Kratos Defense & Security Solutions, Inc. (KTOS) Q4 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. And welcome to the Kratos Defense & Security Solutions Fourth Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions]I would now like to hand the conference over to your speaker today, Marie Mendoza, Senior Vice President and General Counsel. Please go ahead, ma'am.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions fourth quarter and fiscal year end 2019 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, Marie. Today Kratos is better positioned than ever to successfully achieve our tactical drone strategy and the related significant returns for our partners, our stakeholders, and our shareholders. In my remarks, I will discuss certain of the important milestones we have achieved since our last report to you, including as recently as just last week and what is planned for 2020 and beyond.For our initial 2020 financial guidance that we're providing today, every Kratos business unit is forecasting year-over-year 2020 over 2019 organic growth, except for our training business, which we have an approximate $40 million reduction currently forecast primarily due to an ongoing protest situation we discussed on our last quarter's call with you. Additionally, as related to our initial 2020 guidance, we have excluded or have significantly factored from our 2020 forecast, a number of potentially important items, which we will not include in the forecast until we have both timing and financial impact clarity.For example, we have not included in our initial 2020 guidance any expected financial contribution from Kratos Valkyrie or other tactical drone production system or integration activities. We have excluded these items not as a result of lack of confidence. We have more confidence than ever but rather that certain items like the Valkyrie opportunity are literally currently in the works and we will exclude from our forecast the related potential financial contribution until the quantities, pricing, contract structure and the program timing is finalized.We intend to adjust our initial 2020 financial guidance as appropriate once these expected events occur. In addition to Valkyrie, we also have a number of other important items we have also either excluded from or significantly factored in our 2020 financial forecast that we also will discuss today and for which we intend to adjust our financial forecast once we have resolution or additional clarity as appropriate.And we have also excluded a number of new to Kratos potential large program opportunities we are pursuing, certain of which are currently expected to be awarded in 2020, which we would also adjust our 2024 forecast for as appropriate if we're successful.So for 2019, we finished the year with our unmanned systems business generating year-over-year organic revenue growth of 21.4% and Kratos generating 16.1% revenue growth overall. Our full year-over-year adjusted EBITDA growth was 27.8%, with adjusted EPS growth of 41.7%. And we finished 2019 with a bid pipeline of $7.7 billion, up $1 billion or 14.9% year-over-year with substantially all of our pipeline comprised of single award opportunities. Nearly 15% or $1.1 billion of our bid pipeline is related to our unmanned systems business and this $1.1 billion does not currently include the expected potential production values for Valkyrie, Gremlins or other tactical drone opportunities, which we will adjust the pipeline for, once we have expected additional clarity.We believe our current unmanned systems business opportunity pipeline reflects both the depth and the breadth of the number of drone opportunities available in Kratos. In addition to the Valkyrie and Gremlins opportunity and supports our very strong future forecast and our growth trajectory. In addition to our opportunity pipeline, another key element of our expected future organic growth is Kratos alignment with the National Security priorities as the U.S. DoD and its allies recapitalize strategic weapons systems, in order to address peer, near-peer and nation state threats and the increased funding that is forecast for those areas.We believe that Kratos aligns with DoD priorities as reflected in the 2018 National Defense Strategy and most recently in the 2021 DoD budget request and the future year’s defense program or FYDP, which emphasize includes autonomous systems and drones, space and satellite communications, C5ISR and microwave electronics, missile defense and hypersonic systems.Today, approximately 25% of Kratos’ business is in unmanned systems. Approximately 30% of our business is in space and satellite communications and approximately 25% is a missile defense, hypersonic systems, microwave electronics, missiles, radars and C5ISR with the balance being in turbine technologies and training solutions.As I mentioned before, we're beginning 2020 with Kratos having continued to make significant progress executing our strategy. And we now have greater clarity than ever on our planned significant long-term growth programs, platforms and systems including new funding we understand to now be in place for Kratos’ Valkyrie based on the recently released 2020 DoD budget and related congressional requests.Progress we have made since our last report to you includes, the fourth successful Valkyrie flight in January with all test points being achieved and a re-engineered recovery system operating nominally or without incident. It's being reported that Valkyrie will be flying in an exercise with both the F-35 and the F-22 in the first half of 2020. It’s being reported that the Valkyrie will be involved in the new multibillion dollar Advanced Battle Management System or ABMS program. This is a planned multi-domain mega network to move data at machine speeds, connecting multiple platforms including manned aircraft and drones and where Kratos’ satellite business is also targeting certain space aspects.It was reported that Kratos’ Valkyrie is a Skyborg program drone. With Skyborg being the U.S. Air Force’s artificial intelligence enabled division where future manned fighter aircraft will be supported by unmanned drones. It was reported that the U.S. Air Force selected three next-generation technologies to be developed under the services Vanguard program, one of which includes the Skyborg wingman drone program. Vanguard programs are expected to be game changers, awarded and fielded over a three-year period, which we are forecasting for Kratos’ Valkyrie and which the U.S. AF has recently specifically indicated is the plan for Skyborg.The integration of various communications, payload and weapon system into the Valkyrie are either currently underway or planned, including those under contract and funded. The process to missionize and operationalize aspects of the Valkyrie are also underway or planned, including those now under contract and funded. And the Kratos Air Force Research Laboratory team received a Laureate award for the XQ-58A for technology and innovation, for providing – excuse me, for proving that low cost can be achieved while maintaining high performance with the XQ-58A being the pathfinder for the attributable class of aircraft that provides the warfighter have the capability to project air power with mass, complexity and unpredictability.Also since our last report to you, DARPA has announced a successful first flight of the Gremlins jet drone, which Kratos has the exclusive production rights for. And that Gremlins