Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third 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 be given at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Joining us today is Mr. Eric DeMarco, President and CEO, and Ms. Deanna Lund, Executive Vice President and Chief Financial Officer. I will now turn the call over to Ms. Lund. Ma'am, you may begin.

Thank you. Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions third quarter 2018 conference call. With me today is Eric DeMarco, Kratos' President and Chief Executive 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, Deanna. Deanna stood in today for Marie, our General Cousin, who has who has a very bad cold. Kratos' third quarter reflected the expected continue improvement of our Company's financial maintenance fees, our organic growth trajectory and overall performance and our execution. In Q3 Kratos' gross margins, operating margins and EBITDA margins all increased. We generated positive cash flow and we expect cash flow in Q4 and for 2019 to continue to increase as we transitioned from the investment mode in our Unmanned Aerial Drone business and as we move towards production. Deanna will provides the details on Kratos' overall, third quarter financial performance, and our guidance in our prepared remarks. Kratos' business mix continues to improve favorably as we execute on the plan we communicated to you at the beginning of this year to focus on higher margin programs with better payment terms and liquidity and to deemphasize or not pursue lower margin opportunities. In Q3, Kratos' is bid pipeline increased again up to $6.7 billion reflecting the significant opportunities that we have and Kratos' is alignment with the recently released national security strategy priorities. In Kratos' Unmanned Systems business, our target drone programs perform substantially as expected in Q3. On schedule, on budget, and in line with the expected ramps in production, including our large programs with the U.S. Navy, the U.S. Air Force in the U.S. Army, and we are expecting a particularly strong Q4 from our Unmanned Systems business based on current production and execution schedules. These under contract long-term drone production programs are expected to be key future organic growth drivers for our Company. For Kratos' U.S. Navy SSAT program, we expect a solid Q4 and we expect significantly increased production quantities beginning in the second half of 2019 and we moved from…

Thank you, Eric. Kratos' third quarter 2018 revenues of $159.4 million, up 1.5% from third quarter 2017 revenue of $157.1 million were at the upper end of the range of our estimate of $150 to $160 million. And our adjusted EBITDA of $16.7 million or 10.5% adjusted EBITDA margin exceeded our forecast of $12 million to $14 million. Additionally, Kratos' adjusted EPS of $0.08 per share also exceeded our forecast of $0.02 to $0.04 for the quarter. Our third quarter year-over-year consolidated organic revenue growth was driven by growth of 9.2% in our KGS segment, primarily reflecting demand in our satellites training systems businesses. Revenues in our Unmanned System segment reflected the current year expected production schedule which was down 20% from the prior year due to the timing of the production ramp which occurred in the third quarter of 2017, and which included the initiation of low rate initial production of our SSAT aerial target and an international target program. As Eric mentioned earlier, we expect the production ramp in the fourth quarter to increase in our Unmanned System segments and our full-year 2018 Unmanned Systems revenues to be substantially greater than the prior year. In the third quarter, KGS generated revenues of $126.1 million, adjusted EBITDA $14.1 million and operating income of $11 million, all which were up from the prior year comparable revenues of $115.5 million, adjusted EBITDA of $6.4 million and operating income of $1.4 million. Reflecting the growth primarily in the satellite communications and training systems businesses as well as margin improvement in our modular systems business. From an accounting standpoint, Kratos which required to adopt a new revenue recognition practice beginning January 1 of this year, which can affect the timing of revenue recognition for certain contracts. The impact of this new accounting standard…

Thank you, Deanna. We'll now turn it back over to the moderator for any questions. Thank you.

Thank you. [Operator Instructions] First question that I have is from Ken Herbert of Canaccord. Your line is open.

Hi. Good afternoon, Eric and Deanna.

Good afternoon.

Yes, I just wanted to first, Eric, you went through a number of new potential programs on the tactical side. Just a high level question, as you look at some of the increased sort of maybe caution around what the ultimate fiscal 2020 defense budget could look like. I know it's a fairly tight range. But have you seen any sort of incremental risk to timing on Project A, Z, Spartan any other new contracts or maybe the existing portfolio with was sort of the increased concern around how fiscal 2020 can ultimately look in terms of defense spending?

We are actually seeing an increased interest across the Board because of the affordability of the drones and also can, as you know our drones, they're leading edge, they're not bleeding edge and the fact that they're leading edge, there are proven for the most part they're flying today or what else - what we're doing or derivatives up or what we're flying today. It significantly reduces risk and schedule in our customer's mind, which also obviously ties into cost and affordability. And so we are seeing things accelerate and we are seeing the expectations for those out years accelerate as our customers want quantities deployed, quantities of weapons deployed.

