Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your host for today’s conference Ms. Marie Mendoza, Vice President and General Counsel. Ma’am, you may begin.

Thank you. Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions third 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.

Great. Thank you and good afternoon. Over the past 20-plus years, the U.S. military has focused on winning the fight at hand, the war on terrorism in Afghanistan, Iraq and elsewhere. During that time, our nation’s adversaries have been investing heavily in new technologies and systems to catch up with and potentially surpass the United States and its allies’ national security capabilities. In response, innovation, technology infusion and recapitalization of systems to address peer and near-peer adversarial capabilities and U.S. operational readiness has begun and Kratos is well-positioned for this recapitalization with our proven ability to rapidly innovate, develop and field, leading technology systems at an affordable cost. As a result of these perceived threats, national security and defense related budgets are anticipated to increase globally, including for the U.S. and its allies. Kratos’ core business areas which we believe are closely aligned with today’s national security priorities, include our satellite communications business, where we are an industry leader in providing signal monitoring, intelligence, and command and control equipment, which supports approximately 85% of all U.S. space missions. We also own and operate a global terrestrial network, which monitors satellite signals and beams for our customers, whereby we can identify interference, jamming and other anomalies, and we geo locate where the source of these issues originate, so that our customers can take action and neutralize them. Unmanned Systems, we are the industry leader in high-performance jet powered unmanned aerial drone systems, which are utilized for tactical missions and adversary threat representation for operational readiness. Microwave electronics where we provide subsystems and components in support of electronic warfare, missile, radar, missile defense, ISR and communication systems. In ballistic missile defense, where we provide targets which represent ballistic missile threats of potential adversaries of the United States, like North Korea and where…

Thank you, Eric. Good afternoon. Kratos’ third quarter 2017 revenues of $196.2 million exceeded our expectations of $180 million to $190 million for the quarter, due primarily to strong execution and deliveries in our satellite communications and training systems businesses, and our Unmanned Systems business with certain deliveries previously expected for the fourth quarter, coming in the third quarter. Year-over-year consolidated organic revenue growth of 18.6% was driven by growth across all of our reportable business segments with 10.9% in our satellite communications, technology and training businesses, as result of recent contract awards in these areas, growth of 127.3% in our Unmanned Systems business which was also driven by recent contract awards, and 14.3% in our public safety and security business, driven primarily by a security system deployment for a mass transportation authority. Our Q3 adjusted EBITDA of $14.5 million exceeded the high end of our expectation of $10 million to $14 million, due primarily to a favorable mix of higher margin work and shipments in our Unmanned Systems and microwave products businesses, and improved performance in our public safety business. On a year-over-year basis, our Q3 2017 adjusted EBITDA increased 7.4% or $1 million from $13.5 million in the third quarter of 2016 to $14.5 million in 2017. Our adjusted EBITDA for the third 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 for investors to understand our financial performance. Restructuring related items and other $2.1 million, which includes $2 million representing excess overhead capacity, consisting of $1.4 million in our modular systems and $600,000 in our Unmanned Systems divisions. As production efforts are expected to ramp in our modular systems business, based upon…

Great. Thank you very much, Deanna. We’ll turn it now over to the moderator for questions.

[Operator Instructions] And our first question comes from the line of Ken Herbert from Canaccord. Your line is now open.

Hi. Good afternoon, Eric and Deanna.

Good afternoon.

Good afternoon.

I just wanted to first ask, in the Government Solutions operating segment, the step down in operating profit, I think you attributed that to mix. Can you provide any me more detail, specifically on what that mix impacts was and maybe the -- some of the products that were -- shipments in terms of maybe a little softer than expected in the quarter?

Sure. Those both in our modular systems business, so that was impacted from an operating income perspective due to the excess overhead capacity issues and that was about 1.6 million -- 1.4 million, excuse me. In our satellite and communications business that was primarily a heavier mix of hardware versus software and licensing, which typically would be higher margin. We do expect those shipments, higher-margin product mix to occur in Q4. So, there was a fairly sizable impact during the quarter on that business unit. Those were the two primary drivers.

