Kratos Defense & Security Solutions, Inc. (KTOS) Q2 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and thank you for standing by. Welcome to the Kratos Defense and Security Solutions Second Quarter and 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder to our conference, this conference may be recorded. Now, I would like to hand the presentation over to Marie Mendoza, Vice President and General Counsel. Ma'am, the floor is yours.

Thank you. Good afternoon, everyone. And thank you for joining us for the Kratos Defense and Security Solutions second quarter 2016 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 everyone to please take note of the Safe Harbor paragraph that is included at the end of today's press release. This paragraph emphasis 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, 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 turn the call over to Eric DeMarco.

Great, thank you very much, good afternoon. In the second quarter Kratos Satellite Technology and Training Business unit, are company's largest had very strong performance and with Q2's book-to-bill ratio at 1.1 to 1. This business is currently poised to also a very solid second half of 2016. Kratos' satellite business along with every other Kratos business unit except unmanned systems where we're investing in a new growth market area are all generating positive operating cash flow. Major representative programs that we support in our satellite microwave and modular systems business include AEHF, WGS, [indiscernible] Iron Dome, Sling of David, Arrow, BARAK, SPYDER, Patriot, DDG-1000 and a number of classified programs. The operating cash flow is generated across our businesses have enabled us to make the necessary investment to successfully execute our tactical unmanned combat aerial system strategy. With the recent LCASD win, Kratos has in 2016 been awarded each of the three new tactical UCAVs opportunities that we have pursuing for the past year. LCASD, Gremlins and one additional contract and based on the significant progress we have made both congressionally and with government entities over the past few months. We are confident today that Kratos' UTAP-22, tactical UAS will receive government funding either later this year or in 2017. With these recent significant unmanned system achievements I will briefly frame up the tactical UCAS market and the opportunity Kratos is successfully pursuing in our company's path forward. The vast majority of UAV's and the DoD inventory today are propeller planes design to perform their mission primarily in uncontested airspace with United States controls the sky. These aircraft are vulnerable to sophisticated adversaries as they're generally slow moving, easily identifiable and not very maneuverable. In terms of market participants on the very small tactical side, there are companies like AeroVironment, which is a world leader in small UAVs that primarily support the war fighter on the ground, to give you an idea of the size of their aircraft certain of AeroVironment UASs can be carried in the war fighters backpack and hand launched. Then there are companies like General Atomics, which in my opinion is a fabulous organization and the world leader in ISR and strike UAVs with their Reaper and Predator aircraft, which are also propeller driven. The primary mission of the Reaper and Predator aircraft today is related to asymmetric warfare fighting terrorist and related intelligence gathering. If you're interested in these platforms, take a look at the movie Eye in the Sky for insights into their aircraft, their size which is similar to Cessna and their incredible capabilities and value to US National Security. Kratos is not pursuing these market areas. Kratos unmanned aircraft are high performance jets, which have been specifically designed with jet strike fighter aircraft capability and performance in mind. Kratos' unmanned aircraft are designed to perform their mission in a contested environment in airspace against the potential adversary that is a near peer or peer in war fighting to us and technological capabilities to the United States. Our aircraft have systems, counter measures and the performance features needed to defeat missiles or other threats that maybe coming at them. Our aircraft are made of special composite, are highly maneuverable including being able to sustain upwards of 9 G's or more and they can carry significant payloads long distances in both internal base and externally. Said