And I know your overall sort of bid pipeline has grown, but can you provide any sort of additional detail on the new tactical opportunities? Just even at a high level in terms of the potential revenue upside?

Can have one believes that two, three, four, five years from now there will be high performance unmanned drones accompanying the manned aircraft, which I do when, which is why I encourage people to look at some of the articles I mentioned. This is happening and it is happening in a big way and the ones I can talk about - I'm talking about the other ones that have the last couple of years, as you know, we've been shutdown on a lot of information it is happening. And we believe this is going to be substantially bigger than our target's business. And you heard what I said about that today and that is growing very rapidly and it's going to continue to address the global threats and the exercise weapons systems.

Okay, great. That's helpful. Just one final one, Deanna, the reduction in the cash flow guide this year about $7 million? Is that all attributable to the working capital proceeds, sort of delay on received there. Is there anything else going on?

It's all attributed to that. And we originally expected it in the fourth quarter. It's now moving to the first half of 2019.

Okay, perfect. Thank you very much. I'll pass it back there.

Thank you.

Next question is coming from Mike Crawford of FBR.

B. Riley/FBR thank you. So Eric you mentioned this other new tactical program that will result in new building yet another new production facility and I think you said there will be a material impact in 2020 without going into details of that program. Can you talk about what sort of investment we might expect in that, given the way that you've retained proprietary data rates to things like the Valkyrie?

Yes. So first Mike, thanks for this question. So I can clarify, this was a leased facility.

Okay.

And so there will not be a capital outlay for the facility. The internal build-out of it will not be substantial. This is not millions and millions of dollars. That will not be substantial. The fact that we're under contract, a good portion of that will, will be covered. And I really, I cannot get into anything on the data rights and IP on this I'm sorry.

Okay. That's fine. Then - it's nice to hear that you have in your initial thoughts on 2019 that revenue cash flow EPS I will be up significantly, I think was the effort being used. But do you expect bookings to grow perhaps more quickly than the other metrics given, Gremlins and potential Valkyrie orders and depending on when Project F comes in and then 2020 would be seen revenue growth acceleration?

Yes. Because all of those bookings would be incremental if it's a new business area. So yes, absolutely…

And then 2021 would be margin expansion, right? Because right now you - I think at double-digit margins on your asset but why so say on asset which might take you a couple of years, I get up to that level?

That's correct. We expect to see margin expansion continuing into next year as production levels increase on the targets drones. Then we see them increasing more the following year as we reach full rate production, for example, on SSAT. Then on another program we have. And then layer on top of that if we're successful in the initial production runs and some of these tactical programs and the leverage we expect to get on the fixed overheads and the fixed manufacturing facilities, our model is even increased margins after that.

Okay, thanks. And then final question would be the relative margin potential between targets and the tactical drones? Are they at the same or different?

So the domestic targets and the tactical drones are about the same. Our international target margin opportunities are much, much higher on the international ones. Other than the Mako which has been approved internationally in certain areas, I do not believe there will be any international opportunity for any of our other tactical systems.

Okay, great. Thank you very much.

The next question comes from Michael Ciarmoli of SunTrust. Your line is open.

Hey. Good afternoon, guys or good evening. Thanks for taking the questions. Eric, maybe just on the tactical side. So we now have Program A, Z, F, Spartan, Valkyrie, Mako. I think the other one you said was, correct me if I'm wrong, Thanatos, but I mean we've got so many different variants right now. I guess the technology is still in the proof-of-concept phase here. Can you maybe articulate or elaborate what the key differences between all these systems? And as you guys are looking at, maybe assigning probabilities of what goes and what doesn't go. I mean, can you give us any sense of just sort of why you're seeing all these different programs, maybe what the subtle differences are in the platforms?