program Phase 4 is now moving forward, which I will comment on more later. We believe that these data points over the past few months are representative of the progress, momentum and trajectory.Kratos’ tactical drone initiative continues to make, of our relationships and partnerships with the customer community and have the significant opportunity for our company and our stakeholders. Also over the past few months, Kratos has continued to receive a large number of new product hardware and production programs, including Kratos’ space and satellite business won a position on the $5.1 billion U.S. Army Global Tactical Advanced Communications Systems or GTACS, a multiple award IDIQ vehicle. The GTACS contract is expected to be a key element of the anticipated future organic growth projectory of Kratos’ space and satellite business.Kratos’ unmanned systems division won a position on the $982 million unmanned surface family of systems IDIQ-MAC vehicle. Kratos’ C5ISR business won a $50 million single award contract and our C5ISR business also received an initial $2.7 million single award contract on a new to Kratos large program of record system opportunity.Our microwave electronics business won a new initial $24 million production program for a missile system. And we also recently received an approximate $16 million electronic warfare initial production program as well. These are two new expected to be long-term multi tens of millions of dollar production programs for our company.Kratos’ space and satellite business received a $39 million sole-source space situational awareness contract related to Kratos’ globally owned and operated SSA network. Kratos’ unique and proprietary global SSA network capabilities are an increasing demand in today's congested space environment. So certain of these awards we've received later than we had originally expected, which has resulted in a push out to the right of certain execution aspects.We now have received them, which provide us additional confidence in our projected long-term future organic growth trajectory. In our unmanned systems target drone business, we remain on track to achieve approximately $250 million in revenue in the next few years with Kratos having multiple programs and opportunities expected to contribute to this projected organic growth trajectory.For example, we expect to go into full-rate production negotiations this year on two target drone systems that are currently in low-rate initial production or LRIP, with full-rate production or FRP awards expected either later on this year or early next year. One target drone program that is expected to achieve full-rate production is the BQM-177 or SSAT and it was just recently reported that the U.S. Navy plans to purchase 55 BQM-177As in FY2021. We also expect to begin negotiations on the continued manufacturer of a target drone currently in full-rate production and we expect that these negotiations will involve a substantial increase in quantities produced over the next five-year term.We also expect to begin FRP on a confidential program later this year or early next year. These programs are all sole-source to Kratos. In the tactical drone area, as I mentioned, we believe that Kratos’ Valkyrie has continued to make substantial progress towards being under contract for initial production this year and for future system fielding. The government recently completed its investigation into the recovery system anomaly experienced in the third Valkyrie test flight last year. And we believe that we have successfully addressed this issue as demonstrated in our most recent successful flight a few weeks ago.This resolved recovery system situation and related now complete customer investigation resulted in delays that have pushed Kratos’ previous Valkyrie expectation and program plan approximately six months to the right. These types of anomalies and delays can occur in rapid development programs like the XQ-58.We believe that the Valkyrie funding is now in place with the completion of the DoD fiscal 2020 defense appropriation process, we expect an initial Valkyrie related production system and payload integration award sometime in the current months as we complete the process to work the details with the stakeholders. This is just one of several Valkyrie related opportunities we are currently pursuing, including one with an entity, where we are currently forecasting orders for a total of approximately 30 XQ-58 drones within the next 18 months.As a result of the progress we have made, the availability of initial funding, our communications with our customers, supporters and stakeholders and related expectation of near-term awards, we have now increased our orders for long lead items for the first 12 production Valkyries. Based on our current Oklahoma City fiscal year 2020 manufacturing and build plan, we expect to be able to begin delivery of the first of these initial 12 production Valkyries in Q1 of 2021 with monthly deliveries of additional Valkyries expected thereafter.We are leaning forward here, ahead of the expected contract awards as we are highly confident that receipt of initial Valkyrie production contracts is not if, but when based on the most recent information that we have.In summary, for Kratos’ Valkyrie, even though our previous expectations moved to the right, we have continued to make significant process with our customers. And we now have line of sight on the timing of expected initial contract awards and for an ultimate potential program of record.As I mentioned, DARPA recently reported the Gremlins tactical UAS can successfully executed its first flight in November 2019. This initial Gremlins program flight had been delayed for several months as a result of last year’s California earthquake, which impacted the China Lake flight range operations, where the first Gremlins flight was initially planned. The successful flight was conducted at Dugway Proving Ground.And during the test, which lasted one hour and 41 minutes, the X-61A Gremlin flew with no anomalies and the DARPA Dynetics team completed all test objectives, including transitioning the X-61A from a cold engine start to stable flight, validating Gremlins data links, handing off control of the drone between air and ground control stations, deploying the docking arm and collecting data on the air vehicle.At the end of the mission, however, the vehicle was lost during the ground recovery sequence due to a failure to extract the main shoe. This recovery system is not part of the operational system. This is used for certain test flight only and we understand that our partner Dynetics is working with the recovery system provider to reengineer the system.However, importantly, as I mentioned before, just a few weeks ago, DARPA reported that now plans to award Dynetics, our partner Phase 4 of Gremlins to demonstrate distributed airborne operations using a minimum of four of the X-61A Gremlin air vehicles that Kratos produces.The goal of Gremlins is to enhance the U.S. Armed Forces operational flexibility and to develop the capability for transport or bomber host aircraft to launch and recover large numbers of low cost unmanned aircraft that would augment the capability and increase the survivability of manned combat aircraft in contested airspace.As a result of the successful Gremlins flight and DARPA’s announcement of an expected Phase 4 award, we remain confident that Gremlins will transition to a service and become a major future