Kratos Defense & Security Solutions, Inc. (KTOS) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Kratos Defense & Security Solutions Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the prepared remarks, we will host the question-and-answer session, and our instructions will follow at that time. [Operator Instructions] Now, it is my pleasure to hand the conference over to Ms. Marie Mendoza, Vice President and General Counsel. Ma'am?

Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions third 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’d like everyone to please take note of the Safe Harbor paragraph that is included at the end of today's press release. This paragraph 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, potential market opportunities, operational outlook and financial guidance during today's call. Today's call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today's press release, we have provided a reconciliation of these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP. With that, I will now turn the call over to Eric DeMarco.

Thank you, Marie. Good afternoon. I will open up today’s call thanking both Kratos’ long-term and new shareholders for investing in our company and being owners of Kratos, and I believe that with today’s report and our future forecast, you will see that we are at the beginning of a significant growth and value creation trajectory. I also thank all of Kratos’ employees whose hard work and dedication has enabled and positioned their company for what we believe is and will be a very exciting future time for us. As the headline in our press release noted, for the third quarter Kratos reported revenues of $165 million and adjusted EBITDA of $13.5 million, exceeding our Q3 forecast and we are raising our full year 2016 revenue guidance up to $665 million. Deanna will walk through Kratos’ financial information in detail in her prepared remarks. We have a number of new listeners on the call today and we have had numerous new investors reaching up to us since our Q2 report. Accordingly, I will summarize the market opportunity, our strategy and Kratos’ leadership position in the high performance unmanned aerial system market space. The vast majority of UAVs and the DoD inventory today are propeller planes designed to perform their mission primarily in uncontested airspace where the United States controls the sky. These aircraft are vulnerable to sophisticated adversaries as they are generally slow moving, not very maneuverable and do not have significant stealth characteristics. In terms of market participants on the very small tactical side, the industry leader is AeroVironment or AVAV, with tactical 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 a war fighter’s backpack and hand launched. Then there is General Atomics, which in my opinion is a fabulous company 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, performing their mission in an uncontested environment where once again the U.S. owns the sky. Kratos is not pursuing either of these market areas. Kratos’ Unmanned Systems are high performance jet aircraft made of special composite materials, which have been designed to have manned jet strike fighter performance like an F-18 for example. Kratos' unmanned aircraft are specifically designed to perform their mission in a contested environment and airspace, against the potential adversary that is a near peer or peer in war fighting and technological capabilities to the United States. Kratos’ aircraft have systems, counter measures and the performance features designed to defeat missiles or other threats that may be coming at them. Said another way, Kratos' unmanned aircraft are designed to be shot at with missiles and other systems and survive, which in a target drone configuration is what our industry-leading unmanned drone aircraft currently do every day. Kratos’ aircraft are also highly maneuverable, including being able to sustain upwards of 9 Gs or more and they can carry significant payloads long distances in both internal base and externally. Additionally, Kratos’ aircraft do not need a runway to take off or land in the event there are no runways available or if they have been taken out of action. Kratos' unmanned aircraft are primarily launched off a rail from land, sea or air, and they are recovered via special parachute including in the water, if required. Other than Kratos' aircraft there are very few, if any, high performance unmanned aerial systems addressing the anti-access area denied contested aerospace environment that the U.S. would face against a peer or near peer adversary. We believe that we are the industry leader in high performance unmanned aircraft and that the future market opportunity will be for thousands of these types of low cost, high performing systems as the U.S. military continues its transition or pivot from fighting terrorist to preparing for peer or near peer adversarial confrontation in a highly contested environment. We demonstrated the performance and capabilities of Kratos' unmanned tactical aircraft at the end of last year when we made aviation history at China Lake demonstrating that a manned fourth-generation fighter aircraft can control multiple Kratos' UTAP-22 Jet Aircraft, including manned, unmanned teaming or operating in a loyal wing man scenario. As a result of the significant investments Kratos has made in the unmanned aerial systems area since 2013, which aggregate to over $50 million in internal research and development, contract design development and capital expenditures. Over the nine month period ended September 25, 2016, Kratos’ Unmanned Systems division has received a number of highly competitive new tactical high performance unmanned aerial system contract awards. These include, the Air-Force Research Lab or AFRL, Low Cost Attritable Strike Demonstration or LCASD, which calls for a long range high performance jet powered unmanned combat aircraft, which we will be flight demonstrating in approximately 24 months. The base LCASD contract award was $7.3 million, with an additional $100 million in potential initial additional government funded development spirals available, which we expect to be exercise over the next few years, potentially beginning as early as 2017. Once developed, the LCASD production objective that the Government has identified is for price point for these aircraft of $3 million each for order quantity lots below 100 aircraft at a time and $2 million each for order quantity lots above 100 aircraft at a time. Accordingly, we believe the potential market opportunity for the LCASD type aircraft is in the several hundreds of millions of dollars based upon the information provided in the government solicitation. A second new UAV contract that Kratos received is the Defense Advanced Research Project Agency or DARPA Gremlins program, a prime Phase I contract award of $3.9 million, which we are currently performing on and we just submitted our Gremlins Phase II proposal last week. Phase I is currently scheduled to lead to a systems requirement review in the next few months, at which time DARPA plans to down select the two teams issuing contracts of approximately $20 million each for Phase II preliminary system design. In mid-2018, DARPA is expected to hold the preliminary design review and one team will be selected for Phase III, an estimated $40 million contract concluding with flight test in 2020. The government has indicated that the price point for the Gremlin aircraft will be approximately $700,000 each for order quantity lots of 1,000 once in production which could be expected approximately three years from now. At these estimated production levels, we believe the potential market opportunity for Gremlin type aircraft is in the high several hundreds of millions of dollars up into billions of dollars. The third new UAV contract we received is confidential and a tactical high performance UAS contract award that we are unable to publicly disclose specific details at this time. Under this confidential program, if we are ultimately successful order qualities for this high performance unmanned tactical aircraft that Kratos would produce are also expected to be in the thousands with the price per aircraft in excess of $500,000 each. We believe that the potential market opportunity for this aircraft, [inaudible] production is in the high several hundreds millions of dollars up into the billions. If successful, initial production of this aircraft is currently expected to begin in approximately three years. And just in the past few weeks, we received the fourth new sole source contract award with an initial value of $12.6 million from the Defense Innovation Unit Experimental or DIUx in conjunction with the U.S. Strategic Command or STRATCOM and the Strategic Capabilities Office or the SCO related to Kratos’ UTAP-22 unmanned combat aircraft. The DIUx contract calls for the integration of certain sensors into Kratos’ UTAP-22 to explore the use of high-speed drones in either fully autonomous or semi-autonomous roles, in support of fourth-generation and fifth-generation fighter aircraft Under the DIUx contract, multiple Kratos UTAP-22s are scheduled to fly in a significant exercise in the first half of 2017 with the goal of demonstrating a number of advanced mission capabilities in a complex environment. The DIUx award is the most important step to-date towards our objective for the UTAP-22 achieving initial production status in 2017. At an expected price point of $1 million to $3 million per aircraft depending on configuration in payloads, we believe that the potential market opportunity for the UTAP-22 could be in the tens of millions up to the hundreds of millions of dollars. In addition and also very importantly, we have recently entered into discussion with another U.S. government agency regarding additional funding for Kratos UTAP-22 aircraft, which we are hopeful of receiving in 2017. We believe that Kratos’ recent UTAP-22 unmanned aircraft success is very important to the near-term as the UTAP-22 exist today, it’s proven, it’s flying and it fills the current high performance UAV capability gap existing in the industry with the LCASD and Gremlin systems currently being in development and not expected to be in production ready for few years. With the DIUx contract award, all of Kratos’ high performance UAV initiatives are now funded by customers, expect part of the LCASD, where we are sharing the funding under our cost share type contract. 