Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will host a question-and-answer session and our instructions will follow at that time. [Operator Instructions] As a reminder, this conference is maybe recorded. It is now my pleasure to hand the conference over to Ms. Marie Mendoza, Vice President and General Counsel. Please proceed.

Thank you. Good afternoon, and thank you for joining us for the Kratos Defense & Security Solutions second quarter 2017 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 emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today’s call. Today’s call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today’s press release, we have provided a reconciliation of these non-GAAP financial measures to the company’s financial results prepared in accordance with GAAP. With that, I will now turn the call over to Eric DeMarco.

Thank you. Good afternoon, everyone. Over the past 20-plus years, the U.S. military has rightly focused on winning the fight at hand, the war on terrorists and Afghanistan and Iraq. During that time, our nations adversaries have been investing heavily in new technologies and systems to catch up with the United States. In response, the United States in the U.S. recapitalization and a technology infusion of strategic weapon systems to address potential peer and near peer adversaries has begun and Kratos is well-positioned for this recapitalization with our proven ability to innovate and rapidly design, engineer, develop, demonstrate and field leading technology systems at an affordable cost. Consistence with the appearance of peer and near peer adversary’s threats and the related recapitalization of our nation's strategic systems, national security and defense-related budgets are increasing globally. In the United States, the U.S. House has tentatively approved a defense budget of $698 billion and the U.S. Senate has requested a budget of $708 billion, a significant increase over recent years and both higher than the President's request. So clearly it appears that the consensus is for increased national security spending. It is also very encouraging that the bipartisan house request and the bipartisan Senate request are approximately 1% apart at this stage of the process. Areas of the 2008 DOD initial budget submission with significant growth include the missile-defense agency, with the request of $8.5 billion up 11.8%, space-based systems with the request of $9.8 billion up 36% and science and technology, which includes DARPA, DIUx, defense tech and innovation initiatives up 5.6% at $13.2 billion with each of these being primary customer and program areas of Kratos. Also, importantly and directly relevant to Kratos is the upward trend internationally of defense and security spending and particularly related to missile and radar…

Thank you. Eric. Good afternoon. Kratos reported second quarter 2017 revenues of $185.7 million, which exceeded our expectations of $170 million to $176 million for the quarter, due primarily to strong execution and leasing and deliveries in our satellite communication and training systems businesses and our unmanned systems. Our year-over-year consolidated organic revenue growth of 10.4% was driven by growth across all business segments with 4.7% in our satellite communications technology and training businesses as a result of recent contract award in these areas, growth of 24.7% in our unmanned systems business, which was also driven by recent contract awards and 24.7% in public safety and security business, driven by security system deployment program for a mass transportation authority and to a lesser degree due to a new physical access control project for a large healthcare customer. Our Q2 adjusted EBITDA of $11.5 million which at the higher end of our expectation of $8 million to $12 million due primarily to a favorable mix of higher-margin work and shipments in our satellite communication technology training system and cyber related businesses. On a year-over-year basis, our Q2 '17 adjusted EBITDA decreased from $13.5 million in the second quarter of '16 to $11.5 million reflecting the increase here in proposal cost in our unmanned systems business, primarily resulting from our pursuit of the new large UAS opportunity that Eric mentioned. Our adjusted EBITDA for the second quarter is from continuing operations and excludes the following charges, which have been reflected as adjustments consistent with our prior presentations since we either believe the items are nonoperational, nonrecurring in nature or meaningful investors to understand our financial performance. Restructuring related items and other $1.4 million, which includes approximately $100 of related severance and terminated employee-related costs, $1.3 million representing excess overhead capacity in our…

In closing and very quickly, I want to remind the group that a number of Kratos' Board of Directors, our venture capitalists are active entrepreneurs and business advisors in the technology field. As a result, Kratos has great visibility and relationships with companies that are focused solely and specifically on unique technologies and products certain of which are directly relevant to national security and Kratos' business with areas we are focusing on including high-powered lasers, space situational awareness, next-generation engines for unmanned aerial systems, exotic materials for unmanned aerial systems and additive and other exotic manufacturing techniques for unmanned aerial systems. We believe that Kratos' access to these types of specialized and focused leading technology companies is a clear advantage for our company, especially as related to the US DOD's third offset strategy and its objective to innovate and rapidly identify, assess, test, demonstrate and field leading technology systems at an affordable cost. This aspect of Kratos we truly believe is a clear competitive differentiator that very few companies in our sector have and especially as related to our high-performance unmanned aerial drone systems. I'll turn it over to the moderator for questions now.