another way, Kratos' unmanned aircraft are designed to be shot at with missiles and other systems, which in a target drone configuration is what our systems do every day. Additionally, our aircraft do not need a runway to take off or land in the event that are unavailable, they're being used by manned aircraft or if they've been taken out of action. Kratos' unmanned aircraft are primarily launched off a rail from land, sea or air and they're recovered via special parachute including in the water, if necessary. Other than Kratos' UAVs there are very few, if any high performance unmanned aerial systems addressing the anti-access area denied contested aerospace environment which the DoD has clearly identified as the US capabilities gap. We believe that Kratos is the world leader in these types of high performance unmanned aircraft and we believe based on needs and requirements that the future market opportunity will potentially be up to thousands of these types of low cost, high performing systems. We demonstrated the performance and capabilities of Kratos' UTAP-22 Tactical Jet Aircraft at the end of last year. When we made aviation history when a manned fourth generation fighter aircraft took control of multiple Kratos' UTAP-22's and demonstrated a number of mission sets including this manned, unmanned teaming. Kratos' UTAP-22 unmanned aerial system which we self-funded the development and flight demonstration for in 2014 and 2015 is Kratos' initial tactical unmanned combat aerial system. As I mentioned earlier, we expect to receive government funding for UTAP-22 in either late 2016 or in 2017. On the LCASD program, which Kratos recently won and which is a larger and more capable aircraft in the UTAP-22, we will be developing and conducting flight demonstration for this platform over the next 30 months. On the Gremlin's program which Kratos received a Phase I prime [ph] contract award earlier this year. It's for our relatively smaller high performance UAV that is launched from a C-130 aircraft and subsequently air recovered after the Gremlin UAV has performed its mission. The Gremlins development program is expected to last three to four years. This timing is wide, the Kratos UTAP-22 unmanned aircraft is so important in the near term as it exist now, it's flying today and it fills the current capability gap requirement while the LCASD and Gremlins systems are in development and will not be ready for few years. The current price or cost point for these classes of high performance jet aircraft that the government is currently indicating starts at approximately $300,000 and increases up to $5 million per aircraft depending on type and payloads. Kratos is the recognized industry leader at being able to quickly design and deliver high performance, low cost, unmanned aerial systems in this price range. Previously stated, just as General Atomics is the undeniable market leader in its class of UAV's. Kratos' vision is to be the market leader in the new and rapidly growing high performance jet powered unmanned combat aerial system market space. On the strategically importantly LCASD program win. Kratos beat out six other competitors and we believe Kratos won the contract award because Kratos had the best solution period. The LCASD award is a cost share contract with the government initially funding $7.3 million and Kratos making up to $33.5 million investment over 30 months. In addition to the initial $7.3 million in LCASD government funding, we expect up to $100 million in government funded spirals related to LCASD will be exercised over the next few years providing further potential scale and financing for this program. We structured our LCASD approach in a very thoughtful manner to ensure that Kratos would own the design rights to key aircraft and system intellectual property, so that we would capture the long-term economic value over the life of this platform which is expected to be extremely significant. Specifically, the LCASD BAA [ph] envisions hundreds or thousands of these aircraft being produced in the future at a cost of $2 million to $3 million per plane and we intend for Kratos to be the sole manufacturer due to the data and intellectual property rights, we intend to retain as a result of Kratos' funding of this development effort. The estimated LCASD production value would be in addition to the $100 million and potential development spirals I mentioned previously. Accordingly, for this potential multi $100 million or