Good day, ladies and gentlemen, and welcome to your Kratos Defense & Security Second Quarter 2013 Earnings Conference Call. [Operator Instructions] I would now like to introduce your host for today's conference, Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary. Deborah, please go ahead.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Second Quarter Conference Call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer. Before we begin the substance of today's call, I'd like to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos corporate website at www.kratosdefense.com. It is also available on the SEC's website. Additionally, I'd like to remind our listeners that this conference call is open to the media, and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the company's website later today. During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance and the potential impact of sequestration and the constraints on the federal budget, constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including those found in the Risk Factors section of our annual report on Form 10-K, and our Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including our annual report on Form 10-K, and any of our other SEC filings for a more complete description of these risks. All forward-looking statements are qualified in their entirety by this cautionary statement, and we undertake no obligation to…

Great. Thank you, Deborah. Today's announcement regarding Vice Admiral Gerry Beaman joining our company is an important milestone in the execution of our strategy in building a leading technology and product-based national security company. Admiral Beaman is President of Kratos' newly established unmanned combat aerial systems, or UCAS, division and Senior Vice President of our Strategic Programs. We believe that Vice Admiral Beaman's decision to join the company is continued confirmation of Kratos' strategy, our UCAS initiative, our belief that the future of aerial combat will be dominated by low-cost, unmanned composite aircraft, the capabilities and performance characteristics of our platforms and the significant investment we are making in this area. With the formation of our UCAS division, we will also now have a separate Advanced Drones & Target Systems division, led by Wayne Armstrong. Wayne has approximately 25 years experience with aerial drones and target systems. And this reorganization will allow Wayne and Kratos to specifically focus on our critically important aerial target customers, the United States Navy and the Air Force. Additionally, Tom Mills, previously President of our Gichner Business Group, will now be President of Kratos' Modular Systems division, with major programs supported, included Aegis, Patriot, THAAD, the Electromagnetic Railgun, Littoral Combat Ship, DDG 1000 and work with certain other agencies. Related to the formation of our UCAS and ADTS divisions and our long-term strategy, we also announced today that we will be further increasing our internal investments in the unmanned system and drone area by at least an additional $5 million over the balance of this year. This investment, which includes additional aircraft flight tests, also includes investment related to a specific customer platform and opportunity, with this customer being one of the most important to our entire company and our long-term strategic plan. In summary,…

Thank you, Eric. Good afternoon. Our second quarter revenues of $235.2 million came in at the high end of our expected range of $230 million to $235 million, due in part to stronger demand in our Public Safety business and our Satellite Communications business. Our revenues increased year-over-year 7% from $219.8 million in the second quarter of 2012, reflecting the contribution from CEI as well as organic growth of 17.5% in our Public Safety and critical infrastructure business. These increases were partially offset by the timing of shipments in our Specialty Ground Equipment business and Electronic Warfare Products business and by continued compression in our Legacy Services business, which contracted an additional 16.7% compared to the second quarter of 2012. However, the Legacy Services business remained fairly stable on a sequential basis compared to the first quarter of 2013, with a 1.3% reduction sequentially. From an annual run rate perspective, our Legacy Services business is currently operating at approximately $88 million, down from approximately $100 million for fiscal 2012. Our adjusted EBITDA of $24.6 million for the second quarter is from continuing operations and excludes restructuring and acquisition-related items of a $100,000 net credit and stock compensation costs of $2 million. The $100,000 credit in net restructuring and acquisition-related items are comprised of the following items: One, the net reduction of a $2.7 million litigation accrual, resulting from the completion of a litigation matter assumed in the Integral acquisition, which is net of $400,000 of litigation costs related to another litigation matter, related to a prior acquisition; two, $1.9 million in costs related to restructuring activities, related to excess capacity and overhead costs and other cost reduction activities; three, $600,000 related to non-recurring audit fees associated with a change we recently made in external auditors; and four, $100,000 of acquisition-related…

Thank you, Deanna. With that, we'll turn it over to the operator and open it up to questions.

[Operator Instructions] Our first question comes from the line of Mike Crawford of Riley and Company.

Mike Crawford from B. Riley. My first question is, what is it that Admiral Beaman sees in Kratos? That seems to be quite a coup to land an executive of that caliber for your company?

We believe, with the transition and the transformation that's going on in the national security environment right now, and the opportunity there is for disruptive technologies that have high capability, high performance that can address certain missions at a reasonable cost, he sees that out -- opportunity out there and he sees the capabilities that Kratos has. And he believes that he can make a significant personal and professional impact on the company and its valuation.

