Good day, ladies and gentlemen, and welcome to the Kratos Defense and Security Solutions Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. [Operator Instructions]. As a reminder, this conference call may be recorded. I would now like to introduce your host for today’s conference, Ms. Deborah Butera, Senior Vice President, General Counsel, Corporate Compliance Officer and Secretary. Ma’am, you may begin.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense and 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 would 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 businesses going forward. Any matters discussed today that are not historical facts – particularly comments regarding our future plans, objectives, contract opportunities and expected future performance; the potential impact of sequestration, federal government shutdowns and the constraints on the federal budget; the timing and expected impact of the pending divestiture of our US and UK electronic products businesses, and the Company’s planned use of the proceeds from that divestiture, including the Company’s repurchase of a portion of its outstanding senior notes – constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including those found in the Risk Factor section of our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements. We encourage…

Thank you, Deborah. Kratos’ second-quarter revenue and adjusted EBITDA came in within our previously forecasted guidance range, with both being sequentially higher than Q1, including adjusted EBITDA increasing nearly 60%. And we continue to forecast the second half of 2015 revenue and EBITDA to both be sequentially higher than the first six months of the year. In Q2, Kratos’ mix of business trended more towards higher-value differentiated products, including unmanned systems, satellite communications, microwave electronics, and specialized training systems, with second-quarter satellite communication products and related cyber business gross margins of approximately 50% being represented of this favorable mix. We expect this favorable mix trend to continue into the second half of the year, with higher revenue and profitability in each of these areas, and lower than previously expected revenue in our modular systems business, with a certain large government agency program now pushing out into next year. In Q2, PSS’s revenues continue to trend lower, though at a higher margin rate, with PSS year-to-date booked gross margin on the majority of new programs being approximately 30% or higher, and with our most recent week’s bookings being at just under 34% gross margin. In the second quarter of 2015, PSS’s executed gross margins on programs were sequentially higher than Q1, with the month of June’s executed gross margins being the highest so far in 2015. We expect PSS’s gross margins and EBITDA rates to continue to increase in the second half of 2015, as older lower margin programs are completed, and new higher margin programs we have been booking continue to come online, with PSS 2015 revenues expected to be lower than we originally forecast, as we are aggressively focusing on these higher margin programs. Accordingly, and a result of the business mix changes, we continue to expect second half…

Thank you, Eric. Good afternoon. As a reminder, all financial data has been recast to reflect the US and UK electronic products business as discontinued operations for all periods presented. Our second-quarter revenues from continuing operations of $160.5 million came in our expected range with sequential growth from our first-quarter revenues of $156.9 million or approximately 2.3%. Revenues generated from the discontinued operations were $22.3 million or combined aggregate revenues of $182.8 million for the quarter, including both continuing and discontinued operations. On a year-over-year basis, revenues decreased from $204.2 million in the second quarter of 2014 to $160.5 million for 2015, with the largest decreases in the PSS segment of $28.2 million resulting from the one-time $13 million equipment order we disclosed last year, coupled with sustained change and strategic focus in PSS to emphasize higher-margin smaller projects, which is impacting overall sales volume. Decreases in our KGS segment of $15.6 million was a result of reduced shipment of hardened mobile, tactical facilities for a certain US government agency customer in our modular systems business. As we had mentioned on our last conference call, we made significant personnel and cost reductions in our PSS business in the first quarter, and we have started to see the initial impact of the reduced cost structure in line with our recent change in strategic focus on reduced volume, higher margin work. We are going to continue to right size the PSS business cost structure in order to achieve our profit margin expectations. As Eric had mentioned earlier, the new security system deployment work we have been booking in the PSS businesses this year has been at substantially higher margin rates and smaller in size than in previous years. We are also completing work on the remaining PSS backlog of certain of the…

Great. Thank you, Deanna. Moderator, we will turn it over to you for questions.

Thank you, sir. [Operator Instructions]. Our first question is from Kevin Ciabattoni of KeyBanc Capital Markets. Your question please.

Hi good afternoon Eric and Deanna.

Hi

Hi

Thank you for taking my questions. So it sounds like the strategy in PSS – in terms of smaller deployments, higher margins – is going as planned. I mean, any specific examples you can cite there in terms of how you’re going after that business differently? And Eric, maybe, I don’t know if there’s any kind of target gross margin – you gave some color as to kind of where it’s heading. Is there kind of a long-term target you have in mind for that business?