a larger opportunity. Kratos will be making an investment over the next 30 months of approximately $33.5 million. We currently estimate that approximately $10 million to $15 million of Kratos' investment will represent hard assets that Kratos will own including aircraft, support test and other equipment and software. We anticipate that the remaining investment of approximately $18.5 million to $23.5 million over the 30-month period will be spent primarily on development activities and due to the specific nature of this contract per our accountants, we will be required to accrue this month upfront and recognize a related charge in Q3, 2016. We plan to specifically identify this accrual in our Q3 financial report and to exclude the related charge from our calculation of adjusted EBITDA due to its one-time and non-recurring nature. In summary, on LCASD if the platform is successful, it could become the largest opportunity in Kratos' history. I've mentioned previously, that by June of this year. We would at inflection point, with the key tactical new UAS programs, we've been competitively pursuing being awarded and the future direction of our company being clear. Accordingly, I will discuss the business model that Kratos will start moving towards now that we've successfully been awarded every one of the tactical UAS program, we were pursuing and now that anticipate near-term funding for Kratos UTAP-22. Kratos' core businesses are satellite communications, microwave electronics and unmanned systems and these are the three businesses we expect to drive Kratos' business model and grow at the most going forward and for the foreseeable future. With the programs, we're now under contract on. The improving DoD budget the related additional clarity that we have and the growth potential that we see in these businesses. We believe that we can achieve a future base business model of approximately $800 million in annual revenue, adjusted EBITDA margins of approximately 10% and significant operating cash flow excluding any acquisitions. We believe that this base business model could be significantly better including specifically on cash flow and profit margin. If we are very successful with our tactical UAS business. We are not putting a specific timeline on the achievement of this base business model, but we expect to begin moving towards it in 2017, including that we currently expect our unmanned systems business to approximately double in size over the next 24 months or so based on existing long-term contracts that we now have. Additionally, we expect that substantially all of the tactical UAS initiatives and programs we have been investing in will be funded by the government beginning in 2017 excluding the LCASD cost share portion. We will remain focused on using the cash flows from our operating units to fund the LCASD program and we expect the entire company's cash flow to significantly improve as we move towards this base business model. For our 2016 guidance, with the US Defense budget having now bottomed and turning upwards which provides increased visibility of the contract award and booking and as demonstrated by our Q2 performance, we now have additional confidence. Accordingly, we are increasing Kratos' financial guidance for full year 2016, increasing our full year revenue guidance by $10 million above the current consensus estimate of $649 million up to $659 million and increasing adjusted EBITDA guidance by $1.5 million over our current street consensus of approximately $40.5 million up to approximately $42 million. This expected growth trajectory is being driven in part by the significant amount of work that we booked in the first half of 2016, that will be converted into revenue in the second half including in our satellite communications business, where we have large shipments and deliveries currently scheduled to begin in September and continue through the end of the year. We expect the second half of 2016's financial trajectory to be very similar to the first half of the year, with Q4 being stronger than Q3 just as Q2 was stronger than Q1. Accordingly, we are currently forecasting Q3 revenue of $160 million to $165 million and Q4 revenue of $174 million to $179 million with Q3 adjusted EBITDA of $9 million to $11 million and Q4 adjusted EBITDA of $12 million to $14 million. Depending on program execution delivery schedules and mix. Q3 could be somewhat strong than this guidance, as we're hoping to be conservative. Deanna?