Okay, all right. And then, you'd mentioned references to a customer for this UCAS division. Is that a potential customer or is that a landed customer?

cannot talk about that, Mike, in any way.

Switching gears. Another reference you made, regarding the use of radars for the F-16s, you've referred to the Saber radar as your -- as our radar. Is that -- I thought that's Northrop Grumman?

Yes, if I did, I misspoke. It's Northrop's, and we are a key critical partner to Northrop Grumman.

Supplying what Herley components?

We're -- it's [indiscernible] early and all -- we are under an NDA, Mike. But we are a key partner with Northrop Grumman on their radar.

Last question is on the NGJ. So Raytheon won the award, EADS is protesting it. Is that something that you -- and you said that could be one of the largest programs for the company. Are you expecting to get revenues from that this year? Or is that more reflective of potential future upside?

It's -- so, you're right. There was a protest filed. There's been a stop work issued to Raytheon. Today, the U.S. Senate came out, and in addition to the stop work and the protest, the Senate said that maybe there should be 2 winners and not just 1. So there's -- in my opinion, there is nothing in here for 2013. Nothing. This is -- it's too bad. This is what happens on these major initiatives. But we are extremely well positioned, and the fact of the matter is, this program is going to move forward at some point.

Our next question comes from the line of John Nelson of the State of Wisconsin.

Questions, my questions on -- are on -- the PSS area showed nice increase in margins. And could you discuss briefly the margin potential there, and also why are the margins increasing, because you're getting efficiencies from learning how to do this better, versus just the scale increasing over time?

John, this is Deanna. So from an efficiency perspective, I think it's mostly related to some cost reduction actions we have taken, which we discussed on the first quarter call. So we -- we're seeing the benefit -- the partial benefit of some of those reduction actions that we took in the second quarter. So we do expect, as Eric had said, that trajectory on the EBITDA margins to improve over the second half and for the second half operating margins to exceed the first half, because both of the internal growth that we expect to continue to see, as well as more importantly, the efficiencies of the cost reduction actions we've taken in operational efficiencies.

And John, as the revenue increases, we expect to see leverage on the G&A, where the G&A will not increase proportionately to the revenue, which will also help margin expansion.

Okay, good. Are the -- does it seem like in the PSS area that the decisions are getting -- also getting pushed out, and due to the sluggishness of the economy? Or are they actually getting accelerated because of the security concerns increasing?

John, they are actually accelerating. It's -- the threat profile in many of our verticals right now, in particular in the mass transit area, in the municipality area and in energy and energy transport, is significant. And as I indicated in my prepared remarks, there are a number of large bids that we are in the middle of going after, that are supposed to be awarded right now, in the first half of '14. And even putting those aside, the bid pipeline is as strong as it's ever been.

Okay, excellent. Also on the -- one more on the debt refinancing potential. Could you just explain briefly what kind of time period you'd be operating in, as far as when you'd be able to start working on that?

Sure, John. So as you may recall, the no-call list in June of 2014. So we are preparing the documents to be ready to refinance anytime between now and that time. And we're really watching a number of factors, one being, where the market conditions are, what the rates are that we're looking at, because there is a fairly substantial make whole payment. So the make whole payment is roughly today, about, just over -- a little over $50 million. And that does decrease about $5 million per month, until as we approach that June of '14 deadline. So we are looking at the various factors, from a market condition perspective, and when the right time would be to go. But it could be anytime between now and that June 2014 timeframe.

Okay, excellent. And then just one more, I -- in a mention on the press release of Vice Admiral Gerald Beaman, you mentioned under Tom Mills being named President of the Modular Systems division, Major Programs. One I hadn't seen -- or is the Electromagnetic Railgun, is that -- does that have the potential to be a really significant program for you in the future?

It does, John. But not in the near future, not in the next couple or 3 years. BAE was recently down selected in the competitive procurement with General Atomics. So BAE is -- system has been selected to move forward, so that now is moving forward out of Dahlgren, and moving into the next phase of development. The current thinking is that in a certain flight of the DDG-51s, that these would be integrated into the DDG-51, where the 5-inch gun goes. So it's moving ahead, it's very well funded. We are on this program in several different areas, but it will not be major for us in the near term.

Our next question comes from the line of Mark Jordan of Noble Financial.

Eric, the UCAS initiative that you have, is that based on a CEI platform?

Yes, sir, absolutely.

You said that you are increasing your R&D in the second quarter. If you look at least at the reported R&D line, it's been relatively flat. Are a lot of those expenditures being caught -- are being booked in cost of goods sold, but not in your R&D line?

