Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Second Quarter 2018 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 call will be recorded. I would now like to introduce your host for today’s conference, Ms. Marie Mendoza, Senior Vice President and General Counsel. You may begin.

Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions second quarter 2018 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 very much, Marie, and good afternoon, everyone. In Q2 we continued the successful execution of our strategy to be the affordable alternative prime platform and system provider in our core C5ISR market areas including high-performance, unmanned aerial drones, training systems, microwave electronics, satellite communications and rocket systems. In the past five months, we have announced approximately $380 million in new contract awards, including $220 million in the second quarter, leveraging off of our technology and intellectual property, and reflecting the strength of Kratos’ business model with the vast majority of these contract awards related to long-term multi-year programs and platforms where Kratos is the prime contractor and system provider. In Q2 Kratos’ bid and proposal pipeline increased $0.5 billion from $6 billion to $6.5 billion, representing the increasing alignment Kratos has with the U.S. and its allies’ national security priorities, all providing confidence in our 2018 financial forecast and future growth trajectory. As I discussed at the beginning of this year, we are focused on increased margins and free cash flow, and we are making decisions for the business specifically focused on these objectives. And in Q2, Kratos’ gross, EBITDA and operating margins all increased as production programs ramp up and investments in unmanned systems wind down. We expect each of these financial performance matrices to continue to improve in the second half of 2018 and we continue to expect Kratos to return to positive free cash flow generation in the fourth quarter of this year. Since our last earnings call, Kratos’ unmanned systems business delivered our first production BQM-177 SSAT drone to United States Navy under Low Rate Initial Production or LRIP Year 1, which we received in 2017 for 35 drones. Earlier this year, we received SSAT program LRIP2 for an additional 25 drones which we…

Thank you Eric. Good afternoon. Kratos’ second quarter 2018 revenues of $151.2 million were above the range of our forecast of 140 to $150 million. And our adjusted EBITDA of $12.1 million exceeded our forecast of $9 million to $11 million. Additionally, Kratos’ adjusted EPS of $0.02 also exceeded our forecast of breakeven to $0.01 for the quarter. Second quarter year-over-year consolidated organic revenue growth of 2.2% was driven by growth of 60.4% in our unmanned systems business including Low Rate Initial Production 1 of our BQM-177 or SSAT aerial target. In the second quarter, Kratos Government Solutions division or KGS, generated revenues of $115.6 million, adjusted EBITDA of $8.5 million and operating income of $5 million, all of which were down slightly from the prior year due primarily to the continued decline in Kratos’ legacy government services business. From an accounting standpoint, Kratos was required to adopt a new revenue recognition practice, beginning January 1st of this year which can affect the timing of revenue recognition for certain contracts. As a result of the adoption, Kratos realized approximately $3.6 million of increased revenues in the second quarter with approximately $900,000 and $2.7 million in the increase related to the KGS and KUSD divisions respectively. On a year-over-year basis, our Q2 ‘18 adjusted EBITDA increased 18.6% or $1.9 million from $10.2 million in the second quarter of ‘17 to $12.1 million in the second quarter of ‘18. Our adjusted EBITDA for the second quarter is from continuing operations and excludes non-cash stock compensation cost of $1.7 million, severance related costs of $200,000 and $2.8 million related to the pending legal settlement and related legal costs associated with the matter involving a former employee that was part of an acquisition of a legacy government services company in 2006. Kratos’ operating income…

Thank you, Deanna. We will now turn it over to the moderator for questions.

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

Thank you. Eric, you talked about this, I believe you called it program F that had test flights that could lead to orders in 2019, it could be a multi-hundreds of millions of dollar platform. Is that -- did I hear that correctly? And then, secondly, what is the competitive picture regarding this program. So, is this the case where you’re falling off against someone else, or maybe the customer is deciding whether to do this or potentially to go in somewhat different direction, can you just add some more color on to that?

Yes. So, on the first part, Mike, of what you said, the flights have occurred and they were 100% successful. The competition has already occurred relative to this system, I have to be very careful here. And us and our partner with the system were successful. We were victorious. And now, we -- as we head into ‘19, as I indicated that we have to do some things but we are hopeful for an initial production order in 2019.

Okay. Maybe a segue there. Is that -- I think it’s probably mid ‘19 when you might see the first planes come off of the line in Oklahoma? Is this something you would build there?