I think just so I understand correctly, you do sequentially and year-over-year expect to see growth in operating income in this particular segment, correct?

Ken, we don’t provide guidance on a segment by segment basis, just on a full consolidated basis.

But, Ken, I want to reiterate what Deanna and I said in our prepared remarks. The mix in satellite in Q2 was very strong, the mix in Q4 looks -- right now, it’s shaping up will be the strongest quarter of the year; being product and delivery based on small production lots that include software and the firmware, it can just be lumpy. So, it’s just the timing matter.

And if I could just finally, on the unmanned segment. I appreciate the doubling of the business without any of the tactical opportunities. You did however mention Eric that you do expect some uptick in funding associated with UTAP-22 and I know you recently had some successful demonstrations there. Can you just provide an update on that particular program, maybe some of the technologies you recently validated and what you view as the potential sort of magnitude of what could be the upside there, heading into 2018?

Yes. Ken, this is one of the programs that as I mentioned last quarter, going forward, we have to be very, very careful on what we talk about. So, I apologize, I cannot talk about what we validated and I’m not -- I can’t talk about what’s going on here. I apologize.

Maybe then, if I could just finally, on the legacy business, you have highlighted a number of opportunities around missile defense and the target side of that business, and I know there seems to have been a step-up in contract activity there for you. Maybe you can just talk into 2018 around missile defense opportunities and the upside you potentially see there as part of that step-up in unmanned?

Absolutely. So, relative to missile defense on unmanned, Ken, is that where you are going? Is that it?

Yes, exactly, missile defense in general.

In general, got it. So, missile defense in general, we are one of the two primary providers of ballistic missile target systems that are used to exercise from radar systems like AMDR, which we have had several successful tests recently, weapon systems, surface based, surface-to-air missile systems, one of which was validated at Formidable Shield. The OPTEMPO here is increasing significantly, it is expected to increase significantly for us going forward because of world events. We are a key provider on specific hardware on the Patriot, Missile Defense Battery; we are right now in a very large production run on Patriot batteries for our prime customer. There have been some large, recent awards for THAAD. We have historically been one of the key providers for THAAD related ground equipment. A very big one, fingers crossed that we’re going to get very soon has to do with the Barak-8 missile where our content is around $40,000 per missile and we’re hoping to get an order to begin the production run of several hundreds of these in the next couple of quarters. So that that missile defense system is a key system for us. That’s just a handful of the ones we’re involved in, Ken, that come to mind.

And our next question comes from the line of Mike Crawford from B. Riley. Your line is now open.

Thank you. Can you provide some color on how you’re progressing with SSAT production as you kind of move up the learning curve on LRIP1 production and what that could mean for margins in LRIP2 and for that [ph] production?

Absolutely. So, we received LRIP1 at the end of Q2. We had expected to receive it much earlier in the year, possibly even at the beginning of the year, but because of the 2017 continuing resolution went almost six months, there was a new production start, we got it later than expected, we got it in…

End of June.

End of June, June 30. So, as I believe I indicated on our Q2 call, we worked very closely with our customer and we leaned forward and we have placed orders on most of the long lead items on the building material including number one, the turbo fan engines. So, we are ramping up very quickly now on these first number of drones. Deliveries are going to begin next year. And we expect sometime in the middle of next year, depending, nothing crazy happens with the 2018 budget, to get LRIP2, which has an opportunity for significantly increase quantities. Those would overlap on top of LRIP1. So two things would happen, we’ll be coming down the learning curve, and we’ll be able to spread the fixed overhead manufacturing cost across a greater number of units, which hopefully will just increase overall profitability for the entire -- those entire runs. And then, currently, full rate production, which is expected to be even a greater number of units, is expected to begin in 2019 at which time greater quantities, greater learning margins would hope to increase further. And Mike, I don’t want to give any rates on that, right now, because we are still working some of these things with our customer.