Yes. And Mark, let me be very clear. We're increasing the investment. The big pieces of the investment are in the flight in the next 6 months or in the flight test area, a number of flight tests, where we have to lease our range. We have to bring our -- we bring our assets out and we fly them. And in non-recurring engineering, which would be in cost of sales versus SG&A.

And Mark, just to add to Eric's comment, the run rate of R&D at about $4.5 million to $4.8 million run rate in the current quarter, we do expect that to increase over the -- sequentially in the third and fourth quarter.

Okay. Question relative -- is there competition developing an alternative platform that you would be competing with, over time? And secondly, if you're successful this year in your demonstration flights, would it be logical to assume that the development cost would flip to be customer funded in 2014?

On your first question, no, not at this time, with effect of the system that we're aware of. And on the second part of your question, unclear, but I doubt it, Mark. I doubt it.

The 3 large PSS bids that are due to potentially be awarded in the first half of 2014, are those -- do you -- who is the competition that you have for those? I know in the past that you've talked that pricing on the initial phase has been pretty cutthroat, in that margins would expand typically as you get more add-ons? Would that be similar with these 3 opportunities?

At this point, we do not believe so. We do not believe so at this point. And Mark, very importantly, on your previous question, as we're funding it, and on the platforms that we're funding, we keep the IP.

Right. And as -- and so therefore, that would really move forward as a commercial -- in essence, a commercial product where, say, profit margins would not necessarily be bound by sort of government restrictions?

No. No, it would mean that, because there are TINA issues, truth in negotiation act issues, where it has to be a fair price to the government and the taxpayer. But it would -- it would insignificantly impede competition for that type of a platform.

Okay. Final question relative to sequestration. It's probably logical to believe that for -- we're going to be living in a CR world for an extended period of time, and sequestration, or a tight budget at least, will be there moving forward. Now we've seen some business, as you mentioned, being pushed out, that you would have expected in the first half of this year and to being received in the fourth quarter. Let's flip forward into fiscal year 2014. Do you think it is logical that, that continues? Or once you started to see a flow, do you think orders will tend to flow more normally after this initial period of freeze?

Mark, I'm with you. And right now, we believe that we're heading into another continuing resolution, which will be a continuing resolution on a continuing resolution, which is an appropriations bill. So I'm not exactly sure what that means, very candidly. I'm not sure. I believe that this year, '13, is, as Deanna alluded to, is going to be similar to '12, where the second half of the year, either Q3 or the Q4, or both, is going to be -- in this year, we're looking at Q4's going to be very, very strong, very strong as customers, right around the federal fiscal year of 9-30 are either spending everything that they've got left in front of 9-30 as they head into the new year, or they're going to obligate it, or commit it, and then we ship it in Q4. I think we're looking at the same thing in '14 right now. I don't see anything changing that, where customers, procurement officers, PEOs will hold it close to the vest, because they're unsure what's going to happen. I mean, look what just came out, it was either Monday or Friday, it was a letter from the Department of Defense to all the various agencies, get ready for a 20% office cut, and service contractors will go first. We're in products, so it won't impact us. But with stuff like that out there, people are going to be holding their money close to the vest until it gets to the end of the fiscal year. Then of course, they want to spend it all or obligate it all. So if they ask for that same amount or more the following year, not that they would get it, but no one will sit there and say, well you didn't spend what you had last year, you know what I mean? And so that's -- I think that's kind of the new norm, which is why, very similar to last year, we're looking at a strong second-half in this time the fourth quarter.

Our next question comes from the line of Sheila Kahyaoglu from Jefferies.

In terms of my first question, I mean, revenues grew 7% in the quarter, but SG&A was up double digits. Can you give us a little bit more color on where you are, Eric, with integrating CEI, and maybe how that's factoring to the higher SG&A costs?

Right. Let me -- I'm going to have Deanna comment on more of the details on SG&A first. And then I'll touch on the integration.

Yes, and so, Sheila, there's a couple of things that are impacting SG&A. One, the comments that I made in my prepared remarks regarding the investments that -- or the additional costs that we're incurring related to IT, security and network costs and security. So that's a fairly substantial increase year-over-year, just because of the -- to address the perceived threat from a cyber perspective. That's 1 piece. And we had the audit fees, the non-recurring audit fees that occurred during this quarter related to our change in auditors from Grant Thornton to Deloitte. There were some fairly sizable onetime fees that were a result of that departure. So those are 2 of the items I can comment on, specifically.