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 expected long-term economic value over the life of this platform, which as I mentioned previously is expected to be very large. Owning the intellectual property or data package in Kratos’ unmanned aircraft and systems is a key part of Kratos’ strategy across our company for increasing shareholder value and Kratos’ intellectual property ownership position in our fleet of unmanned aircraft is significant. Each of these unmanned combat aerial system awards that Kratos has received is related to the need to find the more affordable price point for delivering high performance aerial combat capability to the U.S. armed forces. We believe that Kratos’ four high performance jet powered unmanned aerial system contract award thus far in 2016 validates Kratos’ position as the leader in this new and growing market area. Previously stated, just as General Atomics is the undeniable market leader in propeller based UAV's. Kratos' vision is to be the market leader in the new and rapidly growing low cost, high performance jet powered unmanned combat aerial system market space. In our unmanned target drone aircraft business, we remained on track for Kratos’ BQM-177 unmanned aircraft system to begin low rate initial production in the first half of 2017 after the 2017 DoD budget is finalized. We expect the SSAT program to grow significantly in 2017, 2018 and 2019, as we expect low rate initial product quantities to increase each year and as we enter into full rate production. We believe that the potential market opportunity for this platform to be an in excess of $1 billion. As a reminder, our SSAT or BQM-177 aerial target is the next-generation Navy Sea Skimming Subsonic Subscale Aerial Target replacing the Navy’s remaining inventory of BQM-34s and BQM-74s, which are currently being used for training to simulate threat to ships and shore installations. Kratos’ BQM-177 unmanned aerial drone aircraft is one of, if not the, highest performance UAV in existence today. We also remain on track for certain confidential program to begin low rate initial production in the first half of 2017 also after the 2017 DoD budget is finalized. We believe the potential market opportunity for this platform to be in the hundreds of millions of dollars. We continue to expect to receive a large sole source unmanned aerial drone system award from a new customer by the end of 2016 or the beginning of 2017 with this initial award being in the tens of millions of dollars, and we are currently pursuing a new multi tens of millions of dollars unmanned drone system opportunity from a separate U.S. customer with an expected award in the first half of 2017. All of Kratos’ unmanned aerial combat, tactical and target drone aircraft require significant initial investment by the customer in ground, launch, recovery and other equipment and infrastructure would provides an important long-term competitive advantage and barrier to entry for Kratos when we have gain that customer. We are currently forecasting that revenues related to our unmanned systems business will approximately double in size over the next 24 months, with this forecast being driven primarily from existing unmanned aerial target drone programs Kratos is currently under contract on. In addition, with continued success or growth in our new strategic unmanned tactical initiatives, including LCASD, Gremlin, the confidential program, I mentioned and UTAP-22, we believe that we could significantly exceed this growth target. During the third quarter of 2016, Kratos’ core satellite technology and training business, our company’s largest business continue to have exceptionally strong contribution of revenue and EBITDA growth and cash flow generation. Kratos’ satellite business is the industry leader in command, control, RF intercept, geolocation and signal monitoring, and we are seeing strong tailwinds due to the proceed nation straight threat from China and Russia to the U.S. space assets, as well as increase bandwidth demand from military and our other customers. The specific example of the mission critical national security work Kratos provides in the satellite area is the work with the air force Joint Functional Component Command for space or JFCC space, which is part of the U.S. strategic command. The DoD relies on commercial bandwidth to support mission critical needs, including reconnaissance, surveillance and broadband communications between commanders and field units. Under Kratos’ JFCC space contract we are providing RF monitoring, interference protection and geolocation services for all DoD leased Ku and C-band commercial bandwidth worldwide and X-band geolocation in certain locations. Kratos is delivering these services from a Kratos owned global infrastructure that includes a confidential number of world-wide monitoring sites, hosting more than 60 antennas, providing visibility to over 60 satellites, 100 beams and 200 transponders, comprising an extensive world-wide network of RF monitoring and interference detection sensors in geolocation systems. This infrastructure is one of Kratos’ most valuable assets and we believe that Kratos is the only company capable of providing these types of services today. Other major national security programs Kratos’ satellite business supports includes, the Wide Band Global Satellite, Advanced Extremely High Frequency, Space-Based Infrared System and GPS III. I encourage you to watch online last year’s 60 minutes special on space war threats with General Hyten, Head of the Air Force Space Command for very clear understanding of the threats being addressed here. In the commercial satellite market where Kratos is also the industry leader in command and control, a recent report forecast that 1,450 new large satellites will be launched over the next 10 years, with an additional 880 satellites to be launched by surveillance and military agencies. These quantities exclude the thousands of small satellites expected to be launched by company likes OneWeb and SpaceX. Accordingly, we believe that the macro market drivers for Kratos’ satellite business in both the national security and commercial markets will remain strong and drive demand for Kratos’ satellite ground control, RF monitoring, interference and geolocation equipment. We consider Kratos’ satellite technology and training business to be one of the crown jewels of our company, with Kratos’ core business is being unmanned system satellite communications and microwave electronics. As we enter the fourth quarter, in addition to raising our full year 2016 financial guidance, with the programs we are now under contract on, improvements in the DoD budget environment and the resultant related additional clarity that we have. We are providing our initial full year 2017 financial guidance for revenue of $700 million to $720 million and adjusted EBITDA of $52 million to $54 million with the 2017 quarterly trajectory very similar to what we are doing in 2016. Based on our initial 2017 business forecast, we believe that this guidance is conservative. Additionally, with the strong forecasted completion of 2016, initial 2017 guidance and the expectation that our unmanned business will approximately double in size over the next 24 months, we are reiterating that we believe we can achieve a future target base business model of approximately $800 million of annual revenue, adjusted EBITDA margins of approximately 10% and strong operating cash flow. We also believe that this base business model could be significantly better, including specifically on revenue growth, cash flow and profit margin, if we are very successful with our tactical UAS business as none of these opportunities are included in our target base business model plan at this time. We are not putting a specific timeline on the achievement of this base business model, but we believe that we have clearly begun moving towards it with our current and forecast financial performance that we are reporting today. We remain focused on using the cash flows from our operating units to fund our expected growth and investments such as the LCASD program and we expect the entire company’s cash flow to significantly improve as we move towards achievement of this base business model. Deanna?

