Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Fourth 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 be provided at that time. [Operator Instructions] I would now like to turn the conference call over to Senior Vice President and General Counsel, Marie Mendoza. Please go ahead.

Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions fourth 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 and good afternoon. Kratos' fourth quarter and full-year 2017 financial performance clearly demonstrated the continued successful execution of the strategy we began a few years ago to build the technologically differentiated product and intellectual property based business focused on the rapid development, demonstration and fielding of affordable systems for national security. Today's announcement of the pending sale of our public safety and security system integration business for approximately 70 million and expected net cash proceeds continued the successful execution and a position Kratos for the significant organic growth trajectory we are forecasting for our company over the next several years. The divestiture of PSS will further reduce Kratos' net leverage, improve our financial flexibility and financial matrices going forward including Kratos' growth rates, margins and adjusted EBITDA rates and position Kratos' as a pure-play high-growth defense, technology product and systems company. We believe that the business we have built in Kratos from the portfolio of systems and products we offer positioned our company for future, year-over-year revenue, profit and cash flow growth irrespective of temporary or quarterly bumps resulting from the recurring DoD budgetary delays. The success of Kratos as business model is also demonstrated in a number of unmanned drone system contract awards, we have recently received including $93 million and $81 million, a $24 million and a $23 million award each of which are sole or single source to Kratos. Importantly and similar to Kratos' AFSAT program with the United States Air Force and our SSAT program with United States Navy each of these recent awards are expected to be multi-year multi-decade programs in length with significant future increases and value expected with 100s and potentially 1,000s of Kratos' drones ultimately delivered. And additionally, a government agency has recently issued an intent to award Kratos an…

Thank you, Eric. Good afternoon. Kratos’ fourth quarter 2017 revenues of $202.2 million exceeded our expectations of $185 million to $195 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 and execution previously expected for the first quarter of '18, occurring in the fourth quarter. Fourth quarter year-over-year consolidated organic revenue growth of 11% was driven by growth of 65.9% in our Unmanned Systems business driven by lower rate initial production of certain of our aerial targets in '17 and growth of 11.8% in our PSS business driven primarily by a security system deployment program for a mass transportation authority. Revenues in our largest segment KGS declined slightly by 0.4% due to a reduction of over 15.3 million year-over-year in our legacy government services business, substantially offset by year-over-year increases in all other business units within our KGS segment. The growth in our KGS segment went approximately 12% year-over-year for the fourth quarter excluding the reduction in our legacy government services business. Our Q4 adjusted EBITDA of $17.8 million slightly exceeded this high end of our expectation of $15.4 million to $17.4 million, due primarily to a favorable mix of higher margin work and shipments in our Satellite Communications Unmanned Systems and microwave products businesses, and improved performance in our PSS business. On a year-over-year basis, our Q4 2017 adjusted EBITDA increased 32.8% or $4.4 million from $13.4 million in the fourth quarter of 2016 to $17.8 million in the fourth quarter of 2017. Our adjusted EBITDA for the fourth quarter is from continuing operations and excludes the non-cash goodwill impairment charge of 24.2 million and non-cash stock compensation cost of 1 million. On a GAAP basis net loss for the fourth…

Great, Deanna. In closing I want to state that our public safety and security businesses management and our employees they just did outstanding job, supporting Kratos in the midst of the 2011 budget control act related sequestration and the significantly declining in reduced DoD budgets. I know the entire management team extremely well and I thank them all for everything they have done for this company. To the PSS employees over the past several months I have gotten to know the key leadership is Kratos and I can assure that there is no better home for you other than this company. Their leadership team and their management team is outstanding. They have the absolute right strategy for their business and your business combined and the opportunities we all going to have personally and professionally of very candidly far greater than we could have given you because their focus is fully on your business. So I thank all of you as well. With that I’ll turn it over to questions.

[Operator Instructions] Our first question comes from Mike Crawford with B. Riley FBR. Your line is now open.