Yes, and Sheila, as we talked about in Q4 and in Q1, we have been focusing our IR&D not only in the UAS area, but in the electronic warfare area and the MILSATCOM area.

I got it. And in terms of some of your recent wins, whether it's the FMS order to Iraq and the missile systems that you might provide there, or the F-16 radar modernization, where you're supporting Northrop, can you talk about, when you expect some of them to materialize into revenues. I know some of -- the F-16 MOD might be further out, but just to give us some idea.

Right. So let's go down a few of these. So APR-39 is under contract and it's contributing now, and that is expected to increase contribution next year and then, at this time, significantly increase contribution in 2015. P-8 is just entering full rate production. As I mentioned in my prepared remarks, Boeing just received its -- an order for an additional 13 aircraft. We have not received ours yet, but we expect to, by the end of the year, which will start contributing in 2014. That is very similar with Hawkeye and their recent order. That should start contributing in 2014. As I mentioned on next-gen jammer, unclear, completely unclear to me, especially after what the Senate came out with today, okay. On the radar, I don't want to get into the details on that right now, but that could be very promising for us. I'll put that more out in late '14 or '15. That's -- I think those are the major ones.

Got it. And then just one final one on PSS margins, you expect them to increase in the second half. Is it -- and I know somebody asked this earlier on. But is it because of the add-ons? Or is it -- the pricing is a little bit more favorable? I wasn't quite sure on that.

It's primarily the result of cost reduction actions we took after the first quarter. If you recall, we made some strategic decisions to go after and bid on some very large procurements which we won. And we had to bid aggressively. We got those in, and as we talked about in Q1, we had to understand the lay of the land, how those were going to play out, how that deployment was going to look. And we have taken some significant cost rationalization steps that the impact of that will be full -- begin to be fully realized in Q3 and Q4, because we took those in Q2. And then -- and the vast majority of the bids that we've been winning in the past quarter have been at a more normalized profit rate, where we did not have, I'll just say, some very aggressive competitors doing things that were abnormal.

Our next question comes from the line of Tyler Hojo of Sidoti. Tyler Hojo - Sidoti & Company, LLC: Just a -- first question. Eric, you mentioned AMDR. Just wondering if you could tell us perhaps who you're positioned with, and how big of a program this could potentially be for you guys?

I'm sorry, I cannot talk about what teams we're on, because again we are under -- on virtually every one of these, we're under NDAs with the OEMs. And depending on how it would fall, and who the winner would be, this would be a moderate win for us, or it could be a very significant win for us, depending on who ultimately won. I think current timing is it's scheduled to be awarded, I believe, by the end of this year, I think. Tyler Hojo - Sidoti & Company, LLC: Yes, that's what we're hearing. Okay, that's understandable. And just in regards to the incremental $5 million investment in the unmanned drone program, I know you've gotten several questions on that. But if things go according to plan, I was wondering if you could maybe just quantify the timing surrounding kind of an order?

And at this time, I'd like to turn the program back to Mr. DeMarco for closing remarks. One moment, sir. [Technical Difficulty] Our next question is from the line of Michael Ciarmoli from KeyBanc Capital Markets.

Operator, we're still on the last question with Mr. Hojo.

My apologies.

Tyler, at this time, I should not probably get into timing. Tyler Hojo - Sidoti & Company, LLC: Okay, that sounds fine. And just last -- the last question for me, just in regards to the PSS business. Just given the pipeline of bid and proposal you have out there, just wondering what our expectation should be in regards to the growth rate. You put up, I think 18% organic growth in the quarter. Is that rate of growth sustainable, as we look into the back half and into 2014?

I think that we're -- for the back half, we're definitely looking at continued strong teams growth rate year-over-year. Let's assume that we do not win any of those major procurements in '14, I think we're solidly looking at 10%, okay. My personal expectation with that division president is significantly higher than that. But 10%, we'll say is -- we're comfortable talking it about here, based on what we see.

And our next question, our final question, comes from the line of Michael Ciarmoli from KeyBanc Capital Markets.

It's actually Kevin on for Mike. Just a follow-up real quick on Tyler's question on the $5 million unmanned investment, is any of that salvageable? I mean, is there -- if that order doesn't come through, is there a potential for reuse for some of that investment?

Absolutely.

Okay. And then you also mentioned, I think last quarter, that you were expecting some pretty good milestone payments related to that business in 3Q. I'm just wondering if those are still on track.

We're going to -- they moved a month or 2, not the event, but the payment. So the events are now looking like they will occur in September, God-willing, with the payments in Q4.