Thank you, Sir. [Operator instructions] Our first question will come from the line of Mark Jordan with Noble Capital Markets. Please proceed.

Good afternoon, Eric and Deanna. First question is one more let's phrase it as a generic question, if you're working on a program with the DOD and it's have fallen out in one, and its transition is to a classified and restricted basis, generically is this typically a sign that the potential customer is taking a much more serious attitude towards his program and its potential long-term involvement?

Generically speaking, yes sir, absolutely correct.

Okay. Like to leverage off one of your last statements about investing in technologies relative to UAV engines, as I believe that the largest single cost of UAV or missile is its engine and that many of your large prime competitors use William International and Teledyne for some of their power plants for missiles. What is your strategy and can you differentiate yourself meaningfully on a cost basis with the application of a new vendor or a new technology and where are you on that timeline?

As you can imagine Mark, I am smiling, this is a very, very competitive area. All I am going to say is we have a number of initiatives going including with next generation engine technology with private companies that we're looking at. And we are very confident that this in the near term and mid and long-term is going to be a clear differentiator for us. We've been working this for a long time. It's one of the most closely held aspects of what we're doing. And you're exactly right, it's a key element in the building material. So, we are focused on it for competitive reasons. I really don't want to say much sir.

Okay. You mentioned earlier also that DOD investing more in technology and that DIUX is probably going to get more funding. What implications are for this increased funding relative to your initiatives with UTAP-22 and the flight test that are expected here this fall?

We're right now working on a $12.6 million contract with the DIUX. It's our understanding it's one of the largest and most important that they were awarded to date. The DIUX's stated mission, publicly stated mission is to identify a technology once it's identified and get it under contract in a couple of months, demonstrated in 12 months and get it fielded or get into production in 24 months. They assessed our technology in August of '16. We were under contract on September 30. We are scheduled to demonstrate roughly within that 12-month period and we're tracking through their stated mission statement. We believe that if we continue to be successful and meet their objectives that we will continue to be funded and potentially at increased levels and that's really all I should say on that one sir.

Okay. Final question for me, you mentioned a potential contract award late this year, early next upwards of roughly $100 million. Those are rather strong statement in terms of expectations. Is that a function that there is no manufacture out there that has the tooling or capabilities to compete with you for a rapid delivery of a high-performance upscale target today?

Yes, sir. That's why.

Our next question will come from the line of Mike Crawford, B. Riley & Company.

Can you clarify, whether your increased revenue guidance includes any amounts for tactical combat drone initiatives or is that only for targets and then the other aspects of your business?

It includes some very slight amounts relative to some development work we’re doing. We’re obviously ramping up now on asset that we had a lot of wood to chop on that. And if that comes in a little short based on our forecast and some of the tactical things were working on can backfill that. Tactical things come in a little short. We probably can do some extra work on asset or some other ones. And so, it's not precise but there is not much at all in our forecast we are using that is upside.

Thank you. And then you said because of some of the probe-in nature of interest for some of these tactical programs that is going to be increased spending to protect your daily rights and is that spends something that's going to be included in your adjusted EBITDA presentation or excluded has been the case in the past with some of the bank covenants?

I'm glad you asked the question, Mike. Let me be very -- let me clarify this very carefully. On the existing programs that we’re on, we are not increasing any spend, we’re on plan the only one were spending any money non-right now is LCASD which we've explained and is out there. What I was talking about specifically was this new opportunity that were going after and since the last call we made the decision based on something that we were going to make the investment to make sure that we own the intellectual property in that platform and in certain systems relative to that platform. So, this is not going to be excluded, it is in our EBITDA. It’s the primary reason we did not increase our EBITDA. This is a lot of money we’ve been spending and we’re going to continue to spend in Q3 and Q4. But we think it's well worth that, just to maintain where we’re at, later on we can do something we will maintain where we’re at and make sure that if we're successful here, we own the data rights.

Okay. Thank you, Eric. And then in the satellite tech and chain business, that was $260 million or so of revenue last year, can we step back in time to when you acquired integral systems back in 2011. And back the time, there was a talk of moving EBITDA of that business. Like $15 million to $35 million based on some cost savings and some other things you are doing with the business. How would you characterize has been a success of that and at what kind of EBITDA level contributions you get from your satellite command and control business today?