Thank you, Eric. Good afternoon. Our third quarter 2016 revenues of $165.4 million was at the high-end of our expectation with the year-over-year consolidated organic revenue growth of 2.9% driven primarily in our satellite communications and training businesses, and in our Defense Rocket Support Services businesses. Our Q3 adjusted EBITDA of $13.5 million was above our expectation primarily due to a favorable mix of higher margin work especially in our satellite communications, training and cyber-related businesses. Our adjusted EBITDA for the third quarter is from continuing operations and excludes the following charges which have been reflected as adjustment consistent with our prior presentation since we either believe the items are non-operational, non-recurring in nature or meaningful for investors to understand our financial performance. Restructuring related items and other of $19.6 million, which includes an $18.7 million contract loss accrual that we expected to record related to the recently awarded LCASD contract. As we discussed on the last quarter conference, we are required by the accounting rules to record a loss accrual for the estimated investment that we expect to make under the cost sharing arrangement of approximately $33.5 million. The remaining balance of the expected investment of approximately $14 million, reflecting the estimated value of the aircraft we will build and retain, as well as related software, tooling equipment and launch equipment is expected to be recorded as capital assets over the next 24 months or so. Any changes to the estimated loss accrual or estimate capital assets maybe reflected in future periods. Also excluded from our adjusted EBITDA is $700,000 representing excess overhead capacity in our unmanned systems division. On a GAAP basis, net loss for the third quarter was $23.6 million, which included the restructuring, LCASD and other items I previously mentioned, $2.6 million of expense related to amortization of intangible assets, non-cash stock compensation of $1.1 million and a $1.9 million tax provision. Moving to the balance sheet and liquidity. Our cash balance was $20.5 million at September 25, up $2.9 million from $17.6 million at June 26 plus $700,000 in restricted cash. Kratos also had zero amounts outstanding on its bank line of credit at September 25. Availability on our line of credit at quarter end, net of our $11.2 million of letters of credit outstanding was $44.8 million. Cash flow from continuing operations for the third quarter was a generation of $3.4 million. Capital expenditures for the quarter were $1.6 million. The total net increase in cash was $2.9 million for the quarter. DSOs remained flat at the end of the third quarter compared to the end of the second quarter 114 days. Our DSOs continue to be impacted by milestone payments on long-term delivery projects but we are unable to contractually invoice for amount until the completion of certain milestone and/or the final delivery of products for the demonstration of certain flight parameters specifically in our Unmanned System segment. We expect certain of these milestones to be achieved in the first and second quarters of 2017. Our contract mix for the quarter was 82% of revenues generated from fixed price, 12% from cost plus type contracts and 6% from time and material contracts. Revenues generated from contracts with the federal government were approximately 58%, including revenues generated from contracts with the DoD and with non-DoD federal government agencies. We also generated 7% of our revenues from state and local governments, 23% from commercial customers and 12% from foreign customers with our aggregate non-DoD revenues compromising 42% of our total revenues. Backlog at quarter end was $901 million with $582 million funded and $319 million unfunded. Kratos’ book-to-bill ratio was 1.2:1 for the third quarter and for the last 12 months ended September 25 0.9:1. Eric?