Theoretically, this is something we would build there. Yes, absolutely.

And then, final question just relates to this. I guess, I’d call it historic and NDAA. It’s been 22 years since we got a budget on time. I mean, I know, it’s not quite so critical, now that you already own LRIP 1 and 2 and AFSAT. But, awarding [ph] a budget in place by September 30th pull in some stuff that might otherwise be pushed for you?

Yes. Mike, the 2019 NDAA, if it holds, looks great for Kratos. It looks great. And I’ll just name one or two programs, the SSAT program, under a continuing resolution, there’s no increase in production, the previous year production rolls over. So, the sooner a 2019 budget is authorized and in place, the sooner we would receive the increased production quantity funding, which would drive our revenue. That would be exactly similar for AFSAT with the Air Force. The sooner 2019 budget is in place, the sooner the increased quantities above the 2018 quantities are funded, so the sooner we would see that growth. So, two points again. 2019 NDAA looks fantastic for Kratos right now, and we are very hopeful as you alluded to that we will not have an extended continuing resolution this year.

And our next question comes from Ken Herbert with Canaccord. Your line is open.

Eric, I wanted to ask you first, margins in the Unmanned Systems segment, nice sequential increase, 15% to 16% incremental margins there. Was that really just volume at the Sacramento facility or was there anything else unique in the quarter that we should keep in mind around the margins?

There was one unique item. We had one very successful mission that was a positive. Now, we have similar mission scheduled in the second half of the year and in the first half of ‘19. So, I don’t want to leave you with the impression that it’s a one-off. These types of missions could and very well may reoccur, but that was one that occurred and it was the first one of its kind.

Okay. And I guess the implication of that would be sort of a one-off positive from a mix standpoint?

That’s how I would take it from now. Yes.

And for the full-year, as you -- maybe you got another one of these, but it sounds like as some of the programs ramp, when I think back to the first quarter, you called out really sort of three items that will drive margins in the segment over time. FMS being one, obviously Sacramento volume, and then the third being Oklahoma City. But, it sounds like this year it’s really maybe these one-off items, but then missions, but then more specifically just Sacramento having an impact. Are we in position to see the second half step up that you talked with everything else largely coming out of Sacramento on the target drones?

Absolutely, we’re looking in the drone business, particularly Q4, and that has to do with the timing of the receipt of these big programs that we just got. But Q3 right now, we’re looking to be about the same, up somewhat to Q2, but then Q4. As we start delivering out and executing on these new awards, this is under contract, we just have to execute, we see a significant step up, and then continuing that into ‘19

So, top line in the segment is similar in the third quarter to the second quarter?

I’d say approximately similar. We may do better -- it’s execution. We got a lot -- we have a lot of wood to chop and we’ve got the wood right with us.

And then, if I could, for you or Deanna, you’ve talked earlier this year, and it sounds like you’re on track considering the reaffirmation of the free cash flow guidance, but some notable working capital opportunities. Can you maybe just give an update on your progress here and thinking around working capital as a source of cash through this year and next year?

There’s a number of very large platforms that we are prime on, specifically in the training side on -- and as well as on the unmanned that we expect those milestones to be collected in the fourth -- third and fourth quarter. So we have a very good visibility on that, and also some also on the Modular Systems side.

Okay. Because it sounds like all of the -- or really all the upside and -- or to hit the full-year guidance happens in the fourth quarter, which clearly brings some risk. But, I guess, it’s fair to say you’ve got very good visibility on sort of the second half and fourth quarter in particular?

That’s correct.

We have at this point, we probably have the best visibility into the next six months that we’ve had in several years.

And Eric, just one final question, there’s been a lot of discussion lately on hypersonics, and I am sure you’re probably limited just to what you can say, but maybe not an opportunity near term. But, can you just talk about how you’re positioned? Is this market really seems to be seeing some great opportunities here near-term and longer-term? But how do you think about that market relative to Kratos?

With Under Secretary of Defense, Griffin and his push for more testing, don’t do one -- I am making -- this is an example, don’t do one exquisite test every 5 or 10 years and if it fails, you’re put back 5 or 10 years or similar to what Dr. Roper said very recently, in the past few days. He wants to change the thinking that you can have a successful failure, successful failures. In these areas that you mentioned, there is going to be far more testing. Test, test, test, test, get it right. This is the sweet spot for Kratos’ affordable, low-cost rocket support stacks. This is what we do in the ballistic missile target area. We believe we have the absolute right product at the right time that gives the right profile for this mission at the right price. And this could be a new, significant growth area for us over the next few years as the hypersonic programs ramp up.