program. Program F, which has now been renamed Airwolf, remains on track. Additional funding is now in place and multiple additional system demonstration flights over the next several months are now scheduled.Program Thanatos and all other Kratos’ tactical drone programs and initiatives also remain on track with our expectations, including a Kratos’ tactical drone deploying other tactical drones in a demonstration this year. Over the past several weeks, we have received a number of inquiries regarding the 5GAT or 5th Generation Aerial Target drone, as a result of certain publicity the 5GAT program has received and certain comments made in the public marketplace.Accordingly, I’ll address certain of these inquiries now. Kratos is on the 5GAT program team and is working under a contract funded to Kratos by the government. A few weeks ago, it was reported that the 5th Generation Aerial Target drone successfully had its initial ground engine test run. The 5GAT has not flown yet and its first flight is currently scheduled for later on this year.The 5GAT is a very unique aircraft developed for a unique mission set as a target drone, not a tactical drone and is vastly different from Kratos’ Valkyrie. For example, the Valkyrie can fly for greater than nine hours on refueled, the 5GATs imply approximately 1.5 hours on refueled. The Valkyrie has internal weapons or bomb base. The 5GAT has no internal weapons or bomb base.Kratos’ Valkyrie is runway independent, while the 5GAT has landing gear and is tied to and dependent upon a runway. And the Valkyrie is affordable and low cost at approximately $3 million, while the 5GAT is reported to cost approximately $10 million. These are just some of the differences between the 5GAT and the Valkyrie.Additionally, Kratos have its own 5GAT solution that we have not previously disclosed which we are confident will prove to be a far better solution for a majority of the currently envisioned mission sets at an affordable cost. For Kratos’ Unmanned Systems business including targets and tactical drones, in spite of certain of our programs expected initial or increased production moving to the right, including from the recent CRA, we are expecting strong year-over-year organic growth for 2020 over 2019 with the timing of program and contract awards, including the so forth contract awards I mentioned determining the ultimate magnitude of this expected growth. We are also expecting even greater year-over-year organic growth for 2021 over 2020, based on current program visibility, the 2021 DoD budget request and the FYDP.In our Space and Satellite business, as I mentioned since our last report to you, we have received a number of important contract wins. So certain of these awards will received later than we initially planned, which is pushing certain related 2020 execution to the right.Included in these delays was an expected sole source contract award related to a large new satellite program, which is forecast to be a significant long-term future organic growth driver for the business and one of our larger future programs. There are also numerous additional new space and satellite opportunities that we are pursuing, including as related to the next generation National Defense Space Architecture or NDSA, which is anticipated to be compromised of seven different layers, which include a transport layer to provide assured resilient low latency military data and communications connectivity worldwide to a full range of warfighter platforms, a battle management layer to provide architecture, tasking, mission command and control and data dissemination to support time-sensitive kill chain closure at campaign scales, and also a tracking layer to provide global indications, warning, tracking and targeting of advanced missile threats, including hypersonic missile systems.Related to the NDSA, the Pentagon recently stated that they want industry to provide one satellite per week under its plans to orbit the seven constellations with each satellite having a different function. The satellites are anticipated to be smaller at a few hundred kilograms cheaper at approximately $10 million each and shorter live at about five years than today’s typical military satellites, which can weigh tons and cost billions of dollars and which are expected to operate for decades.This is all part of the space market transition I have been talking to about on previous calls, which we believe will provide Kratos with an incredibly large opportunity for our ground C2, SSA and other equipment. Under the NDSA program, the DoD has announced its plan to orbit several dozen satellites through 2022 then expecting to continue to launch dozens more. We are truly excited about this new opportunity.Also in our space business in Q4, we continued the expected transition to the software defined content product model and business mix, we have discussed previously. We expect the transition from legacy dedicated analog hardware products to open architecture software defined products to continue in 2020, resulting in a reduced revenue growth rate, but also resulting in an expected higher EBITDA margin.We saw this trend in Q4 of 2019 with a mix of somewhat reduced revenues and higher profit margins. Irrespective of the business mix transition that’s occurring and certain program delays, we are expecting solid organic revenue growth for our satellite business in 2020 over 2019 with further organic growth expected for 2021 over 2020.And our Microwave Electronics products business, as I mentioned before at the end of 2019, we received the initial $25 million production order what is expected to be one of the largest programs for this business and we also received the expected initial $16 million production award for a new airborne EW system.Our microwave business currently has an all time record backlog and similar to Kratos’ Unmanned Systems and Satellite Communications businesses, we are expecting solid 2020 over 2019 organic revenue growth with that growth expected to continue for 2021 over 2020. Our C5ISR BMD targets hypersonic systems and turbine businesses are also forecasting organic growth for 2020 over 2019. With the recapitalization of strategic weapons systems being a key driver of this forecasted growth, including in the missile, radar, hypersonic, BMD and unmanned systems areas. Kratos’ Turbine’s next generation engine programs and initiatives remain on schedule.In C5ISR, as I mentioned, we recently received a new approximate $50 million single award contract, which we expected to begin contributing immediately in Q1 of fiscal 2020. However, this Kratos award has now been protested by a competitor with a resulting stop work notice issued to Kratos by the customer.Accordingly, we have removed the expected financial contribution from the single award program out of our initial 2020 guidance until the protest situation is successfully resolved. As I discussed earlier and on last quarter’s call, in our training business, Kratos’ is largest contract with the U.S. and Royal Saudi Navy also remains in a protest situation as we discussed previously. As this protest situation is being resolved, Kratos currently expects to continue working at least through March 31 of 2020. The situation is significantly impacting Kratos’ initial 2020 guidance with an approximate $40 million 2020 to 2019 revenue reduction currently forecast due to the uncertainty. We will update our guidance accordingly as this situation is resolved. Deanna?