Okay. Thank you, Eric. Related, when you started progressing down the path of all this internal R&D in the Unmanned Systems business, you took down what had been a third production line at CEi and have been running, just two, I believe, AFSAT and Firejet et cetera, and are you now back up to running three production lines in Sacramento, or still two in the R&D line?

We are back at three and we are going to be full-blown at three next year in 2018. We are also doing the development programs there as well. So, this…

And then, in the past week, I think we saw the first production of a transaction agreement from the DIUX take one of these incubated technologies out, to the broader market, so this company worldwide technology for cyber security product employees management product. Is that something that you are looking for on the Mako as well?

We are working on a number, Mike, of OTAs across the Company, with differentiated offices. It’s part of our strategy. And we are working on that type of vehicle with the customer that you mentioned. I don’t want to get ahead of any customers or anything here but that is the model we are pursuing, not just there but elsewhere across the company.

And then, one final question. In September your RT Logic business was named with number of other companies as part of the near $1 billion IDIQ for weapon systems research test and evaluation. Is that -- can you talk about what’s going on there at all?

Absolutely, Mike. That is a -- we are looking that as a fantastic vehicle, not just for RT Logic but across our Company, based on the statement of work and the applications that are appropriate underneath that vehicle. This was a key win, our RT Logic guys, they are some of the best in the absolute Company and they drilled it this for the entire business. This is one -- I’m glad you are asking unless you and I both stay on top of this one going into 2018 and 2019, this could be another growth driver for us across many disciplines that are noted in that statement of work. So that was a good one that you picked up.

And our next question comes from the line of Mark Jordan from Noble Capital. Your line is now open.

Eric, you mentioned pro Formidable Shield free trials out in the North Atlanta in September and October. I know that there were multiple Firejets used in that exercise. Was Firejets used in that application because your of SSAT was not available or is Firejet a very viable alternative in the -- for military sales area for that type of training exercise?

Good question, Mark. It is it is absolutely spot on for foreign applications as in Formidable Shield. QinetiQ put out a press release, they are a strong strategic partner of Kratos. QinetiQ has the 20-year CATS contract with the UK Ministry of Defense for their weapons ranges and providing them threat representative targets. QinetiQ’s press release talked about this was the first time that they are now providing those targets to the UK Ministry of Defense. This is -- I think they actually said in their press release that this is the most sophisticated target which it is in their inventory that they’re providing, the MOD -- the UK MOD. This is just one example where we see significant growth opportunities going forward. I was forwarded a briefing over the weekend on the high-performance target market internationally and globally. And Mark, very simply said, when you see friendly ally countries to the U.S. buying U.S. weapon systems, they want to exercise those weapon systems against the best targets, which are U.S. targets, which are Kratos targets because you know we deliver to the U.S. Navy, Air Force and Army. And right now, the Firejet is the tip of the spear for us. And it is -- we are selling it to a number of international customers. We just signed a contract, I can’t disclose who for, a number of them with an additional international party. So, you are spot on, on this relative to FMS and direct commercial sales internationally.

Okay. Could you comment on what your debt refinancing strategy and/or plans will be?

We -- as you can imagine with our bonds now approximately 18, 19 months out in the middle of 2019, we are very closely studying alternatives for the Company, right now. The markets -- the debt markets, and our current contemplation would be a straight debt refinancing, debt for debt. The markets are very, very strong right now, and they are very strong for Kratos. You may have seen -- and Deanna will help with me here, recently the rating agencies that they upgrade us.

Yes. Shortly, after the equity, the last equity ratio that those agencies upgraded us.

So, we’re -- Mark, we’re closely looking at this right now. Our net leverage right now is under 3 to 1. We have completely restructured and repositioned the balance sheet and we’re looking to take advantage of that as soon as practical.

Okay. Do you have a sense of the current debt load that you have? How much you would reduce that, $369 million of debt to -- in this next round and any sense of -- would you pay down a $100 million of that, and if so, what kind of drop in rate would you assume?