Thank you. And our next question comes from Josh Sullivan with Seaport Global. Your line is open.

Can you just comment on the assets you’re winding down here, what the revenue impacts would be?

For -- depending on what we may do with these and rather not talk about that now, but Josh, it’s millions -- it’s not insignificant, it’s millions of dollars. It’s millions.

And then, just on unmanned side, I mean, you’ve been very successful winning lot of these awards. Can you just talk about the competitive environment? I mean, are you seeing any competition on the horizon? I mean, how your peers responded to your position?

Okay. So, I’m going to break that into two pieces, the target drone and the tactical drone. In the target drone, we have the three largest customers in the world, the United States Navy, the United States Air Force, and United States Army. And we won all competitive solicitations; we’ve won them and we’ve got them. As we just announced a few weeks ago at Airshow, we’ve now got the UK Ministry of Defense via QinetiQ who has the cash contract. They are also in the top -- putting the U.S. aside, top 3 or 4 other target users. We are chasing, for competitive reasons, I’m not going to mention, a very large one, not the one I mentioned in my prepared remarks that’s going to come down next year. But, this customer is buying U.S. weapon systems and they’ve already approached us. So, they want to execute -- they want to exercise those weapon systems against our targets because ours are the most direct representative. In our class of target drone, there is nothing like them, nothing. And so, the competition in the U.S. is nil; and internationally, it’s very limited because we’ve got the platforms. Now, on the tactical side. Similarly, on the target side, we have the one competitive solicitations. We won them, either as a prime like the Valkyrie or with our partners, Gremlins or program F that I mentioned. We are very aware of our customers, what the potential competitors are doing. However, our -- we have two primary competitive advantages. Number one, we are the leader. We were here first with these platforms. And number two, the affordability. We are going from a target drone which is designed to be attritable or shot down, so it’s low cost and going up to a tactical drone versus the competitor that’s going from an exquisite manned aircraft or an exquisite multi tens or hundred million dollar drone down to an attritable drone. That gives us an advantage because of the path we take. So, we’ve got to execute, we cannot step on our toe, we’ve got to meet our customers’ expectations and we are going to be successful.

Thank you. And our next question comes from Ben Klieve with NOBLE Capital Markets. Your line is open.

First, just a quick clarification question, and I apologize for making you repeat yourself. But my audio is little spotty here. What did you say the charge was you are expecting in the third quarter from the exit of your non-core business?

We did not mention the dollar amount. Okay? But, we do not expect this to be a gigantic charge.

Okay.

A couple of million bucks or something. That’s what we’re thinking, from a equipment standpoint, et cetera. From an equipment, personnel that type of a thing, pack [ph] facility, the facility closure, those types of things. That’s what we are looking at.

And then, in [technical difficulty] couple of questions here. One, are you able to elaborate the level of which revenue go pulled in from the third quarter to the second quarter?

I’d rather not get into the details on that because it’s all combined within the one segment, KGS.

Okay. That’s not a problem. But, I guess a follow-on question to that then. Is the -- did that dynamic at all impact what you see kind of the growth trajectory of the microwave business here over the next couple of quarters and into next year, or do you simply think that that was just kind of one-time timing thing of pulling revenue in from the third to the second quarter rather than a step function in the demand?

We are significant activity in the microwave electronics area, specifically related to missile and radar systems. There was an article just in the past few days on David’s Sling. We are designed in on David’s Sling. There was there was a successful intercept in India recently of new surface-to-air missile of theirs, we’re designed in on that missile. So, from a trajectory standpoint, we are looking at a solid, long-term growth trajectory. I’m going to go year-over-year because we are the subsystem or the component manufacturer that go into the system. So, we are like the tail behind the dog. We are not the dog driving the thing. So, on an annual basis year-over-year, the trajectory looks very, very solid here. So, I don’t look at that move to be a left as a one-timer in the grand scheme of what’s going on.

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

It’s actually [indiscernible] for Michael. So, I just wanted to get started, get a little bit of update on the Oklahoma facility. So, perhaps if it’s going according to your plan, any hiccups there? And also if you can quantify any additional investments to meet the capacity on unmanned side?