Thank you, Eric, good afternoon. Kratos’ fourth quarter 2019 revenues of $185.1 million were just below the low end of our estimate of $187 million to $207 million, primarily as a result of our training and C5ISR businesses and delays in expected contract starts and the timing of production ramped in our Unmanned Systems business, certain of which have now received and the production schedules are forecast to contribute commencing and Q2 of 2020.Our adjusted EBITDA of $20.2 million was at the high end of our estimate of $14 million to $20 million, due to a favorable mix of revenues and execution, primarily in our space and satellite communications, training solutions and microwave products businesses. Our adjusted EPS of $0.09 per share also exceeded our forecast of $0.03 to $0.07 per share for the quarter. Excluding the impact of FTT, which we acquired in 2019 and which contributed $14.8 million in revenues for the quarter, Kratos’ revenues grew again 3.6% in the fourth quarter compared to the prior year. Importantly, there was no CRA in 2018 like we had in Q4 of 2019.In the fourth quarter, KGS generated revenues of $146.8 million up 14.6% from $128.2 million for Q4 2018. Adjusted EBITDA of $17.3 million or 11.8% of revenues up from $15.1 million in Q4 2018 and operating income of $12 million up from $11.6 million in Q4 of 2018. Excluding the impact of the FTT acquisition, KGS revenues increased organically 3% year-over-year.Operating income and adjusted EBITDA were positively impacted in the fourth quarter by a favorable mix of revenues, including higher margin software revenues and leverage on fixed manufacturing overhead and administrative expenses.Revenues in our Unmanned Systems segment increased 5.8% from $36.2 million in the fourth quarter of 2018 to $38.3 million, and adjusted EBITDA was $2.9 million for both period primarily reflecting project mix including that in 2019 and forecast for 2020 we are working on a number of new tactical drone development programs, which typically have a lower profit margin than full rate production programs. This increased mix of development programs is expected to continue into 2020 until certain new production awards or increases in existing production programs are received.Our Q4 consolidated operating income was $9.3 million, down from the fourth quarter of 2018 operating income of $10.8 million primarily due to approximately $600,000 in legal fees in 2019 related to an ongoing dispute with an international customer and $800,000 of increased amortization related to the FTT acquisition.Our adjusted EBITDA for the fourth quarter is from consolidated continuing operations including net income or loss attributable to non-controlling interests, and excludes non-cash stock-based compensation cost of $2.8 million. Foreign transaction gains of $100,000 and acquisition and restructuring and related items and other of $400,000 and legal costs of $600,000.On a GAAP basis, net income for the fourth quarter was $3 million, which includes $400,000 of loss attributable to non-controlling interest and a tax provision of $1 million and loss from discontinued operations of $700,000.For fiscal year 2019 revenues increased $99.5 million or 16.1% from 2018 to 2019. Excluding the FTT acquisition, which contributed $52.5 million, revenues increased 7.6% organically. Full year 2019 adjusted EBITDA increased $16.8 million or 27.8% to $77.3 million.Moving on to the balance sheet and liquidity. Our cash balance was $172.6 million at December 29th. At quarter end, we had zero amounts outstanding on our bank line of credit and $5.4 million of letters of credit outstanding. Debt outstanding was $295.1 million at quarter end, and net debt was $122.5 million. Our LTM adjusted EBITDA was $77.3 million with a net leverage ratio of 1.6 to 1.Cash flow generated from operations for the fourth quarter was a use of $1.3 million, less capital expenditures of $8.4 million or free cash flow use of $9.7 million. For fiscal 2019 cash flow generated from continuing operations was $28.9 million, less CapEx of $26.3 million for free cash flow generation of $2.6 million. In addition, we collected $3.6 million in FY 2019 related to the legacy projects we retained from our disposition of the PSS business. This compares to our estimated free cash flow expectation of $10 million to $20 million for 2019 with the primary variance being due to certain expected receivable collections that did not come in before year end. This was reflected by the increase in DSOs from 120 days at the end of the third quarter to 130 days at the end of the year being primarily due to contractual milestone payments on long-term delivery project in our Training Solutions business.The most significant items impacting the milestone collection and DSOs at year end was a termination for convenience or a TforC on a very large substantially complete simulator training program that we received in late November. A TforC can occur from time to time in the government contracting industry basically representing exactly what they say. That is the originally planned scope period of performance or number of systems to be delivered as being changed at the convenience of the government customer through no fault of the contractor.Under long-term contracts, like the training system project, milestone payments are typically paid by the government customer at 80% or 90% of costs incurred as program milestones are achieved with the last 10% or 20% of payments withheld until final delivery has been accepted. On this contract, Kratos’ receivable balance, which is primarily related to these final billings withholds or retention amounts are currently over $11 million. We’ve expected to bill nearly $9 million on this project by 2019 year end, however, due to the TforC, we will now not be able to bill and collect these amounts until we have completed the termination settlement process with the customer.Also impacting Kratos’ 2020 cash forecast with a customer-requested delivery – schedule change for a separate large training system program. This training system delivery schedule delay, which resulted from customer requested configuration modification also resulted in delays in certain billing milestones until unit deliveries are made. As a result, program deliveries have now been pushed from 2019 and 2020 to 2021. With this situation impacting our estimated 2019 billings by an approximate $5 million. A contract mix for the quarter was 81% fixed price, 14% cost plus, and 5% time and materials.Revenues generated from contracts with the U.S. Federal Government for the quarter were approximately 71%, including revenues generated from contracts with the DoD, non-DoD federal government agencies and FMS contracts, which were approximately 11%. We generated 12% from commercial customers and 17% from foreign customers.Our book-to-bill ratio for the quarter was 1.1 to 1, and for the trailing 12 months was 1.1 to 1. Our bookings were $177.5 million for the quarter, with total backlog of $601.2 million. Our bookings for the year were $718.7 million.Today, we are providing an initial guidance for 2020 a full year revenue of $740 to 780 million. Adjusted EBITDA of $72 million to $78 million. Operating cash flow $30 million to $50 million, and capital expenditures of $43 million to $48 million. And free cash flow guidance of a generation of $7 million to a use of $18 million.Our initial guidance includes a number of factors and assumptions I will discuss. Excuse me. As you know, our industry had a three-month continuing resolution to begin the fiscal year with the CR being resolved at the end of December with the 2020 DoD budget being approved. As we discussed with you on last quarter’s call under a CR, there are no new programs start, no new production cost cut and no new increases on existing production contracts.As we discussed, when we reported Q3 over the past few years, Kratos has been very successful in receiving numerous new program awards, which programs are currently in development and with the initial production expected to commence our programs that are currently in production with increased production expected. As result of our large number of new programs Kratos’ near term forecast was exposed to potential delays at a CRA cost. This was the primary reason that we stated that we would wait until now to provide our initial 2020 financial guidance so that we could have more current information we provided our 2020 forecast.In summary, the CR basically pushed a number of expected contract awards and expected program execution or ramp up to the right from approximately three to six months impacting our 2020 first half forecasts and pushing certain expected programs and program ramps into the second half of the year more into 2021. This is often taken into consideration in today’s initial 2020 guidance.Additionally, we have excluded from our initial 2020 guidance any battery or other tactical drone production or tactical system revenue, which we will continue to exclude until we receive contract awards and understand their exact scope, timing, deliverables and related financial contribution. We have also significantly factored and reduced our initial 2020 guidance for the USN RSN app contract protest situation, which Eric mentioned in, which we will also discuss with you last year.The currently estimated impact of this USN app Navy training program and protest situation is approximately $40 million and reduced revenues from $19 million to $20 million and that reduced expected margin rates due to the new contractual structure. We have also eliminated from our guidance any 2020 contribution from the $50 million C5ISR award we received, which was protested by a competitor and we have factoring inventory guidance, continued headwinds from our legacy government services business, which is forecasted to decline approximately $10 million from $19 million to $20 million. Even when factoring into our initial 2020 guidance all of these considerations for 2020, every Kratos’ business unit is forecasting organic revenue growth over 2019 except for our training solutions business. The current operation tempo of the RSNF contract and the impact of the reduced government services business has also been reflected in our first quarter 2020 guidance.For fiscal 2020 Kratos is currently forecasting capital expenditures of $43 million to 48 million, which includes approximately $15 million to $17 million related to the 12 production Valkyries. Eric had mentioned that we are leading forward and planning and building company-owned tactical drones prior to contract we see, which will be reflected as capital expenditures.Once we have received contract awards, the cost will be transfer to a revenue generating program. We’re also forecasting approximately $5 million for certain Kratos capital target drones that we plan on building to have on hand in order to be able to quickly address customer lease or other machine requirements. And we are forecasting capital investments of approximately $5 million related to small engine development at KTT and investment, aggregating approximately $9 million to $10 million for new business opportunities in our satellites in C5ISR businesses.We expect our estimated cash taxes to be approximately $3 million to $4 million for 2020 reflecting the impact of our over $300 million in net operating losses that we have. Amortization is expected to be approximately flat at approximately $8.5 million for 2020 and depreciation is expected to increase approximately $4 million per year to $20 million for FY 2020 reflecting the increase in capital expenditures we have incurred over the past few years.The company intends to adjust the impact of depreciation expense for purposes of computing adjusted EPS going forward to address this expected to increase to provide way more comparable metric on a year-over-year basis. As such, the forecasted adjusted EPS for FY 2020 is $0.44 to $0.47 compared to FY 2019 adjusted EPS using a similar adjustment for depreciation expense of $0.48 per share. First quarter 2020 adjusted EPS is forecasted at $0.05 to $0.08 compared to Q1 2019 on a comparable basis of $0.11 per share. Eric?