So, Mark, when we did the equity raise, our intention, stated intention was to use approximately $100 million of those proceeds to redeem or retire debt. So that’s still within the range of what our expectation is. As far as rate, it’s a little premature to discuss where we think it could end up at.

Yes, depending on which path we chose…

Yes.

If we went bonds or we went term debt or we went a bank, they all have their pluses and minuses of course. So, we’re looking at all that. And obviously, we’re in close communication with the rating agencies relative to that as well.

Yes. Just the final question, relative to the debt issues. Would it be safe to assume that you would like to implement some restructuring by the end of the first quarter of 2018?

Mark, all things being equal, it would be great if we could have this all wrapped up by Q1? Absolutely, yes sir.

Final question for me is relative to DSOs and milestones. Obviously, when you had UAV customers singing contracts with you a year or so ago, your capabilities were not as demonstrated in the marketplace as they are today. Moving forward, as you sign contracts with customers, will you be seeing improved cash terms because your capabilities are demonstrated now and therefore being able to get cash earlier because there is less technology risk for the customer?

You are exactly correct. Especially with the most recent awards that we have been awarded, they are more progress billing focused rather than milestone focused, so yes.

Yes. We are strategically moving more towards progress billing, Mark.

And our next question comes from the line of Michael Ciarmoli from SunTrust. Your line is now open.

Maybe, just first on the -- just for clarity, the bookings front. That was the strong bookings in the quarter. You had the $65 million that flipped out the last quarter. I was just trying to get a sense, I guess the year-to-date is about 0.8 times or so. What areas of the business are you seeing weakness in the bookings?

Our government services business. Our government services business, Mike, is about $70 million or $80 million, something like that. And those contract vehicles are typically three to five years. And so, when you win a contract, let’s say it’s a $30 million contract to book $10 million of it in funded and $20 million of it in unfunded, and that’s the booking. And so that cycles. And we have had very low bookings thus far this year in our government services business directly related to that. That bookings cycle starts coming back next year. But that’s what the number one downer has been, legacy government services contracting. [Ph]

Just to put it in more clear focus, it’s every business with the exception of that legacy government services business had a book to bill over 1 to 1 over -- for quarter. That clearly was it.

And then, just Deanna, I want to make sure I heard you correctly, the free cash flow this year, given the collections, it’s going to be negative 55 million this year?

That’s correct.

So, as we look into next year, the expectation is positive free cash flow, so you will get the pickup in the collection, presumably. I think Eric, last quarter, I believe you did a walk for us in terms of what some of the investment things that roll off. But I mean are we thinking an improvement over the $55 million? Can we get to -- is it just above breakeven or can you maybe quantify the level of cash flow to some extent next year?

Yes. So, Mike, let me walk that through what the investments have been this year. So, of that $51 million to $58 million of used this year, $42 million to $54 million of that is Unmanned Systems. So about half of that is CapEx, some of it is LCASD investment that is non-capital related. And then, there is about $18 million to $22 million related to milestones that will be collected next year. So, as Eric and I both mentioned, the investments in LCASD are winding down. To-date, we’ve invested about $6 million on the LCASD non-capital investment where the total we expected over time is $13 million to $14 million. So, there’s a little bit less for Q4 as well as some into 2018. The CapEx we expected on LCASD was about $15 million to $17 million; to-date, we’ve incurred about $10 million to $11 million. So, there is still some to be completed in the fourth quarter and in 2018. But clearly, the lion’s share of that investment was completed -- will be completed in 2017. So, in addition with those investments winding down and those milestones being collected, we’ve also entered into production on LRIP, which is progress billing focused and that was $37 million award that we announced at the end of June and that will be on a progress billing perspective. So, there’s a lot of -- as you can imagine on a number of the programs in Unmanned Systems, in 2017, they were in development. So, they were either at low margin, no margin or negative margin; and those are going to [ph] flip into profit in 2018. So, you’ve got both those waves, if you will, impacting total consolidated cash flow.