Absolutely. The long-term target sustained across the business we’re looking is 26% to 28% executed. We’ve been booking, as I said, in the 30% range. And so, if we can execute it 90% of that or so, we should be able to achieve the 26% to 28%. And on the first part of your question, Kevin, we are passing up and not pursuing and not bidding on a number of very large opportunities, where there is significant competition from large well-known system integrators that are turning into low-priced technically acceptable shootouts.

Okay. What, I mean, just in terms of background, I mean, if you look back a year or two in that business, kind of what were the gross margins of the business you – the existing business you have versus the kind of 30% to 32% you mentioned in the last couple weeks, months?

Yes. So, 18% to 22%.

Okay.

And what drove our decision to do this is, over the past three or four years, is defense budgets were coming down. And we were looking – we always have high margins in our defense business, so we were looking for growth, and this was a great area to grow. Well, defense budgets, they are firming up. We are seeing that in certain areas. Some of our division presidents have actively been telling us that, and which has been the impetus to switch the strategy.

Okay. I’ll let that kind of transition into my next question on defense budget, I guess. Looking at kind of where the budget stands today for 2016, it seems like we may get a continuing resolution for at least a few months at this point. Have you guys factored that into your guidance in terms of maybe bookings pressure or, I guess, specifically maybe any issues that might come up with these new unmanned contracts that you’re – either won or are working on?

Yes. We – as you just indicated, we right now are fully expecting that there’s going to be a continuing resolution authorization. Very similar to last year from October 1, that will hopefully be resolved between Thanksgiving and Christmas. That is what we are expecting. We do not believe that – the continuing resolution, we do not believe that it will impact the demonstration flights that are scheduled for Q4. We don’t believe it’s going to impact those two large international opportunities. It is possible that that one large domestic tactical opportunity we are pursuing, that is currently scheduled/planned to be awarded in Q4, it’s possible that could be pushed out into the New Year because of the CRA.

Okay, perfect. And then last one from me and I’ll jump back in queue. Any kind of color you can give us on free cash flow expectations for the year? And maybe the case – obviously, I know 2Q and 4Q tend to be lower just with the interest payments. But anything in terms of additional detail you can provide?

Sure, Kevin. This is Deanna. For the second half, especially with the activities of the pending close of the transaction, taking – putting that aside, our expectation is for free cash flow for the second half to be breakeven to positive $5 billion.

Great. Thanks, guys.

Fixed [ph]

Our next question is from Mark Jordan of Noble Financial. Your question please.

A couple of numbers that reflects some of the heightened investments you’re doing this year. I want to see if I’ve got all of the numbers down. And if you could add more depth to them, I would appreciate it. I think you said you are spending $17 million to $20 million of internal R&D, and that CapEx would be $13 million to $15 million, heavily skewed towards aircraft that you will be demoing for trying to attract new business. Is there additional investments beyond that that you are making?

There are, Mark. So they would actually be in our G&A line. So that would be the bid and proposal type cost that Eric was talking about, as far as infrastructure costs as well. So that – those costs are embedded in SG&A and we have not called those out separately.

Okay. Relative to that one opportunity that is relatively near-term, could you tell us exactly where that program is, which is the one that the large UAV contract that could be awarded in the – implied in the October November timeframe – is the RFP out on The Street? How long will that cycle be? And specifically when do you think that is going to be potentially awarded?

Yes. The RFI came out several months ago. We have responded to that. There have been significant communications back and forth since then. Mark, the RFP is expected out in the next two weeks. The response time is supposed to be something like a couple of months, and then the award period is supposed to happen immediately after that.

That is a rather rapid cycle, is it not, for this type of business?

Absolutely. It absolutely is. It is – what I told you it’s stated, it’s out there, and it is very rapid. It’s a very rapid path from this customer.

Okay. Last question from me, and it centers as a series around your flights you will be demoing this – in the fourth quarter, relative to what I believe is a potential Navy customer. As you know, the U-class is out there, it’s been a program that’s delayed, rumored to be incredibly costly. Is it true that you are dealing with the same program office as the U-class? And is it your understanding that that office is looking for a – wants a combat vehicle that can survive in a contested space? And can – is the U-class reasonably priced to – if it’s designed to survive in combat?