Thank you, Deanna. So in closing, today Kratos has four high performance low cost attributable tactical jet drones in our class flying that I can disclose with you. The Valkyrie, the Gremlins, Mako Airwolf. We are the only company with affordable drones in this class that are flying today, and we have several others in development including certain we have not disclosed for competitive security related or other considerations.As represented by certain programs that the DoD has disclosed to date, including Skyborg, ABMS, Vanguard, LCAD, The Arsenal Plane, and most recently DARPA’s LongShot Gunslinger programs. We believe there will be significant future demand for drones like Kratos.We believe that the momentum the Kratos has is reflected by was what reported most recently by the Air Force just last week. Where the Air Force stated that the Valkyrie will fly in the services next Advanced Battle Management System experiment in April and that the Air Force expects that we’ll see an attritable drone program called Skyborg in the fiscal 2022 budget. We believe that if we continue to execute, we will be successful.With that, I’ll turn it over to the moderator for questions.

Thank you. [Operator Instructions] Our first question comes from Sheila Kahyaoglu with Jefferies. You may proceed with your question.

Thank you. Good afternoon, Eric and Deanna. Eric, thank you for all those comments. I just wanted to clarify some of the Valkyrie items if you don’t mind. You mentioned it slipped to the right, but we have a budget in place. Can you walk through the timeline for Valkyrie and how we should be thinking about that? And then just related to that bigger picture on the unmanned profitability was a little bit late. What are the moving pieces as we go through 2019 into 2020 on the mix?

Right. So on Valkyrie, Sheila, I’ll talk about what’s publicly out there that you can go and reach to. As I mentioned, we’re going to be flying in an exercise with both the F-22 and the F-35 sometime in the next few months. The Air Force has announced that we will be flying in the ABMS program in the next couple of months. The budget, if you take a look at some of the budget lines, like the tech transition program, that’s for prototyping and experimentation. There’s $219 million in there. If there was a congressional ads specifically for the LCAD of $100 million. There’s another line for experimentation project funds of about $90 million and there’s another line for the future Air Force integrated technology demos of $157. That all ties into what the Air Force stated last week, that in the 2020 budget, they believe Skyborg and I – my understanding is they were talking Skyborg and the Valkyrie interchangeably, that the Skyborg program is adequately funded for 2020. It’s adequately funded for 2021 and its heading towards Skyborg is its heading to a program in 2022.So to your question, we need to continue to successfully execute, continue to successfully fly. We are in discussions right now with customers for, as we talked about contract awards, because of our belief of what’s about to happen. We are starting to build. We have begun building 12 initial production Valkyries. So we can start delivering the first of these in the first quarter of next year and then deliver one or two a month every month thereafter. So, we believe that we we’re tracking and if we execute, we're going to succeed.