Thank you, Eric. Good afternoon. Our second quarter 2016 revenues of $168.2 million exceeded our expectations with year-over-year organic growth of 21.2% in our satellite communications and training business, 8.6% in our microwave electronics business, 1.8% in our defense rocket support services businesses offset by year-over-year reductions in revenues generated by our unmanned systems, modular systems and public safety businesses of 1%, 5.5% and 14.4% respectively. Strong bookings execution and the timing of certain shipments in our satellite communications business positively impacted our quarterly results. As certain shipments that we had expected in the third quarter of 2016 occurred during this quarter. In addition a very favorable mix of satellite product shipped during the second quarter positively impacted our profitability. Modular systems and public safety declined were primarily the result of reduced shipments of hardened mobile tactical facilities and our change in strategic focus in our PSS business to pursue primarily smaller size, higher margin, security system deployment projects, rather than larger size projects which typically have lower margin rate. Our Q2 adjusted EBITDA of $13.5 million was driven by increased Q2 revenues and the positive impact of favorable mix of higher margin product shipped. As Eric briefly mentioned, we continue to maintain significant engineering technical management and other unmanned aerial system related resources in anticipated of successfully being awarded three new high performance tactical UAS program opportunities, which the company was competitively pursuing, which have all now been awarded. The last of these three awards that we were expecting was the LCASD contract that we announced a few weeks ago. Also as we discussed in our last earnings conference call, we completed the restructuring actions in our modular systems division resulting in a restructuring charge of $4.7 million during the second quarter. The charge was comprised of $3.4 million non-cash impairment of fixed and intangible assets related to our Charleston office and approximately $1.3 million related to an excess facility accrual and other related phases. We have now completed the transition of the operations from our Charleston to our Dallas town facility. Accordingly, our adjusted EBITDA for the second quarter is from continuing operations and excludes the following charges which have been reflective as adjustments consistent with our prior presentations since we either believe the items are non-operational or non-recurring in nature or meaningful for investments to understand our financial performance. Restructuring related items and other are $5.5 million which includes $4.7 million restructuring charge related to the modular systems business facility consolidation that I mentioned earlier. Approximately $700,000 of under-utilized capacity related to the unmanned systems business and approximately $100,000 of severance cost. Also excluded from our adjusted EBITDA is $900,000 representing initial investments related to our unmanned combat systems imitative, which we began to make prior to the LCASD contract award. As Eric mentioned earlier, we plan on recording an accrual for the estimated $18.5 million to $23.5 million of development investment related to the LCASD contract in the third quarter, which is net of the estimated capitalizable cost of $10 million to $15 million. The amount of accrual may change based upon the amount of the investment that is ultimately capitalized as hard assets related to the aircraft tooling and related test in launch equipment as well as potential other costs related to the design and software of the vehicles. Consistent with how we have presented the investments in our tactical aircraft vehicles in the past such as for the UTAP-22, we will exclude these investment amounts for purposes of presenting adjusted EBITDA. On a GAAP basis, net loss for the second quarter was $10.4 million which included $2.6 million of expense related amortization of intangible assets non-cash stock compensation of $1.6 million and $1.8 million tax provision. Moving to the balance sheet and liquidity. Our cash balance was $17.6 million at June 26, down $2.5 million from $20.1 million at March 27 plus $700,000 in restricted cash. Kratos also had zero amounts outstanding on its bank line of credit at June 26. Our availability and our line of credit at quarter end, net of our $13 million of letters of credit outstanding, was $48.4 million. Cash flow from continuing ops for the second quarter was a use of $900,000. Capital expenditures for the quarter were $1.4 million. The total net decrease in cash was $2.5 million for the quarter which includes the semi-annual interest paid in May of $15.8 million. DSOs decreased from 124 days at the end of the first quarter to 114 days at the end of the second quarter, primarily as a result of two sizable advance billings, which were made during the first quarter and which had now have been collected and for which revenues and work performed are starting to commence. As we perform work on these projects and revenue is recorded, our DSOs are expected to reduce accordingly. DSOs expected to be offset impart by the continued impact of milestone payments on long-term delivery projects, where we are unable to contractually invoice for amounts until the completion of certain milestones and/or final delivery of products or the demonstration of certain flight parameters specifically in our unmanned systems segment. Our contract mix for the quarter was 82% of revenues generated from fixed price contracts, 12% from cost plus fixed fee contracts and 6% from time and material contracts. Revenues generated from contracts with the federal government were approximately 61% including revenues generated from contracts with the DoD and with non-DoD federal government agencies. We also generated 6% of revenues from state and local governments, 21% from commercial customers and 12% from foreign customers with our aggregate non-DoD revenues comprising 39% of our total revenues. Backlog at quarter end was $875 million with $542 million funded and $333 million unfunded. Our book-to-bill ratio was 0.8:1 for the second quarter and for the last 12 months ended [indiscernible] was 0.9:1. I'll turn it back over to Eric.