I’ll take part of that, Mike. When we did buy Integral Systems. There were a couple of contract CCS-C and Raiders, which were in development at time, which we knew within two or so years from the date of acquisition, would be -- would transition to more of a production type contract which is what did occur and has occurred. So that did, we took that into consideration when we acquired Integral Systems and knew that the revenues would -- would reduce as a result of that activity.

It’s a mid-to-high teen business, like depending on the mix of the products. It’s mid-to high teens, the pure satellite business.

And then last question relates to what you consider core or non-core that it's been a little bit of a shifting line in the sand in the last couple years. It seems with all the training opportunity with the transport, helicopters and the MCAT, you know maybe that's more of a core business now than non-core. Where would you put services and PSS and container, containers on that scale?

Services and PSS are non-core to our strategy in the investments we’re making. The Modular Systems business, as is I think you know we are deeply embedded with virtually every major, major prime on their radar and missile systems, including Patriot and Fed and some other radar ones I am not sure, I can say publicly. There is the level of spend in those areas particularly in the Middle East and in the Pacific is increasing. And our modular systems business is realizing the benefit of that and we think it's going to continue realize the benefit of that going into next year. In addition, and I'm not going to talk about programs because they are confidential but in Europe and specifically related to NATO. There are a number of programs going on right now that are ramping up relative to the perceived Russian threat to the NATO countries. And this is driving a need, not just for missiles and radar but for tactical gear that our Modular Systems business is directly embedded in. And the last one is a couple three months ago we reported the initial contract award on a space-based system that our modular systems business is now providing the ground equipment for multimillions of dollars initial phase. And so, our primary investment businesses, our satellite communications and I tie fiber with that of course. Our training business, electronic products and obviously unmanned. And our Modular Systems business is starting to feel the impact of the increase spends because of the threat environment.

Okay. And then just one last question if you can bear with me. I know that the defense budget looks like they are rising globally, not just in the U.S. But we also have this budget control act. So, that's kind of the one thing that stands in the way of potentially mocking these things up despite what Congress or the demonstration wants. So, what are your thoughts on how that might play out?

I obviously have no idea, but I am optimistic and I said this in my prepared remarks because from bipartisan standpoint I believe on the house bill, I believe from the house to National Security and Defense bill, 81 Democrats voted for it, I believe that. I know coming out of the Senate committees it was bipartisan supported. So, Mike, now this is my opinion. My opinion is that the threat environment or the perceived threat environment has increased to a level that it doesn't matter which side of the aisle you're on they're on. They are going to support some level of increased defense spending. That's my opinion. I don't know what the numbers are, but my tummy tells me things are increasing. And they're going to increase and if that means a modification or an adjustment to the Budget Control Act that my opinion that will happen quick.

Our next question comes from Ken Herbert from Canaccord. Please proceed.

Hi. Good afternoon, Eric and Dianne.

Hi, Ken.

Hi, Ken.

I just wanted to first ask about the -- I mean you confirmed from 16 to 18, the doubling of the unmanned systems business. It sounds very much like are you confirming to the $800 million, $80 million in adjusted EBITDA for 2018 or is that still not completely confirmed yet?

I am not confirming it 2018 yet. There is a lot of wood to chop. We are focused here on executing. The programs we have focused on bringing in some of these ones we can see. But we clearly can we see the path especially with the leverage we believe we’re going to get on the fixed G&A as revenues begin to ramp.

Okay, fair enough. And Eric you obviously for few quarters now you are able to identify incremental opportunities and I know there was a question earlier on this. But not just in the unmanned business but across the board. I mean you are in a part of the budget where it seems like there's greater growth in the opportunities are attacking the navy in the broader marketplace. Are you seeing other companies crop up and maybe start to go after similar opportunities or do you feel like the competitive environment is still relatively stable. I mean how would you characterize that because it certainly seems like it would start to be very attractive?

The competition in certain of our core focus areas is absolutely increasing and we expected that obviously as you're alluding to. We are going to stay focused on what we believe is our core differentiator. That we are very innovative and I mentioned we have access to a number of private companies that are under the radar that are venture backed or private back that are focused on specific elements as I went through that are relevant to our platforms, low-cost where we are -- demonstrating -- we demonstrated more continuing to demonstrate we can rapidly design it, demonstrated and field it at an affordable cost and competitions where it's common, but I believe if we stick to our knitting, I think we’re going to be successful.