How would you characterize your capacity utilization in the Unmanned Systems operation today in California and what room do you have to increase that before up and running in Oklahoma?

That is actually an excellent question. The business is ramping very, very rapidly. My most recent estimates we're going to generate well over a 100 maybe a 130 drones this year just in the current base plan and we expect some additional significant orders coming in. We believe that we are very well resourced and have the capacity to handle whatever practically comes through the end of this year. Our facility in Oklahoma progress there is moving rapidly now. It will be prepared to start manufacturing in the second half of this year. However, we have also now have started having discussions with another mid-cap defense company that we know very-very well. We have an excellent relationship with them and it is possible that we may bring them into the partnership to help us with this production as well. So,, we are mapping it out Mike because things are accelerating rapidly and there are some big things we're not able to talk about that may come to fruition in the second half of this year and we've got to be ready.

Okay, and thank you. And then just two more quick ones, I'll just ask both now, so you said you are under contract for the 5 GAT and so I'm wondering if that is to be used as a target drone or is a tactical combat drone? And then the other one as you talked about recent information leading you to believe that Gremlins could be a game changer and I'm wondering what information would lead you to believe that there would be game changer versus prior expectations?

On the 5 GAT obviously 5 GAT stands for fifth-generation aerial target that's all I can say about that and on the Gremlins Mike I'm sorry I cannot comment on that there has been a number of pieces that have come out in the past three weeks relative to that program that might give you some additional information but I can't talk about that now it's a still competitive.

Our next question comes from Ken Herbert with Canaccord. Your line is now open.

Eric and Deanna, I really appreciate all the detail. I just wonder Deanna really I mean the guidance calls very significant improvement in cash from operations and free cash flow for the full-year. I know you went through some of this, but how will you characterize maybe the risk to that 40 million in cash from operations at the midpoint for 2018? And maybe just a little more detail on specifically, what you assume working capital and some of the other key pieces to provide?

So some of the rest are there is some flight milestones that need to occur on some of the Unmanned programs which just doing part arrange time to get on to certain ranges that Ken delayed that milestones so that's one of the risks some of the other ones we don’t really see as risky because they are just really hitting certain performance metrics that are in our control which obviously that the flights on range time those are not totally in our control. From a working capital requirement prospective we do expect some use in working capital as we continue to grow the business but that some of that is offset in the cash flow guidance that we given with some of that milestone that we do expect and to collect. Some of these milestones are milestones we had expected in the second half of '17 and they have moved into '18 to some of them we do expect to see some in the first half of '18.

And Ken, let me touch on that also, it ties into my prepared remarks on the change in methodology, we’ve now implemented relative to liquidity to increase the liquidity and it's got a significantly drive it. Let’s say for example we have a 15 month production run and let's say based on the build plan, I will just talk about one subsystem. The turbo fans they can come in month eight and you can still deliver on your delivery schedules in months 10 through 15. Historically to be safe to build credibility with the customers to make sure our past performance qualification for bullet proof, we would place the orders because we would know. We would have an indication, we were going to get the order and we would receive those engines in my example in month one. We might not get the milestone for that until month seven or eight, so we would carry that either it in inventory or for what percent completed would be an un-build in revenue. So we been able to change that now with the improved capital structure and our past performance calls, we’re mapping everything in my example to come in month eight that’s when the milestone hits, so we get the engines and in my example we pay for them, there is no liquidity carry. Yes it has moved some of the revenue recognition out into months nine to 15 in my example, it also comes into the 15 month period of performance but it significantly improve liquidity and we’re doing that across the Company now, we've just begin.

And Eric, can you just it sounds great, can you just may be quantify or brackets sort of where you think, just through taking those kinds of steps and more focused on your efficiency. What that could contribute, say in '18 or may be in '19 on a full year basis?

Well this is a -- this is customer by customer, we're negotiating it, we been successful on some of that, that’s far which tighten to your initial question, your improved liquidity for '18. I'm not prepared to do that yet maybe later this year, once we get some of these negotiated, we will be in a better position but I think after all number out there will be unsuccessful with certain customers.

