkyrie?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [10]

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Yes. So first, Mike, look -- and thanks for this question so I can clarify. This was a leased facility, and so there will not be a capital outlay for the facility. The internal build-out of it will not be substantive. This is not millions and millions of dollars. It will not be substantive. The fact that we're under contract, a good portion of that will be covered. And I really -- I cannot get into anything on data rights and IP on this. I'm sorry.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [11]

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Okay. That's fine. Then -- it's nice to hear that you -- in your initial thoughts on 2019 in revenue, cash flow, EPS, all to be up significantly, I think, was the adverb being used. But do you expect bookings to grow perhaps more quickly than the other metrics given Gremlins and potential Valkyrie orders and depending on when Project F comes in. And then 2020 would be seeing revenue growth acceleration?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [12]

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Yes. Because all of those bookings would be incremental, so it's a new business area. So yes, absolutely.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [13]

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And then 2021 would be margin expansion, right? Because right now, you -- I think at double-digit margins on your AFSAT. But let's say on SSAT, in which more like it'd take you a couple of years to get up to that level?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [14]

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That's correct. We expect to see margin expansion continuing into next year as production levels increase on the target drones, then we see them increasing more the following year as we reach full-rate production, for example on SSAT and on other program we have. And then layer on top of that, if we're successful in the initial production runs on some of these tactical programs and the leverage we expect to get on the fixed overheads and the fixed manufacturing facilities, we -- our model is even increased margins after that.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division - Senior MD, Co-Head of The Discovery Group & Senior Analyst [15]

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Okay. And then final question would be the relative margin potential between targets and the tactical drones, are they the same or different?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [16]

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The -- so the domestic targets and the tactical drones are about the same. Our international target margin opportunities are much, much higher on the international ones. Other than the Mako, which has been approved internationally in certain areas, I do not believe there will be any international opportunity for any of our other tactical systems.

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Operator [17]

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The next question comes from Michael Ciarmoli of SunTrust.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [18]

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Eric, maybe just on the tactical side. So we now have Program A, Z, F, Spartan, Valkyrie, Mako, I think the other one you said was, correct me if I'm right, [Fanatose]. But I mean we've got so many different variants right now. It's -- I guess the technology is still in the proof-of-concept phase here. What -- can you maybe articulate or elaborate what the key difference is between all these systems, and as you guys are looking at maybe assigning probabilities of what goes and what doesn't go? I mean can you give us any sense of just sort of why you're seeing all these different programs, maybe what the subtle differences are in the platforms?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [19]

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Sure. The plan might be -- I think the base premise on why we're being successful is the base technology of the target drone is proven. It's flying today. It's low cost, and they're already built to be attritable because target drones are inherently built to be shot down. And as you know, the performance of our target drones are -- they represent, like on the aircraft side, 4.5 generation threats, so like an F-15 or F-18 Super Hornet or an Su-35, for example. And so they have the flight and the performance envelopes that are equal to or better than manned aircrafts, and they're low cost. To your -- now specifically to your question, as I mentioned briefly, these are not bleeding edge. They're leading edge, and they're proven, which reduces risk. It reduces schedule. Because they're affordable, they can be obtained in quantity. And that old acronym back in World War II quantity has a quality all of its own is really coming back home right now, where there is a deemphasis on strategic, exquisite systems that are very capable, but they're very expensive, and they make great, big juicy targets and [distributedly valid ESP]. Because as you know, many of the powers to be in the Pentagon, there will be no sanctuary in a peer-and-peer confrontation. I think all of that is trending in our favor here. All of it. It's trending in our favor. These are not PowerPoint presentations. They're flying, and there are just minor tweaks, 2 things you make to turn a target drone, and now I'm coming to that part of your question, into an unmanned aerial tactical drone or to turn a target drone into something else.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [20]

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So what's the difference between Program A and Z? I mean is it -- are we talking size? Is it range? Is it payload capability? I'm just trying to understand why customers are asking for different variants when you've already got another variant flying?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [21]

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So certain of our target drones can carry a 600 pound payload, and they can carry it for 3 or 4 hours depending on the mission profile. And certain other ones carry a substantially less payload, could still be a very lethal payload. But they're much smaller, which means maybe they would be much harder to identify and pick up. And certain other target drones that we make, the 167 for example, represents fighters. So its peak performance is at 40,000, 50,000, 60,000 feet. Where the Navy target drone, it to represents cruise missiles, the most sophisticated cruise missiles in the world, and its peak performance is known as 10 feet.