Got it. That’s helpful. I appreciate that. And then, just the last one for me. Eric, on the doubling of unmanned, what is sort of -- when we look out to 2018, what would be the mix versus the target drones, the legacy CEi versus revenues from some of the newer programs, call them the intelligent tactical drones, if you would?

It’s going to be 90-10, 80-20 something like that.

Okay, got it.

90-10, 80-20 in that ballpark.

Okay.

And Michael, one thing I want to add on what Deanna said, very importantly. Our plan to make those investments is the only intellectual property in all the planes, which we do, so no one else can build them.

Sure. No, makes sense.

That was more of a commercial model.

Yes. Since you brought it up with that commercial model, any idea what the margins might be?

Yes. So, you can see this in our previous SEC filings. Before we started investing in tactical, our unmanned business was low-to-mid-teens. Then, we started investing in the tactical and in a couple of next generation target drones. As we saw in Q3 and as Deanna just explained, the investments have started coming off, we made $5 million of profit in Q3 in unmanned and they’re going to continue to come down. Production is increasing in a number of areas now. So we’re now heading into the up step.

Got it, got it. Very helpful guys. Thank you very much.

Thank you.

And our next question comes from the line of Sheila Kahyaoglu from Jefferies. Your line is now open.

I actually did have a very similar question on unmanned and the impact of mix. Maybe could you parse that out a little bit further, Eric, on the moving pieces of unmanned and a significant improvement in earnings there?

Yes. The two big pieces are investments we have been making in a number of drones are winding down. The only significant one we have going right now that’s left is LCASD. We completed the investments in all the other ones and they are flying or they are about ready to fly. And LCASD is going to be substantially done by the end of this year, completely done first half of next year. So, those investments are coming down and those investments were in drones that are now going into production. And so, we have got two foregoing here. The investments or those expenses are coming down and production and revenue is driving up and that is what is driving the profit, which I think last year our unmanned business in Q3 did $1 million in profit and this year it did $5 million, directly related to less investment, and the investment in the drones that we were making to go in the production are now going into production.

And so, we think about the production aircraft for next year, is it just SSAT and AFSAT in terms of…

So, let’s talk about the three primary target platforms. There is the 167. The primary customer for the 167 is the U.S. Air Force. However, we are selling it to multiple international customers, multiple. The primary customer for the 177 drone is the U.S. Navy. We have sold that to multiple international customers, and we expect that to start ramping up significantly internationally, now that the U.S. Navy is going into production. We have been selling the 178, the Firejet to the U.S. Army. But as I was -- as related to Mr. Jordan’s question, that is probably the drone that we are selling the most internationally. And so, all of those, to the three U.S. customers and the multiple international customers that are ramping, is what is driving at across those, and those are just target terms.

And then, on public safety, was it a onetime contract, should we assume more of a normalized run rate for the business?

In the public safety business, we’ve had four or five very large security deployments that we were awarded years ago. And so, Sheila, our strategy was when the Budget Control Act came in 2011 and the base defense budget was going down from 550, 560 to 480, we made a decision that we were going to start bidding on very large security deployments to offset that DoD revenue drop. And we won a number of them and our public safety business revenues went something like 130 to 210. When the bipartisan spending agreement was signed at the end of the 2016 -- at the end of 2015, excuse me, with the President and Congress, which basically shut off sequestration for 2016 and 2017, defense budgets were stabilizing at 530, 535 base. We made the decision not to bid on any more of those large deployments, and we actually announced that in Q3 of 2015 on the call. So, these four or five very large programs that are very, very low-margin, they’re winding down, and they’re going to be almost all 100% complete by the end of this year, one or two might go into Q1of next year, but they’ll all be done. And with those coming down, and we switched our strategy to bid on higher margin, pure system integration jobs, that’s why I mentioned our bookings. Thus far this year, our gross margin and bookings have been 30%. This is why our public safety business -- its profitability is now ramping. The big old legacy low profit ones are coming off and the new higher margin pure security system integration ones are coming in, and that’s why the profitability is ramping.

Okay. So, this is a normalized run rate for profitability going forward?