Got it and then just finally, I can appreciate that, it sounds like with the better source of budget visibility, I know we’re still operating under a CR and I think we all agree that at the end of March is realistic assumption of when we thing finalized for '18. What the pressure in your view and will there be things that might slip into fiscal '19 or your calendar '19 just because the ability of your customers to maybe put all this capital to work in a sort of truncated 6 months fiscal year? Is that a risk that you potentially see the good impact timing on something where you already starting to see may be things loosing up just with, with obviously the better visibility and sort of broader agreement on the budget numbers?

So we had a very similar situation in last year in 2017. And last year in 2017 assuming we get the 18 budget at the end of March, it's very similar to where we got to last year and we did not receive a number of our contracts starts or increase production until June, July, August and we didn’t get one of them until December of '17. Because of the CRA, we've taken those same assumptions and mapped that into our 2018 forecast where assuming we got a 2018 budget at the end of March we are not making the assumption we are going to get all this stuff in April and May. We are spreading it based on our historical experience which we just had last year.

So even though you are obviously guiding to a very strong second half and particularly very strong fourth quarter that already reflects a potential timing risk of some of these contracts?

Yes it does. Yes, our assumption in our guidance if we get at it, there is a budget in place by the end of March 23rd I think the end of March.

Thank you. Our next question comes from Mike Jordan with Noble Capital. Your line is now open.

Eric, a question relative to the SSAT contract, there are option exercise you announced yesterday the 24 million or the DoD announced. Was that a plus up to LRIP 1 and when do you expect LRIP 2 to be released?

Mark, I have to be very careful, on what I say here. The recapitalization of strategic weapon systems has not only begun, but it’s accelerating because of perceived nation state threats. And those weapon systems need to be exercised. So for example over the past couple of decades appropriately we have been addressing the terrorist threat and most recently ISIS and so I’ll use an example our fighter aircraft have been flying missions not against nation say peers in the air but against terrorists on the ground. So, part of readiness now is the increased use of targets to prepare them in my example for taking one nation state weapon system, so things are pulling to the left and quantities are increasing. I don’t want to specifically answer your question and get ahead of the customer but I’ll say again at this level things are moving to the left, and things are accelerating and that’s one program that putting aside these tactical ones that is going to be the largest opportunity the largest program in the Company very soon -- very soon.

Is it correct that you have completed manufacturing of lot 13 of the offset in that ‘14 is expected to be awarded in the second quarter so you will have a gap here in the first half of the year pushing those revenues mainly to the second half?

Yes. So, we are almost substantially complete with lot 13, we are expected keeping in my our liquidity plan we are expected to get going on lot 14, I am going to say July, end of June, July, however we are working on I cannot name customers, certain international, opportunities that are in the line as well. So we should not have the significant break.

The LCASD you said is going to be -- it's first flight will be in Q3, do you have an idea when the decision point might be for the air force to look at procurement of potentially production units?

Yes we do.

Will you share it?

I’m sorry no sir, I’m sorry.

Last question from me, just quite a clarification, PSS is already in service revenue is that correct?

As far as service revenue that we report there is some other service revenue within CGS that has reported in services lines, because there are some services that are wrapped around product and they are actually classified as services.

But a 100%, yes.

Yes, as Eric said, a 100% of PSS is service.

Okay so couldn’t crack that out of that prior services.

That’s correct, yes.

Our next question comes from Seth Seifman with JP Morgan. Your line is open.

This is actually Ben Bernstein on for Set. Just wanted to ask a couple of quick ones on the divestiture of PSS I mean why now, why is now the time to sale this business I think it has been all investors mind for a while as a non core aspect.