Right. Our aircraft in our vision is a much different – much different than the U-class. The U-class is the size of a man; aircraft is roughly the size of an F-14. It has the payload capacity of a significant aircraft and the loiter time of a significant aircraft. Ours are much smaller, much faster, more fighter-like. They have different attributes that some say are much more positive. And where the price point or the cost point of a U-class, say, is publicly out there somewhere between $50 million and $100 million, our price point is somewhere between $3 million and $5 million.

Okay.

And so it’s a different vision. Higher quantities.

And that is a rail-launched version, so if it were for the Navy as an alternative to U-class, it could be flown off of a different ship rather than an aircraft carrier?

Absolutely. Our vision is it does not take any deck time on an aircraft carrier. It is very versatile, and it can be launched off a rail, it can be launched off a number of other means, all of which are mobile and/or transportable or fixed.

All right. And finally, assuming success in the demo flights in the fourth quarter, when do you think the Navy may come to a decision point as to progressing forward with this program or not?

Right. So we are hopeful that our sponsor – and you said Navy, I will say sponsor – that our – we believe our sponsor will be in a position, along with several other customers that we’ve been briefing routinely along the way and are very interested in this, that we will get some traction. And I don’t want to get ahead of anybody, that’s – I don’t want to define it. We will get traction early on heading into 2016 if we are successful.

Thank you very much.

Yes, sir.

Our next question is from John Nelson from the State of Wisconsin Investment Board. Your question please.

Eric and Deanna, a question related to the announcement that you made, the press release on the satellite program that you have introduced called the quantumGND.

Yes.

Could you talk a little bit about what the size of the potential market is for that? And what your thoughts as far as the time it will take you to penetrate this market in a significant way?

Yes, sir. So we are – or we believe that we are the leader in command and control ground infrastructure for the space segment today. We believe that. And that is primarily with geosynchronous orbit satellites and with MiOS. The small sat for the nano satellites are Leos, so quantumGND is a scaled-down version of our big satellite command and control software. Because these nano satellites, even though electronics are getting smaller and the microprocessing technology is rapidly moving forward, these nano satellites do not have the capability of a big Geo. That’s why they are much less costly. And so they need, by definition, to be effective in the market, you need a lower cost command and control system, which is what quantumGND is. John, I am frankly stunned at the number of new – potential new small sat operators that there are on the commercial side. They are talking thousands of being launched. BAE is talking alone putting up 900, I think, in the next few years. It’s incredible. It’s thousands. This market is going to be a multibillion dollar market on both the commercial side and the military side. On the military side, of course, the big focus here is on redundancy and not having all your eggs, my terms, in one big multibillion-dollar satellite basket that can be jammed or shot down. And on the commercial side, it’s communications, its Internet, its delivering service to underserved or non-served areas right now. As you know, QUALCOMM is involved, Google is involved, SpaceX is involved, Virgin is involved, and many, many others. This is going to be a multibillion dollar market, and this is going to be a multi-tens of millions, if not hundreds of millions of dollar opportunity for us. Because we are a premier player in this market right now. We have the products, we have the past performance qualifications, and we have many of the customers already.

And is there – who is your significant competition for this particular side of – the nano side of the market, if any?

There are a couple of guys out there, John. I don’t want to talk about them here. But there are a couple of guys out there – one of them is a private company, one of them is a public company – that are our competition on the big side and they’re the competition here as well.

Okay. Thanks. And with regards to a number of programs that you are focused on over the coming years, like unmanned aircraft and railgun, hypersonic, missile radar, satellite-com, and electronic warfare, have there been any significant changes in the last three to 6 months as far as the size of the market opportunities for Kratos? That is, have they changed in a positive or negative way?

Yes. On every one that you just mentioned, it has changed in a positive way in the past three to six months. And it is happening industrywide because of the shift or the pivot of the DOD from asymmetric warfare or warfare fighting ISIS or fighting terrorists, to nation-state warfare. We are seeing significant interest in the directed energy area and we are winning a lot of contracts in that area. We cannot disclose them, this is both in the laser and the electromagnetic railgun area. As I was talking with Kevin about, this one unmanned aerial system opportunity came up – has come up in the last nine months. And it’s on a very rapid path. And there is another one that we are pursuing, but the RFI is not out yet, that is very similar, that’s on another rapid path. And they are both focused on a certain – on certain threats, which is why we have made the decision and we are going to – and it’s the right decision, to make the investment now. It is impacting our near-term EBITDA. It’s not going to last forever, but these opportunities are here now. And we’ve got to try to win some of these or get on them, because if we do, they will drive the Company over the next several years.