Thank you, Deanna. In summary, every Kratos business is currently generating positive operating cash flow except unmanned systems. Whereas you know we've been making significant investments in pursuing and successfully penetrating a new and high growth market. As a result of these investments from the first half of 2016 Kratos was successfully awarded each of three high performance tactical UAS opportunities we were pursuing, establishing Kratos is a leader in this new growth area for our company. We now expect Kratos as UTAP-22 to receive initial government funding either later in 2016 or in 2017 further establishing Kratos unmanned system leadership position. We expect Kratos unmanned systems business to approximately double in size over the next 24 months and we are now executing toward a base business model of approximately $800 million in annual revenue and approximately 10% EBITDA margins excluding any acquisitions. And we believe that, we could significantly exceed this business model depending on the level of success, we achieve in the tactical UAS area. We are focused on generating value for all Kratos shareholders and stakeholders as we move towards our base business model. With that, I'll turn it over to the moderator for questions.

[Operator Instructions] our first question comes from the line of Mike Crawford with B. Riley & Company. Please proceed.

Eric off the $129 million in satellite technology and training revenue in the first half, how much of that is satellite and how much will be training or maybe another way to ask? How much is core versus non-core given the core business parameters you set out?

Mike, we don't give that detail the significant majority of it, is satellite communications. The significant majority of it, another piece is cyber security related part of which is related to satellite communications and then the other piece is training systems.

Okay, Eric this is the second quarter in the row that you talked about satellite, microwave electronics and unmanned systems is being the core business. Does that mean that you might look to divest non-core businesses?

Mike, we're not to get into a discussion on the line of what strategically we may or may not be doing.

Okay, fair enough. Turning to quickly to unmanned systems. The revenue that you generated in this quarter is that primarily AFSAT production.

It's primarily, AFSAT then Navy, confidential customer. We have a program now with a very large Ministry of Defense internationally and then there is a handful or two of other international customers.

And then, you've taken at least one production line down I believe which is part of the charge Deanna discussed, but what is your production capability in unmanned systems today and if you are in a position to build these hundreds or more units per year in the future, could you do that when your existing operations or do you have different plans?

Right we have done a detail analysis on our capacity against the contracts that are entering production either late this year or the beginning of next year and then what we expect on the tactical side and we believe, our existing capacity is good through 18 or 19, but Mike that would be two to three shifts and then we would have to make a decision.

Okay, thank you.

You're welcome.

Thank you. Our next question comes from the line of Mark Jordan with Noble Financial. Please proceed.

Eric, first you're talking about the doubling of your unmanned systems next year obviously I think that's got to be the Naval target business plus there is another confidential programs that supposed to have that size moving and parallel to that. Could you give us in aggregate the impact of what those programs will have this year and next year?

Right to clarify, Mark. I had mentioned that over the next 24 months, we see it our unmanned systems division doubling, the contributors to that are LCASD, Gremlins, a separate tactical program that we won in the second quarter, the Navy SSAT program which is expected to begin, LRIP 1 either in Q4 or Q1 depending on continuing resolution, a confidential program which is expected to begin production LRIP in Q1, a large new international customer that we believe, we'll be under contract on by the end of this year and then a separate international customer, not quite as large but still several millions approaching tens of millions that we think will be under contract this year, that's the basis. In addition and I'll give some I'll scale it in a minute. In addition that, it appears that OPTEMPO with our Airforce customer and our Army customer is increasing going forward, so we expect some increments there. With that as the backdrop, the biggest drivers will be SSAT, the confidential customer, those two international customers, LCASD, that separate tactical one and Gremlins.

The strong growth that you saw both sequentially year-over-year in the SSAT, where there significant component of one-time deliveries in the quarter or is this $70 million kind of run rate in the [indiscernible] a sustainable rate?

Right, we absolutely believe that it is sustainable, this is in the satellite business. Mark, what is driving it is, I refer back to the Q4, 2015 it was 60-minute special on a $5 billion plus up to the space segment related to Russian and Chinese threat that is the primary driver right now with what we're seeing and it's just beginning and this is protecting the established spaced assets and the ones that are going up.

I would add Mark though that, there were some shipments that we had expected in the third quarter that were made in the second quarter, so that is part of the reason for the jump during the second quarter.

Okay, in the public safety group. It's been running it about $120 million annualized run rate saw an improvement sequentially in terms of profit margins and EBITDA, what would be your goals for that business say next year, as you have the chance to fully reflect some of the structural things you've done there.

Right, so as you know we made a significant restructuring in Q1 in that business, we consolidated things and we had a significant cost reduction. We expect the margin rates to continue to expand in Q3 over Q2, we expect the margin rate to expand in Q4 over Q3 and then we expect the margin rates to continue expand next year. From a revenue side, if that business stays somewhere between $120 million and $140 million that would be great and if we can do margins between 7% and 10% that would be phenomenal.

Okay, a final question from me relative to the microwave grew up [ph]. Since that business is heavily Israel centric should and given the investments I think significant incremental funding that is being made available for missile defense for Israel, should that business take a step function over the next 12 to 24 months in terms of growth?

Mark, you're absolutely correct on this one. We are designed in on handful of missile programs that we have won, our [indiscernible] and over the next 24 months they're expected to go into production every one of them. This is kind of our sleeper and we believe in the next 24 months we are going to see a significant step function in this business directly related to these missile and radar systems were designed in on that have been awarded, that are expected to go on a production.