Okay. That's great. And then if I could, Deanna, you obviously gave against sine very nice incremental detail on sort of moving pieces of free cash flow. This year you're now talking or you’ve been talking and we confirmed positive free cash flow in 2018, but it also sounds like some of the investments are clearly getting pull forward in response to some of these opportunities. Can you just walk through a bit of a bridge from '17 to '18 and maybe just in terms of working capital and CapEx and some of the other investments, the path to positive 2018?

Sure, on the LCASD investment that is non-capital related, that’s roughly $7 million to $10 million this year. It's probably going to be a couple million into next year, but that should drop to the tune of anywhere from $5 million to $7 million just year-over-year. From a CapEx perspective, we've guided to a total $28 million to $33 million this year of which $20 million is related to unmanned. And if you look at what our historical spend rate has been prior to the time that we began this unmanned combat initiative, we've been roughly in the $10 million to $13 million of CapEx. So, and obviously, we’re not providing guidance for '18, but as $15 million of that CapEx for this year is LCASD related which should be substantially complete as we have a scheduled flight in the second quarter -- second quarter, third quarter of ’18. We should be substantially complete on that. So that CapEx should not need to be incurred going forward. So, you take that $28 million to $33 million we back out $15 million and there's some additional investments we’re making in the UTAP-22 area. So that I think should give you enough information and then also obviously as we expect to ramp from as we enter into LRIP on SSAT and on the confidential program, we would expect to see our margins lift especially as we realize the leverage on the fixed G&A that we have as well as when we move from development which are very low margin or no margin projects. As we move into margins on those projects. So, that all that put together we expect to see that free cash flow should be positive next year.

Okay. Great, thank you very much for that details. That's very helpful and if I could just Eric finally in the guidance, the revised guidance for 2017, the $20 million step up just to be clear that encapsulates -- that includes most of the opportunity, think of an opportunity to identify. But it sounds like there might be some things that are timing related from late '17 to early '18 that could swing that, but obviously timing is going to be difficult to predict. But do you feel confident that $20 million captures a lot of what you've talked about today that you visibility on or could there be more that comes in at the end of the year?

I am very -- let me answer you this way. I am extremely comfortable with that revenue guidance, extremely.

Okay. Perfect, I’ll pass it back there. Thank you very much.

Thank you.

Our next question will come from the line of Sheila Kahyaoglu with Jefferies. Please proceed.

Good afternoon, guys. Thanks.

Hi, Sheila.

Just a follow-up on Ken’s question. I think you had mentioned three new facilities in the script. Are those included in the $30 million as well to the 2017 facilities?

They are not included from a CapEx perspective, no. So, they are not purchased facilities. They are leased facilities.

Okay. Got it. Just wanted to clarify that.

Sure.

With the Government Solutions business, it took a bit of a step down on profitability this quarter. Can you maybe clarify or going to what resulted in that -- was it mix or was it just timing?

It’s primarily timing. We believe based on our current forecast that it’s going to step right back up significantly in Q3.

And then on the asset program with all the production coming in, I guess starting in Q3 -- starting Q4?

No, starting in Q3.

Starting in Q3.

One of the previous calls Sheila, you may have actually a question. We gave in advance started buying the long leads to make her that we can meet the customer's delivery schedule. So, we were pretty much locked and loaded and ready to go when we got the contract.

And so, how do we think about profitability of that business as it starts to ramp?

We are forecasting a significant profitability improvement in Q3 and then improving more in Q4 because as Deanna touched on this, as the business now ramps and we get leveraged on the fixed overhead manufacturing cost, the higher number of drones that are going to be going through the incremental cost per drone is going to go down and margins will lift. And so, we see a large increase -- large increase in Q3 depending on what happens in Q4 little bit more, one in Q4 but it's going to be at the same level and then depending on timing of the additional orders I talked about maybe it continues into 18.

So, the unmanned systems business that you talked in the second half.

Absolutely. Absolutely.

Okay. That makes sense. And then last question, just on Gremlins, where are we there. Is it just in -- just the past days right now with the 12 months or any update on that would be appropriate I guess.

It is very competitive, I am sorry, I did not talk about it in the script and I am not talking about it anymore. It’s focus time. So, I apologize.