So, is it correct to assume that there was $40 million in the guide, but now that those 12 production vehicles are six months to the right, so the 2021 guidance?

Well, Sheila, we’re not quite sure what you’re asking. This is the first time we’re giving 2020 guidance. So there was nothing included previously because we have not provided guidance previously.

Okay. There was a comment in the prepared remarks said, you alluded to slipping to the right by six months. So, I just wanted to clarify was that the production timing of the delivery?

Yes. So there was a slip in the schedule of estimated production and that is reflected in the 2020 guide. The $40 million we’re talking about is related to the training program, the Royal Saudi Naval Forces that’s the impact from 2019 to 2020.

Okay. Got it. And then just a follow-up on the unmanned profitability, if you – is there any way you guys can bridge to that?

Sure. So from an operating income standpoint, so for the fourth quarter of 2019, there’s approximately $600,000 of legal fees related to a dispute with an international customer – an international target customer that is included in the operating income. And then the other piece is the mix of programs. It’s more focused in the fourth quarter, two developmental programs, which are typically on the lower side of a margin rate perspective as compared to production margin rates.

Okay. Thank you.

Sure.

Thank you. Our next question comes from Pete Skibitski with Alembic Global. You may proceed with your question.

Yes. Hello guys. On the $50 million C5ISR when it’s been protested, can you tell us the name of the program and maybe when the protest period is expected to be up? I didn’t think at like 90 days to rule on it. And then how many years would that be executed over if you do retain it?

Right. So, Peter, because it’s literally active right now. I don’t want to name the program, because I don’t want to get the customer on publicly involved here. The – you’re right on the 90 days. Typically it’s 110, is the full run period with the GAO, and it was – we were looking to burn it over for four, no more than five years, fairly ratably.

Got it. Okay. Then just one follow-up. Can you update us on some of the hypersonic competitions? The BMD Target, Solid Rocket Motor ones. I think, you had won one last year. Last a second one, and I think you’ve got a third one that was still kind of in the running and maybe you can update us on the third one. And also, I never got a sense of the size and an execution period for the one that you did when?

Right. So the one that we – I’ll start there. The one that we were successful on, the projected contribution to us over the base period and all options and it was a single award contract is $150 million. Okay? That’s, that’s the contribution to us. On – there is a third one, and I’m not going to be talking about it much because it is about to enter the solicitation period. And this year it’s expected to be later this year it’s expected to be awarded and we’re going to compete for it.

Okay. The $150 million, how many years was that over?

The one that was protested?

Another one, you won the first one.

Oh, that one was over up. We’re going to probably, it was six or seven. Six or seven.

Okay. Thanks guys.

Yes.

Thank you. Our next question comes from Ken Herbert with Canaccord. You may proceed with your question?

Hi, good afternoon, Eric and Deanna.

Hi, Ken.

Hey, I just wanted to follow-up on the on the Valkyrie. I mean, Eric, you made a comment that do you think it is or you believe it’s fully funded obviously through the fiscal 2020 enacted budget. But it looks like it’s obviously a high priority for the unfunded list from the Air Force. And that’s obviously not just Valkyrie but, but Skyborg and elements of the ABMS. Can you just comment, if you think your customers priority or intention around the Valkyrie as, as part of the broader Skyborg or ABMS programs have changed or how you view intensity and your customer right now in terms of the schedule and moving forward?

Right. Ken, I, definitely believe they’ve changed. And I’ll point to the – the reported remarks by the Air Force last week where I think, I’m being spot on here, but I may be paraphrasing and I can send them to you. Where as you said, in the unfunded priority list, this is the Skyborg is the number one priority. It was reported that the Air Force said that they were using Skyborg and Valkyrie interchangeably. They – I believe, they specifically said that one of the reasons why Skyborg attributable drone program was not a program of record in 2021 was because they felt it was adequately funded already in 2020 and 2021, and so they were going to move it to 2022.And I believe they said that their enthusiasm remains very, very high for the entire program, which I think is further, my opinion is further represented by we are going to be as publicly available now. We’re going to be involved with the ABMS program very, very soon, which includes the F-22 and the F-35 and those are the ones that are publicly out there and obviously we’re aware of a number of other things that are going to happen or that are expected to happen over the course of this year that we believe, reiterate the enthusiasm for a high performance, very low cost drum.

Okay. Thank you. And I’m imagining, I mean, you’re investing, just on the CapEx $16 million this year for production of 12 of the Valkyries. Are you expecting visibility on a contract to change after the April – the scheduled April testify or do you expect better visibility in later on in the year?

I because of where things are right now, Ken, I’m not getting ahead of anybody. I’m not going to comment beyond the prepared remarks. I’m sorry.

Okay. That’s great. Just one final question. Again on the preproduction, I’m guessing you’ll be prepared to start to deliver, I think you said in early next year or January. Do you expect the $16 million in capital or the spending this year to fully produce those 12 or is that going to spill into 2021 as well?

That’s a good question. We’re – we are planning on delivering the first Valkyrie or Valkyries in Q1, and then one or two every month thereafter.

Okay. So that the CapEx this year funds – the CapEx, but it sounds like production will obviously spill from this year. We’ll cover both 2020 and 2021 of those 12 units.

Correct. And that if we increase the 12 based on input, then we’ll increase it. Exactly.

Perfect. Okay. Thank you.

Sure.

Thank you. Our next question comes from Mike Crawford with B. Riley FBR. You may proceed with your question.

Thanks. Given if you’re excluding that Valkyrie builds that’s being capitalized into revenue guidance until you have better visibility and quantities, pricing, structure and timing. Once we get that, is it expected that you – there will be like a revenue ketchup and that fees then will be recognized as a percent complete based on milestones or is that also unknown?

At this point, what we would expect Mike, is that would be on a percent complete based on the percentage of completion of the cost, the total cost, that’s expected.

Yes. Just hypothetically, let’s say you’ve got an award, I don’t know on the second quarter, then when we see a second quarter reported, there would be like a revenue ketchup as these things move from CapEx and to – I guess work in progress and…

That would be the expectation. Yes.