Sure. Hi Mike. I think the base premise on why we're being successful is the base technology of the target drone is proven, it's flying today, is low cost and they're already built to be a treatable because target drones are inherently built to be shot down. And as you know, the performance of our target drones are, they represent like on the aircraft side 4.5 generation threats, so like a F-15 or F-18 Super Hornet or an SU-35 for example. And so they have the flight and the performance envelopes that are equal to or better than manned aircraft and they're low cost. Now specifically to your question. As I mentioned briefly, these are not bleeding edge, they're leading edge and they're proven which reduces risk. It reduces schedule because they're affordable, they can be obtained in quantity and that old acronym back in World War II, quantity has a quality all of its own is really coming back home right now where there is an deemphasise on strategic exquisite systems that are very capable, but they're very expensive and they make great big juicy targets. And distributed lethality is key because as you know, many of the powers to be in the Pentagon, there will be no sanctuary in a peer to peer confrontation. I think all of that is trending in our favor here. All of it, it's trending in our favorite. These are not PowerPoint presentations. They're flying and they're just minor tweaks to things you make to turn a target drone. And now I'm coming to that part of your question into an unmanned aerial tactical drone or to turn a target drone into something else.

So what's the difference between Program A and Z? I mean, is it - are we talking size? Is it range? Is it payload capability? I'm just trying to understand why customers are asking for different variants, when you've already got another variant flying?

So certain of our target drones can carry 600 pound payload and they can carry it for three or four hours depending on the mission profile. And certain other ones carry a substantially less payload, could still be a very lethal payload, but they're much smaller, which means maybe they would be much harder to identify and pick up. And certain other target drones that we make the 167 for example, represent fighters. So it's peak performances at 40,000, 50,000, 60,000 feet where the navy target drone, it represents cruise missiles, the most sophisticated cruise missiles in the world and its peak performance zone is 10 feet.

Got it. That's helpful. Thank you very much guys.

Yes sir.

The next question is coming from Sheila Kahyaoglu of Jefferies. Your line is open.

Thank you. It's actually Greg Konrad on for Sheila. Just to follow-up on the last question, you mentioned a number of international opportunities in unmanned and I know there's been an effort to streamline the sales process. Is there any way to maybe size the international opportunity, I'm assuming some of these systems are probably not exportable?

Right, and so Greg, you're talking on the tactical side only or both target and tactical?

Both target and tactical.

Okay. So, on the target side, the variance that we still have to be modified and they have to be ITAR approved and it has to be country specific. In the free world, the largest target drone users in the world are the U.S. Navy, the U.S. Air Force and the U.S. Army. And as you know, those are all of our customers. Then after that, for example, there's the UK Ministry of Defense and as you know, a little while ago, we announced that we are working through QinetiQ, our partner. We are now supplying target drones to the UK Ministry of Defense. There is another very large one. The one that I referred to in my prepared remarks were imminently, I believe we're going to be able to announce up to a $100 million contract. The potential of this and once we announced this, you'll understand the dynamics of this user. There are a couple other - I hate to say a handful of other midsized target users internationally that we are pursuing. In addition to the ones that we have that I believe we're going to be successful on in the next 24 months because these customers are buying US weapons systems. And they're not planning on shooting down little drones that ISIS is flying around. They're planning on having to engage a peer or near peer threats with their weapons systems, their missile systems, their radar systems, and they want to exercise those systems against the most threat representative target drones in the world, and Kratos is by far the leader there, by far. It's not close. No one is close. On the tactical side, as I mentioned, we've been approved in a number of countries just over a handful or it may go-to-market or Mako. Okay, I know and I know you know this. That the rules are changing. The cruise missile rule, the law is changing and there are things going on with one of the treaties relative to the intermediate and medium range missiles. Irrespective of that, I do not see right now a large, if a large add-all market internationally for our tactical drones other than makeup. I do not believe that we will be allowed to go there.

Thank you. That's really helpful. And then on KGS, you had really strong margins in the quarter. I mean, was there any type of gain or one-time item or how should we think about the trajectory of a profit for that business?

So in the nature of that business is, we have the satellite business and we have the C5ISR business to combat system business. And as you also know, we do software, we do cyber product, cyber warfare products and then we have the services business. So we have a different margin mix of the different businesses in there. Okay. The mix in there in Q three was very favorable. Q4 is looking really favorable, right? Really favorable right now based on what the customers are demanding and that may very well continue into next year. So it's a mix issue. And as you know, our services business has shrunk and come down substantially and that's when the lowest margins are. And we did win this radar contract, but not by design, but the mix, mix has been becoming more and more favorable as the services business contracts.

And then just one bigger picture question, I mean it's been awhile, but I mean obviously leverage is down to 1.8, I mean you've built up a nice cash stockpile on the balance sheet. You've talked about a lot of investments starting to come down. I mean how should we think about capital deployment going forward and I guess bigger picture, I mean what are you going to do with the cash?