Thank you.

Okay.

Thank you. Our next question will come from the line of Josh Sullivan with Seaport Global. Please proceed.

Hey. Good afternoon.

Hi, Josh.

Just given you are investing in unmanned programs and are going to retain the intellectual property. Is there any way for you to help us understand what the margin profile will look like for those products? Where you own the IT versus maybe a program, where the government funded the R&D?

Before we embarked on converting the target unmanned aerial drones and making the investment in the tactical ones, and you can actually see this now because of the step we segmentized last year. Our margins in this business were mid to high teens, and we’re comfortable that ultimately when we get -- when the development fallout because we’re still developing platforms and when we’re in full rate production that's our objective to get back to where we used to be.

And then just with the number of awards and unmanned aerial drones, you are looking at between now and early 18 some of those being classified -- where you can't talk specifics. Is there any way to scale, kind of the overall dollar value of those awards just in aggregate over the next six to nine months maybe top and the low-end understanding the budgets are hard to time exactly?

Josh, I would I would love to, I am very hesitant and weary on this because of what’s happened from restriction standpoint in the last few months. I’m just very hesitant to select, I just don't want to. Like I said just overall, I’m uncomfortable that people will see the progress that we’re making overall with the unmanned business with the profitability and the revenues is going to take a significant step function in Q3. The second half of the year for unmanned business is going to be -- we execute these programs is going to be very powerful. Revenue and profit very, very strong and whatever I can tell specifically on any of those I will. But right now, I'm just not going to do it sir.

Our next question will come from the line of Eric Selle with SunTrust. Please proceed.

Hey Eric, you said you are extremely comfortable with the revenue guidance and I’ve seen that carries over to the EBITDA. Just the major builders in that, I guess is about 400 basis point growth in EBITDA growth. Is that…

Eric, I lost you buddy.

Can you hear me?

Ask the question again, please. You broke up for some reason. So, I was just asking the major driver…

We’ve lost Eric’s line. I’ll move on to the next one. Our next question will come from the line of Michael Ciarmoli with SunTrust.

Hey, good evening guys. Thanks for taking my questions.

Good afternoon.

You mentioned three new opportunities new customers. Can you maybe give us a little bit more color in terms of what are maybe the plain targets out of that? What are unmanned tactical opportunities. Can you give any more color in terms of what you are looking out there?

The three I was referring to all tactical.

All tactical. Are they all, can even say, are all of your customers still domestic customers. Are you looking at any international customers with these tacticals?

I am smiling. I cannot comment on that at this time. I am sorry.

Just on the budget, maybe going back to what Ken was asking. You said you are very comfortable. Do you need – do you guys need the '18 budget to be signed by September 30. Are you anticipating, that typical Washington grid lock happens again and we go into a continuing resolution. I mean that’s been pretty common. Would that add a wrinkle at all to your plan?

At this time, we absolutely do not believe so. We believe if there is a three or four month continuing resolution. We will be fine with the guidance we’ve given.

And then just a last one for me. You mentioned the CapEx. Is the bulk of that CapEx for the target side of the business? Certainly, it sounds like you're ramping up the AFSAT program or is it more for the tactical side?

It’s primarily off of the tactical. A big piece of it is related to LCASD.

And then just the last one. Any thoughts on the PSS margin. I know they – you know you are kind of grinding through some challenges there. They picked up, they turned positive this third quarter. What’s the expectation there. I mean where can you get those margins into a low single digit, mid-single digit or how you are looking at that business?

As Deanna mentioned in her prepared remarks. We had some severance and some restructuring. So, we continue to address that cost structure in that business and we’re going to continue to do so right now. Our forecast for that business in Q3 and Q4 is to be low to mid-single digit profitability. That’s our forecast. On the very positive side, our bookings in that business for the past four or five quarter, the gross margin has been 30% to 32%, which would equate to -- that would equate to if we execute a mid-to-high single digit profit margin. But we're going to shoot for a low-to-mid and take it one step at a time as we try -- as we try to write this business.

Got it. Perfect. That's helpful. Thanks a lot guys.

Thank you, sir.

Thank you. And I am showing no further questions at this time. So now it's my pleasure to hand the conference back over to Mr. Eric DeMarco, President and CEO for some closing comments and remarks, Sir?

Thank you, everyone for joining us this afternoon. We will be circling up with you for Q3 results in the fall. Thank you.

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