Yes. No, absolutely no hiccups at all. If anything because of the support we are getting at the federal level, the state level and the local level in Oklahoma, it is going absolutely on track, on track. Now, on your investment standpoint, I’m not going to get into the details on credits, et cetera and things like that that we are getting. Let me say this to you that depending on quantities, we are looking at over two-year period of $4 million to $5 million investment, but we get that back through incentives in the following years. Okay? Now, this is a hypothetical. If each one of our tactical programs meet or beat the expectation we are seeing, it’s possible that 4 million or 5 million would have to increase but that would be a good problem to have, then we would revisit the incentive structure.

I guess, one from the supply chain. We heard a couple of players out here on industry now, there is some constraints in supply chain. I’m not sure if it will impact to you guys at all. But are you seeing anything coming in as far as raw material, especially the tariffs, any kind of components demand that’s driving some of -- a lack of capacity there for you guys? Just any comment there?

We are seeing zero adverse impact at all. Remember, on the key subsystems on our drones, we do virtually all the avionics and electronics internally. In addition to that, on the turbo fans and the turbo jets, we have exclusive or special agreements with our providers. I just recently met with them. We’re under long-term bolt-in agreements. So, we are -- no impact.

Thank you. Our next question comes from Greg Konrad with Jefferies. Your line is open.

I just wanted to revisit Oklahoma. In the past, you talked about maybe partnering with an outsourced partner for some production. Any update on that?

Yes. In my prepared remarks I mentioned that we are now receiving product, structures, components, related tooling from two partners. And I called the strategic partners. So, it has -- the beginning -- the initial has begun.

And then, I mean, it’s -- if I look at the cash on the balance sheet, the debt, you’re probably going to be mid ones net debt leverage at the end of the year. How should we think about capital deployment, now that the balance sheet is [technical difficulty]

So, I think we’ve discussed this on the last call. Our expectation is to fund growth initiatives, especially on from a working capital perspective, especially at some of these large procurements, we’re fortunate to win those. We would have some working capital requirements, especially on the unmanned side where the long lead materials are engines as that’s one of large items and the building materials that we do not manufacture ourselves and that typically requires anywhere from a 12-plus-month long lead time order and deposits that are required. So, that we do expect to utilize our working capital and cash on hand to be able to fund some of those growth opportunities.

And then, just last one for me. I mean, you talked about Patriot and FAD in your prepared remarks. I mean there’s a number of large pursuits by the primes in terms of those two programs. When we see some of those contracts closing, what’s typically the lag time where you’ll start to see those contracts?

I have to be -- I don’t want to get ahead of our primes here, buddy. It’s not -- let me just say, it’s not significant and give me a lot of wiggle room on that. Okay? I don’t want to get into it. Because we’re not the prime.

Thank you. And our next question comes from Seth Seifman with JP Morgan. Your line is open.

I wonder if you could talk a little bit more about LCASD specifically and the opportunity next year. You talked about the possibility of an order and quantities around that? I mean, is this something where it kind of starts off -- starts off kind of slow and small in terms of what the order quantities might be or is this something where all of a sudden it’s a program of record where we’re above that 100 unit threshold?

Right. Because -- obviously we’re small defense company. To us, if we were to get an initial order in 2019 on the Valkyrie of 25 drones, that’s significant to us. And so that’s kind of how we are looking at it right now. That if we were to get a -- like you said, an initial order, I’m going to use an example of 25 drones next year and that order ramp up 50 up to the 100, that’s a -- obviously that’s very significant to us.

And then, just one more follow-up for me. The bookings, especially, I mean bookings are very strong on the unmanned side, but for the government systems business, how should we think about where the book-to-bill is going come out for the year?

So, I’ll let Deanna talk about the details on the accounting and everything. But, as I think we’ve put in our press release and as I said, over the past five months, we’ve received contract awards of over $400 million. The vast majority of those are sole source to us. Let’s take the AFSAT program for example. I think that was $100 million -- 100 something million dollar contract award over three years. We know what the uptempo was, so we know what the demand is, so we know 100% of that, if not more is going to be utilized. But, on that award, we will probably only put into backlog year one, when it’s funded which is tied to the fiscal budget; then year two when it’s tied to our fiscal budget. So there is a disconnect between the contract awards we’re getting, not -- which are not IDIQs or not Max. They are single award sole source to us, and what that book to bill shows. So we are extremely comfortable with what the build plan and the execution plan looks like relative to our growth expectations.