Okay and [indiscernible] one last one relative to the, when you take the third quarter charge and you start realizing the expenses of the development of the new drone, how will that flow through the P&L or will it just be excluded from P&L if you're offsetting a reserve. Deanna, can you just talk about mechanically how that's going to flow?

Sure, yes. So Mark, it would be a charge in the third quarter. So it will be our estimated charge for the duration of the 30-month development period that's going to be net of what we think is capitalized, also we're still working through the details of that, but the numbers, the range that we gave was in that $18.5 million to $23.5 million charge that will be recorded in the third quarter and then every subsequent period, thereafter for the 30 months, thereafter it will be the reduction of the accrual on the balance sheet.

So the actual expenses then would be on the P&L or be just a reduction.

That's correct. So yes, so the charge would be upfront and then if there is any change to that estimate during the 30-month period, it would be either increased or decreased accordingly.

Yes, through the P&L, but.

Yes, exactly.

Okay, thank you very much.

Sure, thanks.

[Operator Instructions] our next question comes from Eric Selle wit SunTrust. Please proceed.

Eric, Deanna, great quarter. Wow! You're making us feel good, that's how it works. The first question is your base business does that include one contracts, is there anything in there that could be protested?

Our base business right now, we are currently in a protest situation on one contract in our services business and it's going back and forth and I think it'll probably be cleared up by the end of the year one way or the other and so in our services business there is one. Other than that, knock on wood, we're not in any other protest situations one way or the other across the company.

And does not include when you were using it as your base business going up to $800 million that includes won contracts, correct?

That includes the entire company as it is today, yes sir.

Okay and then there was one that's on protested.

Yes, it's in a protest situation today.

Okay, great. Last quarter you guys made a comment addressing the cap structure, does the pace of wins and the type of funding put that off the table for now?

Well the cap structure comment that we made at the end of last quarter had to do with managing cash flow and as we talked about today, every business generating positive cash flow currently. We were waiting to see where we were going to turn out on these programs and as we've talked about it, if we were unsuccessful we were going to do significantly, a significant restructuring of a bunch of resources that we were holding on the bench to see what happened, which was going to significantly increase profit or cash flow but if we won them and we got funding our UTAP-22, it would take us in the other direction and so that's the direction we're heading right now on that comment, that we, the business is growing we're highly confident it's going to grow, the whole business it's going to grow next year. We're in a move toward that base business model I mentioned and that will address the cap structure.

That's great to hear and then my final question. You guys are basically in the mid-40s EBITDA going to 80 that's about $35 million could you bucket kind of which divisions you're seeing. I'm seeing kind of, if you double UAS there's probably another $20 million I'm guessing just wrong math but could you bucket kind of where that $35 million comes out of it, is it cost savings or is it kind of in PSS [ph] or?

Right, now the biggest piece clearly is going to be our unmanned systems business and the contracts that we have in hand that are going into production either late this year or next year and then they ramp from there. They ramp 17 to 18, they ramp 18 to 19 then go into full rate production, then there is the tactical side of the UAV business. I'll say it again, we fully expect to be fund on everything we're doing except that cost share piece on LCASD next year. Our satellite technology and training division is knocking it out of the park. It is the crown jewel of this company, no question about it and Mr. Crawford asked about you know the satellite piece, our training business is killing it. We just won a huge multi-year, multi-million dollar strategic program that on the KC-46, we won that and that is going to expand going forward. So that's going to be a significant driver. Our training businesses, our electronic products business those handful of contracts programs that were under contract for next couple of years, those go into production, we could see a 50% increase in EBITDA there, easy. Easy because they've been in development and then when they go to production, the margins were all going to go up.

I'll always appreciate the color and once again, solid quarter man. Congratulations to you and your team. Good work.

The team did great, thank you.

Thank you. I'm showing no further questions. So I would like to hand the conference back over to Eric DeMarco, President and Chief Executive Officer for closing comment and remarks.

Great. Thank you very much for joining us this afternoon. Our next scheduled discussion with you'll be when we report Q3 at the beginning of November. Thank you.