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Operator [22]

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The next question is coming from Sheila Kahyaoglu of Jefferies.

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Gregory Arnold Konrad, Jefferies LLC, Research Division - Equity Analyst [23]

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It's actually Greg Konrad on for Sheila. Just to follow up on the last question. You mentioned a number of international opportunities in unmanned, and I know there's been an effort to streamline the sales process. Is there any way to maybe size the international opportunities? I'm assuming some of these systems are probably not exportable?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [24]

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Right. And so you're -- right, you're talking about the tactical side only or both target and tactical?

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Gregory Arnold Konrad, Jefferies LLC, Research Division - Equity Analyst [25]

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Both target and tactical.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [26]

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Okay. So on the target side, we -- the variance that we still have to be modified and have to be ITAR approved, and it has to be country-specific. The -- in the free world, the largest target drone users in the world are the U.S. Navy, the U.S. Air Force and the U.S. Army. And as you know, those are all of our customers. Then after that, for example, there's the U.K. Ministry of Defense. And as you know, a little while ago, we announced that we are working through [Kinetic], our partner. We are now supplying target drones to the U.K. Ministry of Defense. There is another very large one, the one that I referred to in my prepared remarks, where eminently I believe we're going to be able to announce up to $100 billion contract, the potential of this. And once we announce this, you'll understand the dynamics of this user. There are a couple other -- a -- let's say a handful of other midsized target users in the U.S. -- excuse me, internationally that we are pursuing in addition to the ones that we have that I believe we're going to be successful on in the next 24 months because these customers are buying U.S. weapon systems, and they're not planning on shooting down little drones that ISIS is flowing around. They're planning on having to engage peer or near peer threats with their weapon systems, their missiles systems, their radar systems, and they want to exercise those systems against the most threat-represented target drones in the world. And Krato is, by far, the leader there, by far. It's not close. No one's close. On the tactical side, as I mentioned, we've been approved in a number of countries just over a handful for our Mako to market our Mako. Okay? I know and I know you know is that the rules are changing, the cruise missile rule. The law is changing, and there are things going on with one of the treaties relative to the intermediate and medium-range missiles. Irrespective of that, I do not see right now a large, if a large at all market, internationally for our tactical drones other than Mako. I do not believe that we will be allowed to go there.

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Gregory Arnold Konrad, Jefferies LLC, Research Division - Equity Analyst [27]

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That's really helpful. And then on KGS, you had really strong margins in the quarter. I mean was there any type of gain or a onetime item? Or how should we think about the trajectory of profit for that business?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [28]

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So the nature of that business is we have the satellite business, and we have the C5ISR business, the combat system business. And as you also know, we do software. We do cyber products, cyber warfare products. And then in there, we have the services business. So we have a different margin mix of the different businesses in there, okay? The mix in there in Q3 was very favorable. Q4 is looking really favorable right -- really favorable right now based on what the customers are demanding, and that may very well continue into next year. So it's a mix issue. And as you know, our services business has shrunk and come down substantially, and that's where the lowest margins are. And we did win this radar contract, but not by design, but the mix has been becoming more and more favorable as the services business contracts.

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Gregory Arnold Konrad, Jefferies LLC, Research Division - Equity Analyst [29]

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And then just one bigger picture question. I mean it's been a while, but I mean obviously, leverage is down to 1.8. I mean you built up a nice cash stockpile on the balance sheet. You talked about a lot of investment starting to come down. I mean how should we think about capital deployment going forward? And I guess bigger picture, I mean, what are you going to do with the cash?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [30]

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Our #1 opportunity or use for that cash is we fully expect over the next 12 to 15 months to continue to win production contracts at our drone area, and some of these are looking really, really big once -- as we continue to do the demonstration flights and demonstrate the systems. We want to be sure we have the adequate working capital on hand to both psychologically address with our customers and financially address the programs. Let's assume that we went 5, 6, 7 of these over the next 15 months. We don't want to be getting up to do anything. We want to have the liquidity on hand to execute these as we are.