Okay. So the payments have shifted out a quarter, essentially?

Yes, a couple of months. It's...

It's -- Kevin, it's really a matter of 1 month to 1.5 months. But since the original expectation was for the collection to occur in mid-September, that's moving it into the fourth quarter.

Okay, that's helpful. And then looking at Q4, you're obviously, based on the guidance, expecting a pretty strong quarter, and you've said that a couple times. I'm just wondering, what the risk profile is there, in terms of, if we don't see the typical federal budget flush in your fiscal 3Q, and then, the potential for another CR or additional implications of sequestration. What's kind of the risk profile there, in terms of the 4Q expectations?

At this time -- and I want to say that again, because of the environment. At this time, there are a couple of -- 2 large orders that we fully expect to get, book and shipped in Q4. That's what our customers are telling us. That's what they've been telling us, and we fully expect that. If those were not to happen, the total potential impact is $20 million to $25 million.

What -- can you give us any color on what those programs are, or at least kind of, end markets?

No.

Okay. Moving on. The -- I know you talked a bunch about the PSS margins here. Just wondering -- I think you've been expecting some margin, competition, I think you called it, looking forward. And now it sounds like you're expecting those to be -- those PSS margins to be up in the back half of the year. Has anything changed there? I think there were some specific competitors that you had looked at, in terms of the margin competition. Just wondering if anything's changed in that environment.

No. What has changed is, when we talked about -- when we talked at the end of Q1 in our prepared remarks, we had made the decision to aggressively go after a couple of very large metropolitan transit authority security and surveillance awards. We made that strategic decision because, similar to the vast majority of the rest of our business, once you're designed in, and you're in it, you get the initial order, unless you do something very, very bad, you're in for a long, long time. You've got the designs, you've got the layout, you've got the technology. You're in. So we bid aggressively, because we knew some other people were, and we won. And those margins were far below what we would typically go for, okay? We sat down, and we took a look at the deployment plan, and our resourcing and our staffing, and we have aggressively right-sized and rationalized this business in many areas to start increasing those margins. In addition to that, the bids that we've been bidding on winning have been in a more normalized margin. So it's starting to rise now. It's starting to come up. And the cost reduction actions that we took in the second quarter, we did not get a full quarter's benefit for those in Q2. We will get a full quarter's benefit for those in Q -- substantially a full quarter's benefit in Q3, and a complete full quarter's benefit in Q4, which will further increase the margins. And if the revenue continues to increase, as we believe it will, we're going to get leverage on our G&A, which would further increase the margins. And so those are the pieces of why we are confident we're going to continue to see margin expansion in that business.

Okay, that's helpful. And then, one last one for me. Are you guys -- what are you guys seeing in terms of further restructuring actions? I know, we've seen a lot from the primes, looking forward in terms of headcount and cost reductions. Just wondering -- you've done a little bit here, what the plan is across the other segments of the business?

Right. So we have been, I'll say, quietly rightsizing or -- rightsizing the business or rationalizing the cost structure. We're indirect -- or G&A or overhead people, if they leave the company, if they take another position, we're not replacing them. We just have a very senior executive take a position at a certain government agency. We will not be replacing him. A great guy, we will not be replacing him. We will be distributing that work elsewhere. So we're taking that approach across the company. Where we are not -- it's not a hiring freeze, but it's -- we're looking very carefully before we replace any indirects. In addition to that, and in particular in our Specialized Products and Modular Shelter business, okay, there is a complete transformation going on right now in the customer profile and the order profile. And this ties into what we've talked about before on the call, where the strategic -- the defense posture is going from asymmetric warfare and tactical warfare to strategic warfare. And so the product lines are shifting. And this more strategic product lines, okay, are more high value. There's less quantity, they're more expensive and they take less people. And so we're transitioning that workforce as that order flow is transitioning, which is reducing the headcount. We have continued to aggressively consolidate our facilities whenever leases come up. We just completed the consolidation of 3 -- 3 or 4 facilities in the Washington, D.C. area, put them all into one at a much more favorable rate, where we're saving a significant amount of money. I think I mentioned this before. We took the approach of consolidating the communications in the company. We're down to 2 carriers now. The most recent information I saw, we're going to save somewhere around $50,000 a month going forward, starting next month. This is just in cell phone connectivity, by consolidating that. Now we're looking at travel. So these are the things that we're looking at to aggressively manage the cost structure in this environment.

At this time, I'd like to turn the program back over to Mr. DeMarco for closing remarks.

Very good. Thank you very much for joining us, all. We will be speaking with you at the end of Q3. Thank you.