Okay, good. And then is there any significant effort, either by the military or portions of Congress or the White House, to deal with the problems of the contract challenges that you and your competitors sometimes deal with?

Yes. McCain and the Leader of the House Armed Services Committee, they’ve been talking about it, about procurement reform and contract reform. But in my opinion – this is just my opinion – nothing will change here until there is a new administration. Nothing. It is not going to change.

And do you think it would change, or it would be likely to change with a new administration of either party? Or does it have to be Democrat or – I’m sure they’re saying – does it have to be Democrat or Republican to –?

My tummy tells me that it would probably be better with one versus the other.

Okay. All right, thank you.

Okay.

That’s it for me. Thanks, and look forward to the second half with the – especially with the excitement on UCAS.

Thank you very much, sir.

Thank you.

[Operator Instructions]. Our next question is from Josh Nichols of B. Riley. Your question please.

Yes. Thanks for taking my question. I was wondering, so have you seen any continued M&A interest in any of your other business units, like PSS, that you may have been considering to divest as part of a more strategic initiative? And what would it take for you to revisit this plan?

Yes, we have continued to see interest in certain things. And – but we made the decision, as we said last time, we are not moving forward. And we are focused on these program opportunities we’ve talked about today.

Great. And in the unmanned aerial systems, would you ever consider supplying some major primes with any of your primary – with any of your proprietary deposit skins? Or avionics? And separately, do you feel like having IP related to engines would be desirable as well?

Right. So we do provide primes with – I’m going to use the word composite components right now, for certain programs that are non-competitory with us. So we do that. We do provide primes with certain of our unmanned command-and-control avionics and electronic systems onto platforms and programs that are not competitive to us. We do that. We have exclusive agreements with engine manufacturers for our airplanes. And that’s the route we’ve taken to lock up our supply on that – or capability on that side.

Great, thank you.

Yes, sir.

Our next question is from Eric Selle of SunTrust Robinson Humphrey. Your question please.

Hey, good afternoon. Two for two, that’s a solid streak. Looking at your guidance, if you look at your second half guidance, you have sales growing by $46 million and EBITDA growing by $13 million over the first half. Is this sales growth one but not protested, I mean is there any risk to the sales growth from protester CR? Or is that pretty much locked in?

There is always the risk on the protest side. There is. As I said in my remarks, Eric, we are trying to hedge it. And so what do I mean by that? If we believe we are going to win something and it gets protested, typically it gets resolved – typically, typically – it gets resolved within 100 or 110 days. So we’ve tried to build some cushion in on that. But it’s very hard to just assume everything you win is going to be protested and what that’s going to mean. So we’ve tried to use our best judgment on that. The protest activity that happened in the second quarter – and there were three – it did impact us a little bit. But we had taken that into consideration. On the continuing resolution side, as you know, we’ve all been through that for the past several years – we think we know what that has meant. We think we know what that means. And as I mentioned on this one opportunity that we are chasing, we expect a new contract award in Q4 – that could be pushed out because of it. However, we have not assumed, in our forecast, significant revenue at all for that opportunity in the fourth quarter.

So you can say that you have confidence – this is a new achievable believable guidance, and most of that, you have high confidence in, given your calibration of that for protest and CR. But as you look at it, $680 million revenue, how much of that growth – how much of that $50 million of growth in that back half is subject? And would you say one-third of it? Or is it – do you have high confidence over the majority of that growth?

I’m thinking and I’m staring at Deanna as I’m thinking.

I would say there is some pockets where there is – there are some assumptions of some contract award wins that Eric had mentioned, specifically in our modular systems business, which, if those do not occur, then there could be some impact to the revenues. But they are not a significant amount of that second half revenue.