Thank you, Deanna. In closing I want to emphasize something I believe is very important that we have achieved thus far this year. Today, Kratos is working with several of the national security agencies that are on the forefront of the DoD's third off-set strategy. Leading the way in innovative research and development and our critical to the U.S. DoD’s immediate long-term strategic goals, these include, the DIUx, but the primary DIUx objective being reaching out to leading high technology companies that have existing products and solutions, which address an end-user operators immediate capability gap, with my emphasis here being on immediate. The Head of the DIUx, Ralph Shaw, he reports directly to the Defense Secretary, Ash Carter. The Strategic Capabilities Office which also reports to Defense Secretary. This is the home of third offset strategy and was created to re-imagine existing DoD systems by giving them new roles and game changing capabilities to be rapidly fueled it to confound our potential enemies. The Defense Advanced Research Project Agency or DARPA, whose mission is to create break-through technologies for national security, the air force research lab with the AFRL’s mission to lead the discovery, development and integration of war fighting technologies for the U.S. air space and cyber space forces. Today, Kratos is working with each of these critical national security agencies related to our high performance jet powered unmanned combat aerial systems, which we believe is testimony to Kratos’ products, technologies, credibility and our capabilities. Lastly, I encourage you to read an October 26 New York Times article on the Pentagon’s terminator conundrum robots that could kill on their own and an October 26 National Interest article, the F-35 latest trick might change warfare as we know it, both of which I believe provide a very crisp picture of the unmanned aerial system market opportunity and mission we are pursuing. With that, we will turn it over to the moderator for questions.