If you could see me I’m smiling because from our perspective the vast majority of Kratos is investor or potential investors have been encouraging us particularly in the last 12 months and it's been ramping up in the last six months as the other businesses were gaining traction. As why we don’t divest this and become a pure play systems and Product Company. And so we looked at it as we announced that this was a non core business. I think at the end of ’16 and we have had a lot going on if you could imagine this process we use that very delicately with this took an extended period of time and we are where we are and I’m absolutely convinces with what we see coming in our satellite business, our training business our microwave electronics business at our unmanned business focus. We have got to focus on those because we have won some big stuff. We are going to win some other big stuff and we need to focus where the big growth opportunities are.

And I guess I mean not to read into the press release too much but you mentioned the rocket support being noncore and taking the charge there. Should we think about a similar path for that piece of the business?

We are routinely looking at the portfolio to see what makes best sense for the shareholders and that’s all I should say about that.

One last one on cash flow. How should we think about the timing of cash for 2018? Should we expect first half to be an outflow based on LCASD investments and the other drone programs? And then thinking about run rate is it wrong to think that beyond 2019 after these investments are made no cash flow will be significantly higher?

No, I think your thinking is in line with our expectations.

The investments they are going to wind down.

It’s a predominant investment is in LCASD and that flight is scheduled for Q3 so that investment will be complete by fairly end of Q2. The timing is a milestone that will drive what the cash flow is. I think you are actually – your comments on the cash flow generation or the second half being stronger that’s in line with our expectation.

And all other things being equal with the LCASD investment being done this year everything else being equal you would expect '18 by definition '19 would go up significantly.

Especially, if you take into consideration the CapEx that we were historically running at prior to 2017, when we launched this initiative so our CapEx in those years was anywhere from the 11 million to 15 million the last two years have been in the 25 plus range so we don’t foresee that heightened level of CapEx going forward past 2018.

Our next question comes from Noah Popanaki of Goldman Sachs. Your line is now open.

What percentage of the 2018 revenue outlook range that you've given us here is already in funded backlog and how does that are compared to how you've started the last few years on average?

So our total backlog is roughly typically total backlog what we see is converting the revenue in the next 12 months is typically about 50% of that. So and that's if that in line with what we how we've started each year in the past.

That's unfunded or on total?

It's actually more than that from the funded perspective so it's probably closer to over 70%.

Okay, and so it's 70% on the funded 50% on total?

Correct.

And so I should think of to call that 55% to 60% of the year is already in backlog?

Correct.

And is that a pretty normal starting point?

Yes, and as I had mentioned in my prepared remarks that's probably not be indicative of what's going to turn into revenues so for instance it's 93 million award that we received from the U.S. Army at the end of the year this is only 7 million that's included in backlog currently. But we fully expect to deliver on that this year and the next three years, so that would be not necessarily being the backlog but we have very good visibility on that revenue in 2018 and '19 and '20 and the three years as the performance.

So as how much of the remainder of the outlook that's not in funded backlog would you say fits in to that category of thing where it's a little bit of it little bit definitional and you do have visibility versus something that you have to go etcetera?

So a significant piece because we know the up tempo so for we know the Navy is op tempo for their targets in SM. We know the air force is up tempo for apps that in the 167 and right now we have nothing in there at all for loss 14, 15 and 16 we're going to get all three of them at once on the ballistic missile target launch schedule obviously we have that schedule. We know exactly what's coming on that with the U.S. Army on another drone. I can't get into the name on it. We know they are off tempo. None of this was in backlog, but it is very, very significant and these maps into our guidance. We give our guidance based on what I just went through.

If unmanned is doubling '18 versus '16 on the note or call it 115 million bucks, it would imply KGS is growing and your guidance is growing about 3%. Is that accurate? And could you talk about some of the moving pieces there what seems like it would have potential to be passing that given some of the businesses during there may be the government services pieces have drag again, if you could was us through that in a little bit more detail?

That is you’re absolutely correct. The government services piece is the drag.

Is it declining in 2018?