Okay. Thank you. And then on – the 15% of the $1.1 billion been in proposal pipeline that's unmanned, so it's like $165 million, but that's just for targets?

Yes.

Yes.

Yes. And I'll say substantially, there may be a dog or cat in there, but absolutely substantially that's all target drones.

Okay. And then on the Airwolf, Program F, when was that renamed, why was it renamed? Is there any expectation for when you could start to get like low-rate initial production or anything of that sort for that program?

I will just say the decision was made to change the name. And that's what it is now. And we're – we have a number – a number of flights for that in Q2 between 5 and 10 several that are scheduled. And assuming those are successful, the final, I'll call them justification flights would be expected in the second half of the year. And then maybe next year we begin to deliver some units.

Okay, great. Thank you.

Thank you.

Thank you. Our next question comes from Seth Seifman with JP Morgan. You may proceed with your question.

Thanks very much and good afternoon. I wonder in the unmanned business, thinking just about the target drones, we kind of saw run rate in the second and third quarter are kind of reproaching the mid-40s or in the mid-40s came down in the third quarter to something closer to what it was previously. I guess, how do we see that trajectory moving forward? Why did it come down, when can we get back to where we were and then beyond? And then, at what point do you see getting to that kind of $215 million that, that just the target drones can provide themselves?

Right. So we've – there are two programs that we're in development. They moved to LRIP and we've been executing on the LRIP. Both those programs as I mentioned are now planned to go into full-rate production. The one I can talk specifically about because the public information is out there, is on the Navy, BQM-177 program, where they have indicated that it's going to be moving to FRP with a baseline initial quantity of 55 per year and we've been at 30 or 35 per year.And so we see a step up there, that the confidential program that's going to be moving to FRP and that one is expected to get somewhere to $25 million to $30 million in revenue. And then on the AVSAT, the Air Force program, we are entering negotiations for the next five-year build and it appears that those – that five-year build is going to be at quantities that have been higher at the previous annual build levels.So that's how we see the trajectory going up – and the up and down that you mentioned too before, we have two handfuls of international customers that have operations. And those operations are not annual and they're not recurring. There are certain big ones that are every two years. There are some that happen every three years and those have caused some of the ups and that – those are what have been one of the factors causing the ups and downs has been the timing on the production of the drones for those international ones.And very importantly, Seth, on these international ones, certain of the international customers, they do a service-type model. So what they'll do is they will pay us to bring 20 drones out to arrange for an exercise with a fee set for – in my example, one month's worth of work will be paid for that month for those flights, which are called representations.If they shoot down the drones, they buy them and so if one year they shoot down 10 and the next year, they shoot down 20 the year. Of course, we like it when they shoot them down because we get to build more, when they shoot down 20 that can cause an increase in that quarter that they shot more down.

Okay. And then I guess, with regard to the outlook, you talked about some visibility toward 2021. I guess, what level of confidence that do you have that backlog exiting this year will be higher than it was at the end of 2019?

If the expected timing right now holds on some of the – going to full rate production, then it's very, very high that it will, if the timing holds, what's in the 2020 – what was in the 2020 budget, what's in the 2021 request. But Seth, your point is, it's a very important point because let's take this contract where we're looking to – it's going to be a five-year contract and it's going to be a follow on, on full-rate production. And we're sole-source and we own the data rights to the airplane and no one else can build it. When we get that contract award, we may not put five years in our backlog. We will only put in one-year. It's the way we do it. We put in one-year at a time as it's funded, even though it's a single award, sole-source five-year contract. So please keep that in mind also.

Okay, great. Thanks. Thanks very much.

Yes.

Thank you. [Operator Instructions] Our next question comes from Peter Arment with Baird. You may proceed with your question.

Yes, good afternoon, Eric, Deanna. Eric, I guess I just wanted to do, there's been a lot of questions obviously tied to the guidance in Valkyrie. But I guess the two biggest swing factors we should be – the takeaways are thinking about 2020 guidance. Is the $40 million from the Saudi contract, and then the fact that you don't have any Valkyrie in which would have been under percentage of complete, those are the two big swing factors that we should be thinking about?

That's correct, Peter. The other pieces related to our legacy government services business that is expected to decline $10 million year-over-year as well. So you've got reporting on the Saudi, $10 million on services and then the exclusion of any revenue related to production orders for Valkyrie.

Okay. And then if I could just follow-up to that. So the seven – Eric, what's the kind of the biggest swing factor when we're looking at the 740 and 780 that you've given out? Is there anything else that you would call out?

I'm noodling. No, there's nothing else right now that I'd call out on the full year. Nothing.

Okay.

Nothing else – no individual item or program comes to…

So Airwolf – I know that that was always planned to have demonstration flights and sometime during 2020s. Sounds like you've got a lot in Q2 but that sounds like more revenue opportunity in 2021, is that correct?

Yes, of a material one, I would say, yes.

Okay. No, that's helpful. You've answered my question. Thanks again, Eric.

Thank you.

Thank you. Our next question comes from Noah Poponak with Goldman Sachs. You may proceed with your question.

Hello, everyone.

Good afternoon.

When do you now expect a Valkyrie award?

As I said on – I believe Mr. Crawford's question. I am not going to put any times out there as we're in discussion with the customer.

Okay. Eric, you had previously said, you're expected an award within 90 days of a budget finalization – 2020 budget finalization that occurred in – so I guess I'm still confused as, if that occurred in mid-December and the customer enthusiastically wants this capability, why hasn't it – what changed from what you thought what happened in the 90-day window or has the 90-day window not changed?

In my opinion, the primary item that changed is when we have the recovery system anomaly on the Valkyrie. The customer made a decision to do an investigation into what happened. And that investigation took a few months and it is complete now. That is – in my mind is one of the primary ones.

So the investigation from time of that incident until time of agreed upon resolution took exactly how long?