Okay, good. And then if I do the rough math, your contribution margin on an EBITDA growth is about 28%, seems somewhat conservative, given your history. Could you give us some of the major drivers of that EBITDA growth? I mean, it looks like you are basing EBITDA solely on the higher sales on a conservative contribution margin. It seems like mix and some of the PSS book margin could make this look conservative.

Yes. So, Eric, you hit it right on the nose. There’s a couple of areas that would factor into that EBITDA growth. So one would be the product mix. The visibility that we have is that the certain shipments and deliveries in the second half will be on the higher margin side. In addition, on the PSS side with the cost reductions that we’ve made in the first quarter, we expect to see more traction in the second half, as well as the bookings that we have been booking at about 30% on those smaller projects. We expect to see the improvement, if you will, resulting from those booked – the higher book margins as we get into the second half.

Okay.

Eric, one – on your previous question, one item that popped into my head is, as you know, we are involved in ballistic missile target launches, and launches of missiles and rockets for other matters. And those can be scheduled, and then for whatever reason they can move out to the right by the customer, because assets weren’t available, assets couldn’t be deployed, weather, other reasons we shouldn’t be talking about – that could happen. And we have no control over it. We put in our forecast what the scheduled plan is.

Okay. That is great color. And then, Deanna, you spoke about the cost savings. Great job on gross margin, I think it was up over 100 basis points sequentially and 200 basis points year-over-year. You are seeing that mix come through, and that’s great to see. SG&A was a little bit higher year-over-year. I guess my question is, is how much of those employee savings have you realized in the second quarter? And should we see SG&A come down [indiscernible] year?

Yes. So, SG&A – so on the public safety side, there’s about a sequential and a year-over-year reduction of about $1.5 million. The other driver that’s impacting G&A are – there’s two pieces. The cost, the public company cost that would’ve typically been borne by the entire Company with all the divisions, with these discontinued operations, that those costs cannot be allocated to the discontinued operations. And there’s not a lot of infrastructure from a public company perspective that we can eliminate. So that’s part of the driver. The second reason, which is the largest driver, is due to the unabsorbed manufacturing overhead in our modular systems and our unmanned systems business, which has been reflected as G&A in this quarter. So that was roughly about $3.1 million this quarter that was related to that unapplied or unabsorbed overhead that is skewing, if you will, the sequential SG&A and the year-over-year SG&A.

So just kind of parsing, there wasn’t much employee savings in there. That unabsorbed overhead from modular will probably continue. The PSS hits sounds like a one-timer. And then as the public cost of the entire Company, once you sell that, will those costs come down? Or do we have to absorb those for the whole year?

We would have to absorb those for the rest of the year. As we get into 2016, we expect we will be able to see some reduction there as far as like audit and tax fees, like consulting fees. Directors and officers insurance, because we’re a smaller size company – so insurance, that type of stuff, that – we’ll see some of those reductions in 2016 as we negotiate those agreements with the smaller scale, if you will. And just to correct something I think you said, on the PSS side, there was actually a savings of $1.5 million. [Multiple Speakers]

Okay. And that was supposed to be $5 million to $7 million on an annualized basis, is that right?

About $5 million, yes. So that’s about on track with what we expected. But it was just masked by the unapplied or unabsorbed overhead increases to SG&A in our – in the modular systems and our unmanned systems business.

So we could potentially have $3.5 million of employee savings in the back half –?

Yes, for PSS, yes. And then as I think in my prepared remarks and Eric’s prepared remarks, we – our adjusted EBITDA guidance does assume that the adjustment, if you will, for any additional unabsorbed overhead costs, we are taking some actions there to try to mitigate that as much as possible. But we may see some additional costs in both the – we will see that in the unmanned systems area and potentially also in the modular systems business in the second half, but should be at a smaller scale.

The variables – the variable cost element we are reducing or eliminating. There’s the fixed piece that can’t be moved. Its quote/unquote non-cash, but it can’t be touched because it’s fixed.

Understood. Understood. Well, hey, listen, we really do appreciate the new guidance. And solid hit, and look forward to the second half. Appreciate your time.

Thanks, Eric.

Thanks, Eric.

At this time, we have no further questions. I would like to pass it back to Mr. DeMarco for closing comments.

Great. Thank you for joining us today. As we indicated in the prepared remarks, in the next week or so, we are hopeful to be announcing the close of the transaction. And we will be talking with you when we report Q3. Thank you.