Thank you, sir. [Operator Instructions] Our first question comes from line of Mike Crawford with B. Riley & Company. Your questions please.

Thanks. Could you talk about your thoughts on your capital structure where you have $450 million of debt that is not due for three years, but it is high relative to your current EBITDA, you have pointed a bridge toward $80 million of EBITDA over an undefined time period, but that’s also not including success on tactical UAS, so could you just maybe talk little bit about impacts on that structure?

Absolutely. Mike, the first point you made is the most important one. The bonds are not due until the middle of 2019. We are sitting here in 2016. It is clear to us the areas of the national security market that we are in have turned and they are turning dramatically with our performance this year and what we are seeing for next year. As we said in our prepared remarks related to next year’s guidance, we believe if things fall the right way that could be very conservative, as I also said in the prepared remarks where -- we are on the trajectory for that target business plan. So we got a long way to go. We have won a lot of contracts awards, some of these get into production, they are going to significantly increase our revenue, EBITDA and cash flow, and that’s where we are focused and we are very comfortable with where capital structure sits right now.

Okay. And to be clear, you’re talking about the Unmanned Systems business doubling and that’s without any tactical UAS wins or any additional tactical UAS revenue beyond the small real testing amount in developments that you won?

With Zero, with none.

And how -- what’s -- how might one of these LCASD technologies spirals work, if you were to receive one in 2017 for example?