Hold on. Yes, three and a half or four months.

Okay. Should I…

We had it – Noah, we had additional flights scheduled immediately after the third flight where the anomaly occurred that were pushed out to the right, which is turned out to be the fourth flights that just happened a few weeks ago.

Okay. What was below your plan for the fourth quarter of 2019?

So there were couple of production execution that we’ve had some timing delays with some of our vendors in our C5ISR modular systems business as well as some in our unmanned business. And then…

Okay. Do you have – are those in your 2020 revenue guidance?

Yes.

Okay. And then with regard to the margins, we’ve sort of asked about this before, but it’s a little tricky and trying to discern on the one hand new programs in this industry are margin dilutive, before eventually getting to full rate production and you getting down a learning curve and then they can be much higher margins. But on the other hand, you’ve already spent a lot of your own R&D dollars. You’ve already – you already have a lot of capital and facilities in place that are empty, which would suggest that the revenue on these new programs would have really good drop through in incremental margins.You’re guiding to – your guidance for 2020 implies margins down. Even though, you are not including much more of the newer program revenue than we were all thinking you would. So how should we be thinking about the direction of margin? Is it – is that a one year dilution until you can get closer to full rate? Or is it longer than that? Or is it – are they lower margin on a run rate basis? Any more light you could shut there would be helpful.

Right. No – the first part of what you said was absolutely spot on. We have – and in particular our unmanned business, a number of new pure development programs that are ramping, one of the biggest being Thanatos. And as I’ve talked about before and [Audio Dip], I’m going to be scaling back on some of that for reasons, those programs are dilutive to the margins as you’ve said.Going into production, we would fully expect when we receive production orders for Valkyrie or Gremlins. Exactly as you said, those margins in the manufacturing facility are going to be significant, because they’re covering fixed overheads that exist today that don’t have the coverage on the quantities. So you’re correct on that. Now you said that we have empty manufacturing facilities. I want to just address that we do not – we are building fire jet drones right now in Oklahoma City, lots of them. I don’t want to – for competitive reasons…

I shouldn’t have said empty, I just meant less efficient than they will ultimately…

Correct. But your thesis is correct. But as we move from LRIP to full rate production on certain of these target drone programs and as hopefully things materialize the way we believe they’re going to materialize on the tactical side, as we deliver more units, we see those margins being higher and offsetting the lower development margins.

Okay. Thank you.

Yes, sir.

Thank you. Our next question comes from Joe Gomes with NOBLE Capital. You may proceed with your question.

Good afternoon.

Hi, Joe.

When you guys were talking about their successful fourth flight and the Valkyrie, you mentioned something about us substantial envelope expansion. And I was just wondering what you meant by that.

I believe what has been put out there, I believe is higher, faster and more maneuvers. I believe that’s what – it’s been publicly disclosed.

Okay. And you didn’t mention and maybe you can’t as you were talking previously anything on the AeroVironment. I know previously you had talked about an early 2020 flight there and as one of you might be able to give us an update.

Absolutely. So I touched on it briefly in the prepared remarks. But since you’ve asked, I’ll be very specific. We have the AeroVironment tactical drone systems. We have them at our facility. System integration has begun. I was with the CEO of AeroVironment just last week and we specifically followed up on this and he actually sent me something today on it. So things are tracking and I see the only item that can flex specific timing is getting the range slot or the range timing pencil in Q2.

Okay. And just one last one, obviously, we saw last quarter the Dynetics acquisition. And I was wondering, if you might just give us a little color as to what that might mean either positively or negatively towards your relationship with that company.

I have to say I was extremely pleased to see that David King, the CEO of Dynetics is staying with the combined entity, in the same function as the President of Dynetics. I will be with him in a few – we have a meeting scheduled in a few weeks, as you know, they – Dynetics has been just an incredible partner and teammate of ours. And I am very, very hopeful because of what Lido has announced that there will be no change at all and their operating mode and specifically related to us. We’ve seen nothing yet our relationship with them is fantastic. They’re a great company.

Okay, great. Thank you.

Thank you. Our next question comes from Sheila Kahyaoglu with Jefferies. You may proceed with your question.

Hey, guys. Thank you, again. I have two follow-up questions if that’s okay. Eric, on BQM-177, I think you mentioned 55 a year. You had previously, I think talked about a higher number in the 80 to 100 range. Did I misunderstand or is that correct or is there a ramp next year?

Right? What specifically – I’m saying what has been publicly released and that’s what I will say is that, right now in the initial full rate production year one by year one by, it’s out there at 55 drones. The initial – since other – any other quantities beyond that is not public, Sheila, I don’t want to talk about it. That’s what’s out there and I wanted to update people on that.

Okay. Is that lower than what you expected to see or I guess or I have misunderstood the 80 to 100 is not – that’s a full rate number is what you were referring to.

That initial number is somewhat lower than I initially expected. Yes.

Okay. Got it.

We’ll see what happens as we move forward.

Okay. And then, sorry to harp on this, but one last question on the Valkyrie. Do you – you said, you expect a integration award sometime this month. So would that change, how you’re thinking about it or…

No. Sheila, if I said that or insinuated that, I apologize. I have been very careful not to insinuate any timing, so if I did, I apologize.

Okay. Thank you very much.

Okay.

Thank you. Our next question comes from Peter Arment with Baird. You may proceed with your question.

Yes. Just following up on a similar question. So the initial related production system and payload integration award is some point later in the year not this quarter.

I’m not going to say that. I’m going to say, it is – I’m not going to say any timing on it. The discussion and interactions Peter are literally going on right now.

Got it. That’s helpful. Thanks, Eric.

Thank you. And I’m not showing any further questions at this time. I would now like to turn the call back over to Eric DeMarco for any further remarks.

Great. Thank you all for joining us today and we’ll look forward to talking to you when we report Q1.

Thank you. Ladies and gentlemen, this concludes today’s conference call. Thank you for participating.