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Operator [31]

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Next question is coming from Seth Seifman of JPMorgan.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [32]

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So I was -- wanted to start off just asking a question about the model. And it looks like based on the guidance, the EBITDA dollars that we'll see in the fourth quarter will be kind of flattish to maybe slightly down from Q3, even though revenues are going to be significantly higher. And you just mentioned the favorable mix in KGS. So how do we think about that progression? And why there wouldn't be more drop-through on the higher revenue in the fourth quarter?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [33]

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We are doing everything that we can, and we talked about this a couple of 3 quarters ago, that we want to meet or preferably exceed our expectations. And we are focused on that. And so if everything turns out on the high end of everything, maybe we'll do better than that.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [34]

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All right. Okay. And then just -- I guess you mentioned that things were going to -- according to plan on the target side, so definitely appreciated that. And we've had a lot of questions about new tactical opportunities. But like in the near term, the important thing is kind of to execute on the target drones, the programs' record, and you've got a new facility starting off shortly to do that. And maybe talk about a little more color on your level of confidence that, that's going to bring about the kind of EBITDA that you're looking for, and at the -- on the industrialization side, that everything is all ready for these new levels of production that you're looking for.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [35]

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This is on the target side?

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [36]

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Yes.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [37]

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Yes. So we -- as we -- if you refer back to what we've said that our Sacramento facility, right around at the end of '19, will be full up on the target side. The Oklahoma facility is underway. The equipment has been ordered. It's en route. We expect to initially start producing drones there Q1, and we expect a significant increase or ramp in the drones coming out of that facility in Q3, Q4. So it is fully up and capable by the beginning of '20 at which time the Sacramento facility would be at or near capacity. So we are time phasing and sequencing this facility in, and it is a modular or scalable facility. And to Mike's question a little -- Mr. Ciarmoli's question a few minutes ago, a number of the tactical systems, a substantial amount of that aircraft is very similar to the target system. And so our Oklahoma facility is intended to be at least initially the primary provider of most of our tactical drones. Now as I mentioned today, there are certain tactical drones that cannot be built at that facility for security reasons. They are going to be built at another facility, one of which we're going to be executing at least on in the next couple of 3 weeks and have that one ready middle of next year.

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Operator [38]

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(Operator Instructions) The next question is coming from Joe Gomes of NOBLE Capital.

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Joseph Anthony Gomes, NOBLE Capital Markets, Inc., Research Division - Senior Generalist Analyst [39]

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Most have been answered here. But -- and mostly to some of the calls here or a number of companies in the space, there has been some discussion about the employee situation, a bit about getting accessible numbers of employees in there. It's now a somewhat of a challenge. I just wanted to -- how you guys are -- if that's impacting you at all. And if so, how are you dealing with it?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [40]

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That is actually a very intuitive and a great question. We have been and we remain very, very focused on the human capital side and the human resources side, and in particular where the programs are restricted or they're classified and getting the appropriate people for those programs. It is -- we are not running into any significant challenges yet. We're fortunate in where some of our locations are and some of the dynamics that have happened in those locations that have freed up people from other companies, that haven't been successful on things, and these people are qualified to work on some of these programs. This was one of the reasons that we selected Oklahoma because we did a significant study on the human resource pool there and the type of person and can they get cleared, can these people get cleared, et cetera. And that's one of the primary reasons we went there. And on this other facility, obviously, I can't say where it is. But if I could, you'd understand. That's a good spot for this because those are the types of people that have this expertise and that they can get cleared. So we're trying to be as thoughtful and methodical about it as possible. But I don't want to leave the impression on you that this is easy. It's a challenge, and we've got to stay focused on it, and we've got to stay ahead of it.

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Operator [41]

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Ladies and gentlemen, this concludes the Q&A session. I would like to turn the call back over to Mr. Eric DeMarco for closing remarks.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. - CEO, President & Director [42]

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Great. Thank you all for joining us today. We look forward to our next regularly scheduled time to get together. We'll be, as Deanna mentioned, when we report Q4 and when we give our initial '19 guidance at the beginning of next year. Thank you.

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Operator [43]

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Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.