It is declining. It is as we deemphasized it and the bit pipeline is down, as I mentioned in the prepared remarks we lost a couple in Q4, one was like a $50 million we got triple across the board and we lost on price by couple of 100K, so that low price technically acceptable as you know was ruthless in services pace, it's terrible, it's terrible. So let me get another data point on that business for 2017, that RSS business, the book to bill ratio was zero. So think about what our book. Look at so you can reverse engineer what our book to bill ratio is excluding that and as Deanna said on the number of these big programs we don’t even put it in the backlog. So the problematic or contract award book to bill with the Company is extremely strong. But that is, that’s not a tailwind it’s a base wind.

Understood, I will ask one more just on margins, so you guys have this 10% EBITDA, adjusted EBITDA all in target for kind longer term, medium term long-term frame work. I guess that includes PSS, so for the front managing KGS combine that, I guess I implied 11 or 12, this year's kind of 9, is 11 or the 12 the right way to think about that behind 2018 and maybe just up there?

So the number one item to look at first is the $2.5 million number that the Deanna mentioned that was allocated. We're going to cost rationalize, there are there are things like licenses and things like that we have agreements on, but we have negotiate, you just can't fill them. We think we can negotiate ourselves out of the wind down by the year of the year. So our plan is just to reduce that by the end of the year, obviously other businesses are going to grow to make up for it and we're still looking for a normalized EBITDA margin for the Company. When we get to raid on these things is low teens.

Our next question comes from Michael Ciarmoli with SunTrust. Your line is open.

It's actually [indiscernible] for Michael. Just to go back on divesture of PSS and I guess that cash receivable of that coming in into queue, is that the way to look at it?

What we had mentioned was the in our press release announcing that transaction that with regulatory approval and customary closing conditions that we expected in 90 days.

I guess and then once that clears what will the capital structure for the Company look like and perhaps then interest expense outlook?

So, this is going to depend on what we -- on the proceeds. So, under our current bonds we have a year with the proceeds and if they are not redeployed into inventory or receivables or growth in the business there is the ability…

Or other investments.

Or other investments, thank you, there is the ability pro rata to bring some bonds back in that at par. We -- as Deanna and I went through in the prepared remarks, we have a lot of opportunities right now that we have won that production is going to get going as soon as we get god willing -- we are going to get the budget in the second half of the year it’s going to get going, I think we are looking real good on several other very large opportunities, I think we are going to win. And so our plan at least initially is to hold the cash initially. All things being equal and let’s see how we do won some of these, because if we do as and I am the CEO, I drink the Kool-Aid. If we run the table on them, we are going to watch a good part of not all that liquidity to execute on these programs.

I guess the last one then on how would -- I would just say Gichner fits strategically into the portfolio at this point?

Yes so that’s our modular systems division as you know, and right now we are in the middle of some very large production runs, one of them being Patriot. So, whenever you see Patriot like just recently you saw Patriot in Sweden, that’s Kratos, Raytheon is an extraordinary strategic partner of Kratos, as they are a wonderful company to work with. We are on a number of their missile and associated radar programs. We work very closely with Lockheed Martin, very closely with Northrup. And the majority of what we are focused on there is ballistic missile defense systems, we are also on a number of Unmanned Systems, we built ground control stations, for Unmanned Systems, we are also involved Littoral combat ship, we are one of the providers of the mission modules with Littoral combat ship. We designed into electromagnetic rail gun. We designed into high power directed energy systems. This business fits into our focus on strategic systems and it’s in a number of areas we see the budget increasing significantly with the ’18, ’19 bipartisan spending that was signed assuming it gets approved.

Thank you. And our next question comes from Brian Ruttenbur with Drexel Hamilton. Your line is open.

A couple housekeeping adjusted EPS for ’18 should be down from 2017 is that how you are kind of looking at it going forward or you maybe have a negative in first quarter and then turn positive in the second half?

I guess when you made the comment that is down from 2017, our adjusted EPS for the year was $0.12 and what we just guided with 16 to 18 and then the first quarter of 2017 was at adjusted I think that was a loss of $0.01. So it's actually regarding to be up on the quarter and up on the year.