A government agency would come to us with a system that they want integrated into the aircraft and the spiral would be exercised, so we would start integrating that system into the aircraft design in 2017.

And then last question on this front is related to wonderful continuing resolution and upcoming elections, so is there an assumption you are making on when we might have a budget as far as your 2017 guidance is concerned?

Mike, this is Deanna. We assume that that would be resolved in the first quarter.

Okay. Great. Thanks. And then last question relates to your comment regarding another potential agency funding UTAP-22 possibly leading to an award in 2017 and would that be independent of the DIUx demonstration or would that be something that would be contingent on that doing well?

The customer is totally separate. It is a totally separate government agency. And I believe -- my opinion is I believe they -- it is related to we continue to be successful including with what we are doing with the DIUx.

Okay. Great. Thank you.

You’re welcome

[Operator instruction] Our next question comes from the line of Mark Jordan with Noble Financial. Your questions please.

Good afternoon, Mr. Eric and Deanna. First question relative to the pipeline number that you gave $6.3 billion, I -- question number one, I would assume that for you that is primarily a systems or product opportunity and could you give me a sense of what is the duration of that pipeline if you were to realize it all, what would be the timeframe –at which that would be potentially awarded and then be in production?

It’s typically looks out 18 months to 24 months, Mark.

Okay. And again this is all -- this would all be primarily systems related versus base service business?

Yes.

Yes.

Yes. The vast - yes.

Yes.

Yes, sir. The predominant…

Okay.

…is systems, products and solutions, not services.

And that you would expect that all to come be bid and awarded with 18 months to 24 months?

Yes, sir.

Yes.

Looking at your unmanned business, obviously, there has -- historically had losses given the fact that you have been investing heavily there. With the LCASD future bookings at on your GAAP basis at breakeven given GAAP accounting the UTAP-22 receiving funding from the innovation group, should the unmanned systems group generate positive GAAP operating profits in 2017?

That’s the expectation, yes.

Okay. On the Public Safety group that has -- it’s good to see those starting to generate positive operating profits currently, in your model for next year, what do you assume that segment generates with regards to operating profit and I would assume you are expecting get to be relatively flat at $120 million in revenue?

We are going to for next year we are expecting a slight increase in revenue as our strategy of not bidding on the larger jobs, those are falling off, those are falling away and we are bidding on more and more smaller higher margin jobs. So we are expecting a slight increase in revenue next year and we are expecting our margin rates to continue to improve next year above what we are doing this year. We are not ready to give a specific rate on it yet. We’ll probably give more clarity on that when we report Q4. But we continue -- we very importantly we continue to see a positive upward trajectory both in organic revenue growth, profit growth and cash flow.

Okay. Final question for me relative to the LCASD spirals, obviously, under the base program you are investing heavily. What do you believe would the economics of a spiral development program be positive with regards to cash flow and would it -- could it potentially offset some of the investment losses that you have booked today.

The answer to your question Mark is absolutely, yes, on all, yes, we would expect it to be positive, yes, we would expect it to offset some of the investment we are making, and yes, we would expected to be incrementally positive to cash flow, because where we are in certain discussions right now that’s all I would prefer to say.

Okay. For Deanna then an accounting question, if in fact you had the spiral you made money, would you then go back and adjust the reserve on your income statement or would you flow that profitability through the P&L in current period?

I believe it would be treated as a separate contract, because I don’t think it would be combined, because they are not directly linked per se, so I believe it will, if the future awards spirals are profitable those should stand on their own separately. So the loss accrual would remain as recorded.

Okay. Thank you very much.

Thank you, sir.

Yeah.

Thank you. [Operator Instructions] So now, I’d like to hand the call back over to Mr. Eric DeMarco, President and Chief Executive Officer of Kratos Defense & Security Solutions. Sir?

Excellent, excellent. Thank you for joining us today. We are truly looking forward to getting together with you when we report Q4. Thank you.

Ladies and gentlemen, thank you for your participation on today’s conference. This does conclude the program. You may all disconnect. Everybody have a wonderful day.