I’m going to say it’s normalizing, it’s normalizing. We’re going to head into Q4, but as I did say, next year, next year, we expect next year to be far more profitable than -- far more profitable than 2017 because of what I said.

Sure. And just last clarification, for Deanna, on Mike’s question with free cash flow. Do we think about free cash flow swinging from negative $55 million to around -- it could be quite a significant frame to positive $20 million to $40 million next year?

Yes. I can’t give a number, Sheila, since we are not giving guidance yet for 2018, but we do expect it to be positive, especially in the second half of 2018. Clearly, in the first half of 2018, we still have some of these investments that we’ll be completing, but we should also -- that should be offset by some of these milestone collections that have been pushed out from Q4.

And our next question comes from the line of Josh Sullivan from Seaport Global. Your line is now open.

Just a clarification question on the manufacturing footprint. If you do get that that 100-unit order, you mentioned in the prepared remarks or the other recent significant order, do you have the capacity in the current footprint to meet those orders?

We’re comfortable that we’re good through 2019. However, as I believe I said on the last call, we’ve pulled in the new facility. We’re going to be signing those leases by the end of this year. We’ve already started hiring people. We have a key executive who’s agreed to relocate there. We’ll have the ribbing cutting by the end of this year. We’ll be up and running next year. So, we will have the flexibility, if some of these other bluebirds occur, but we can handle it. So, we are tracking this very closely as you’re very attuned to, Josh.

Okay. Thanks for that.

Yes.

And then, I know you don’t want to talk about specific programs, but maybe on a learning curve basis, for the upcoming flight test on the LCASD. Can you talk about any commonality with the test you had maybe on the UTAP-22 or other platforms, flying these drones and swarms of other missions, is the learning curve maybe lower for LCASD, just given that commonality?

Yes. Yes, sir.

Okay. Fair enough. And then, I think you mentioned some investments on the training capabilities, can you dig into that, where are those investments being made?

Those are more of CapEx related.

Any specific capabilities?

Nothing specific to talk.

Yes. The big programs that they are related to are the KC-46 aerial refueler that we won last year, the Marine Corp Common Aircrew Trainer for multiple Marine Corp helicopters we won last year. Those are the two primary ones. Those are the two big ones that come to mind.

Most of the investments for that segment are primarily related to the satellite communications business, Josh, not as much so on the training side. They just happen to be all on the same operating division, but most of it is on the satellite side.

And our next question comes from the line of Brian Ruttenbur from Drexel Hamilton. Your line is now open.

Yes. Thanks very much. Just one final question on timeline of events to watch for catalyst. It looks like the biggest one on the UAS division is the Gremlins in first quarter of 2018. What are the ones should we be watching for along the magnitude of the Gremlin?

If we are fortunate enough to be successful on this approximate 100-unit drone award, that could happen by the end of the year Q1 and if that’s announceable, that would be a biggie. We are designed in on a fighter aircraft on the Electronic Warfare System. And our content is 200,000 to 250,000 per plane. We are keeping our fingers crossed. We are expecting our order for the first 100 aircraft in Q4, Q1. There is a missile system, were designed in, it’s 35,000 to 40,000 approximately 40,000 per missile. We are expecting our order for the first several hundreds of these, Q1, Q2. So, those are some of the biggies that come to mind.

Okay. So, there is top four or five. Perfect. Thank you very much. And then, the last question. Plans to maybe streamline operations, focusing only on UAS, is there any thought about doing that or you are going to be a pure-play player versus these other divisions?

We are very focused and we are going to be more focused than ever on satellite communications, microwave electronics, Unmanned Systems, and our training business which is just ripen. I mean that $100 million contract we just won was fantastic. So, those are the four that have done great and they are really well-positioned.

Thank you. And at this time, I’m showing no further questions. I would like to turn the call back over to Eric DeMarco, for any closing remarks.

Great. Thank you all for joining us this afternoon. And our next scheduled chat will be when we report Q4, I think at the end of February or so. Thank you very much.

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may all disconnect. Everyone, have a great day.