I missed that part. I didn’t miss so the next question that I have is can you name the top three big programs for us to watch? Is number Gremlin, can you just give us the top that we should be monitoring?

So number one, and we are still waiting for formal award, god willing, it's competitive is Gremlin. As I mentioned in the remarks that if we with our partner Dynetics are fortunate enough to be successful here based on most recent data points this is a game changer for the Company if it is the SSAT program. The SSAT is with the navy is replacing certain target drones to 34 and 74 and they are almost out of them and there is significant demand for those. You asked me about the three to watch I’m telling you three I can tell you about. The third one is LCASD. The LCASD program as I mentioned is on schedule on budget, I cannot talk about much of this anymore as I mentioned to everybody at Q2 of the last year but this is a big year as well.

Our next question comes from Greg Conger with Jefferies. Your line is open.

Just a couple of quick ones most of mine have been asked but in the prepared remarks you mentioned small SSAT and it didn’t seem like there is much you could say but I was just thinking just from the opportunities that near term longer-time and maybe just a little bit more color on the size of that opportunity?

So, it is happening right now, as far is getting designed into the constellations and getting designed into the operators. Now is the time to get designed on the ground side where we are. And this is an entire new suite or generation of ground command control and communication equipment for these LEOs versus the GEOs. As I’m sure, the small nano and cube sets, they are going to be far, far less capable, far, far less costly than the GEOs but there is going to be 1000s of them. And so it’s a whole new generation of ground equipment smaller arguably less dynamic, but there is going to be a lot more of it. And so right now is the time to get -- we are getting designed and trying to pick the winners and because of our pedigree with epic, our industry leading command and control software our system. We -- this is a real opportunity for guys like us that we know the operators. There are customers and we took the fast performance qualities and credibility.

And then just staying on space I mean commercial space or I think you've had a really high market share I mean the industry itself is kind of been down it seems like it's starting to show on maybe where getting into the kind of recovery more there I mean it maybe any type of trends that you are seeing on the commercial side?

The primary trend is on the high throughput side and the spot being, and issue that we are seeing that we're addressing with our globally owned stepper monitoring business is monitoring interference related to those spot beings or jamming related to those spot being whether it would be on intended or intended identifying where it's coming from being able to geo-locate or use other means to identify where it's coming from so it can be mitigated or neutralized depending on what the customer wants that's a trend were seeing in that area. And it's only going to grow this has been our opinion the potential for jamming or beams getting crossed or interfering with each other is more and more satellite going up it's only going to increase and being able because of KPIs being able to quickly indentify and remedy that is big business and big money and we are the industry leader in that and I believe we are the only company that has a globally owned and operated network that is were monitoring 100s beams and doing what I've said net it is growing rapidly I think we said in the prepared remarks it grew 35% year-over-year and that tides into directly what you are asking.

And our final question comes from follow-up from Noah Popanak with Goldman. Your line is now open.

I just wanted to ask about the NOL, one does U.S. tax reform change its value? And then two, does the divestiture change its values as a tax filter?

So, tax reform changes the value that is recorded on the balance sheet because it's just at a different rate. And so that's probably some of the movement on the tax benefit that was recorded this period it was change in rate from 35% to 21%. But as far as -- so going forward tax reform carry back is no longer allowed, but carry forward is unlimited. So we are under the current law or prior to the tax reform it was carry back 2 to carry forward 20, so that's not impacted as a NOLs that we have as nearly 390 .million but the go forward piece is what that would be impacted, but it's actually unlimited going forward. So and there is no change and no impact related to the divestiture on our NOLs.

Thank you. With no further questions in queue, I would like to turn the call back over to Mr. DeMarco for closing remarks.

Thank you all for joining us today, and our next scheduled chat will be when we report the first quarter unless something comes up between now and then. Thank you very much.

Thank you, ladies and gentlemen, this does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.