Our number one opportunity or use for that cash as we fully expect over the next 12 months to 15 months to continue to win production contracts in our drone area. And some of these - some of these are looking really, really big ones as we continue to do the demonstration flights and demonstrate the systems. We want to be sure we have the adequate working capital on hand to both psychologically addressed with our customers and financially addressed the programs. Let's assume that we went five, six, seven of these over the next 15 months. We don't want to be getting up to do anything. We want to have the liquidity on hand to execute these as we are.

Thank you.

Next question is coming from Seth Seifman of JP Morgan. Your line is open.

Thanks very much and good afternoon Deanna and Eric.

Hi, Seth.

Okay. So I wanted to start off just asking a question about the model and it looks like, based on the guidance, the EBITDA dollars that we'll see in the fourth quarter will be kind of flattish to maybe slightly down from Q3 even though revenue is going to be significantly higher. And you just mentioned the favorable mix in KGS. So how do we think about that progression and why there wouldn't be more dropped through on the higher revenue in the fourth quarter?

We are doing everything that we can. We talked about this a couple three quarters ago. That we want to meet or preferably exceed our expectations. And we are focused on that. And so if everything turns out on the high end of everything, maybe we'll do better than that.

Okay. And then just, I guess, you mentioned that the things were going according to plan on the target side, so we definitely appreciate that. And we've had a lot of questions about the new tactical opportunities, but feel like in the near-term, the important thing is kind of to execute on the target drones, the programs of record and you've got a new facility starting up shortly to do that. And maybe talk about a little more color on your level of confidence that that's going to bring about the kind of EBITDA that you're looking for and on the industrialization side that everything's all ready for these new levels of production that you're looking for.

This is on the target side?

Yes.

If you refer back to what we've said that our Sacramento facility right around the end of 2019 will be full up on the target side. The Oklahoma facility is underway, the equipment has been ordered, it's en route. We expect to initially start producing drones, they're few one, and we expect a significant increase or ramp in the drones coming out of that facility in Q3, Q4. So it is fully up and capable by the beginning of 2020 at which time the Sacramento facility would be at or near capacity. So we are time phasing and sequencing this facility in and it is a modular or scalable facility. And to Mike's question, a little - Mr. Ciarmoli's question a few minutes ago, a number of the tactical systems with a substantial amount of that aircraft is very similar to the target system. And so our Oklahoma facility is intended to be at least initially the primary provider of most of our tactical drones. Now, as I mentioned today, there are certain tactical drones that cannot be built at that facility for security reasons. They are going to be built at another facility, one of which we're going to be executing that at least in the next couple three weeks and have that one ready middle of next year.

Great. Okay. Thanks very much.

Thank you.

[Operator Instructions] The next question is coming from Joe Gomes of NOBLE Capital. Your line is open.

Good afternoon. Thanks for taking my question. Most of them been answered here, but in listening to some of the calls here or number of companies in this space, there has been some discussion about the employee situation without getting an acceptable number of employees and now it's a somewhat of a challenge. And I was just wondering how you guys are - if that's impacting you at all and if so, how are you dealing with it?

That is actually a very intuitive and a great question. We have been and we remain very, very focused on the human capital side and the human resources side. And in particular, where the programs are restricted or they're classified and getting the appropriate people for those programs. We are not running into any significant challenges yet. We're fortunate in where some of our locations are and some of the dynamics that have happened in those locations that have freed up people from other companies that haven't been successful on things and these people are qualified to work on some of these programs. This was one of the reasons that we selected Oklahoma because we did a significant study on the human resource pool there and the type of person and can they get cleared, can these people get cleared, et cetera. And that's one of the primary reasons we went there. And on the other facility, obviously I can't say where it is, but if I could, you'd understand. Yes, that's a good spot for this because those are the types of people that have this expertise and that they can get cleared. So we're trying to be as thoughtful and methodical about it as possible, but I don't want to leave the impression on you that this is easy. It's a challenge and we've got to stay focused on it and we've got to stay ahead of it.

Okay, great. Thank you.

Thank you.

Ladies and gentlemen, this concludes the Q&A session. I would like to turn the call back over to Mr. Eric DeMarco for closing remarks.

Great. Thank you all for joining us today. We look forward to our next regularly scheduled time to get together. And we'll be, as Deanna mentioned, when we report Q4 and when we give our initial 2019 guidance at the beginning of next year. 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.