Okay. And then, anything further on the government system side?

Yes. So, just to elaborate on that, Seth. So, as Eric has mentioned in our prepared remarks, we have announced $160 million of contract awards since our quarter-end. There are a number in Q that we have not announced yet specifically on our training solutions and our satellite business. So, we do expect to see a rather sizable incremental increase in bookings in the KGS portion of satellite and training in the third quarter, as compared to the second quarter. And just a reminder, our government service business, which is about $60 million to $70 million business, which unfortunately is continuing to be commoditized and we see reductions on a quarter-over-quarter basis, that is unfortunately dragging down some of the book-to-bill ratio within KGS as well.

[Operator Instructions] We have a question from Brian Ruttenbur with Drexel Hamilton. Your line is open.

So, a couple of questions. First of all on book-to-bill, you just talked about that being weak in the one division but very strong in unmanned. Do you anticipate that there’s going to be pick-up in your overall book-to-bill in the third quarter as is seasonally normal.

Yes, we do. And if it doesn’t happen in the third quarter, it’s only because it slips into Q4, but between Q3 and Q4, absolutely.

And then, I have a bunch of questions around program F, which you won’t be able to answer but I felt compelled to at least ask some of them. Is this -- and we are going to play the game, is this this or is this that? Is it a DoD program, or are you the prime on it? Can you answer any of that?

We are the prime.

Is it a U.S. program?

We are the prime.

Okay. Well, I always get something out of that game. Okay. Moving on, your largest new program revenue contributor, can you talk about that what you see in ‘19 and ‘20? Is it going to be potentially in ‘19, is it going to be Gremlin? Is it going to be program F? Is it going to be Valkyrie? Maybe point us in the direction of where the biggest potential is in ‘19 and ‘20?

Okay. So, the biggest potential in ‘19 is the U.S. Navy SSAT. Okay? That’s the biggest revenue potential in ‘19. The biggest revenue potential in ‘20 is in the tactical area. If we get those awards or an award, an award or awards in ‘19, the greatest potential absolutely is tactical in ‘20.

And that’s Gremlin or program F or Valkyrie?

Exactly. And I love them all. So, I don’t want to handicap them.

And we are going to follow-up from Ken Herbert with Canaccord. Your line is open.

I just wanted to follow up on the Mako. And maybe you can’t talk much about this program either, but few months ago you got approval to sell this program internationally, this aircraft. And I’m just curious, I know obviously the U.S. is focused on Valkyrie. But, is there much of an international opportunity for Mako you could talk about? Because it sounds like that program is maybe a little bit further along with DIUx than -- and with the flight test that we’ve been maybe anticipating?

Ken, relative to the domestic opportunities that we have with Valkyrie, Gremlins, program F and Mako, the international opportunity, though it’s millions, it’s not tens of millions or hundreds of millions. And so, I expect, I believe we’re probably going to get some orders and order some orders internationally for Mako in 2019. I think, we will. And then I think it will grow in ‘20, it will grow in ‘21. But I think it’s going to be -- and I’m hopeful and I believe it’s going to be dwarfed by what’s going to happen on the domestic side.

And then, just one quick follow-up on Gremlins. I know there’s been a number of details put out by Dynetics and the customer, and what they are looking at in 2019 and the flight test program. The ability to retrieve the four aircraft and under 30 minutes by the end of next year seems fairly ambitious. But, between now and early next year with the first real test flights, are there any other important milestones you’d maybe just highlight or that we should be aware of as we think about the next six months and into ‘19 on this program?

Ken, I’m sorry. But because we are not the prime, I just -- I cannot and I will not get ahead of Dynetics who has just been an outstanding partner here. But, I -- since you mentioned, I do encourage the group to go to the Dynetics website and see the video that they’ve put out of the plane -- of the Gremlin systems in the air. And I also encourage the group to go see the DARPA videos that have been put out to also show the potential here and how far beyond just to C-130 this goes.

Thank you. And I am showing no further questions at this time. I’d like to turn the call back to Mr. Eric DeMarco for any closing remarks.

Great. Thank you everyone for joining us this afternoon. We truly appreciate it. We will -- unless something comes up, we’ll be chatting with you when we report Q3. Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone, have a great day.