Thank you for standing by. Welcome to the Kratos Defense & Security Solutions’ Third Quarter 2022 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] And now I would now like to introduce your host for today's program Marie Mendoza, Senior Vice President and General Counsel. Please go ahead.

Good afternoon everyone and thank you for joining us for the Kratos Defense & Security Solutions third quarter 2022 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. In the third quarter, Kratos successfully executed on what we could control then it continued in increasingly difficult operating environment, generating a 1.1 book-to-bill ratio, successfully executing a Valkyrie block to flight and receiving a recent new hypersonic system related program award MACH-TB or Multi-Service Advanced Capability Hypersonics Test Bed with our partner Dynetics both which we were able to announce today. We are currently positioned for additional upcoming milestones and significant contract awards, including another important new hypersonic related program we hope to announce by the end of this year, and the definitization of an approximate $250 million potential value microwave electronics C2 program award. Additionally, we now expect two new Valkyrie related tactical drone system contract awards from two separate new customers from multiple aircraft. And we have just recently begun discussions with a potential fourth new customer, also from multiple Valkyrie systems. The interest in Kratos tactical drone systems has recently increased and is gaining momentum. I believe in part due to the ongoing Russia/Ukraine conflict, the heavy use of drones involved including jet drones and the reality the quantities do matter, and that Kratos is the only company with affordable high performance jet drones flying today, also with active production lines. Since our last report to you we have also faced challenges, including that we were recently informed that a certain Kratos satellite program relating -- related to software products expected to be delivered in 2022 to an existing under contract government customer have now been delayed to a future period. And we were informed by another under contract customer that additional funding is now not available for the continuation of a certain non-Valkyrie related Kratos tactical drone program we have been working on. Both of these were previously forecast as important contributors…

Thank you, Eric. Good afternoon. As we've included a detailed summary of the third quarter financial performance and fourth quarter and full year 2022 financial guidance in the press release we published earlier today, I will focus on the highlights in my remarks today. As Eric mentioned, the operating environment remained challenging with continued supply chain disruptions, inefficiencies, an extremely tight labor market and inflationary impacts. As a result, our third quarter revenues were impacted with $11.3 million being deferred into future periods with approximately $5.9 million of associated operating income, including increase inflationary costs. In addition, our operating results included a charge of approximately $3.4 million related to certain non-recoverable costs, including rate costs growth items, resulting from an inability to hire the required planned direct labor base both internally and by our subcontractors to execute on our backlog due to a continuing challenging environment in both hiring and retaining skilled manufacturing personnel, including in our seats by via charges. For example, while we have been successful in hiring over 96 new skilled staff this year in this business, unfortunately, we are down net 14 staff members since the beginning of this year, as we have lost 110 staff members in this business due to attrition from retirement, including from employee decisions made related to COVID fascination compliance and protocol related policies and staff leaving for other employment due to the incredibly competitive and tight labor market, and with significantly increasing compensation. As Eric mentioned, we have recently seen more success in hiring and stabilization in the retention of our existing workforce. And our entire organization is incredibly focused on this primary operational execution area. Additionally, as we are managing supply chain related disruptions and shortages, our operating cash flow continues to be impacted by advanced inventory purchases we…

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

Certainly. [Operator Instructions] And our first question comes from line of Mike Crawford from B. Riley. Your question, please.

Thank you. Given these delays in the tactical drum space, do you think that it's getting harder to cross the so called valley of death? Or maybe one of them didn't make it, or is it now that we're really focused on Dow Theory and maybe some of these newer iterations like that are coming down the pike?

No, it is not harder to get across the valley of death, Mike. And we still have a number of platforms that all of which we've talked about here previously, that our still flying. And that are still going across. As I mentioned over the past year, I think it started after the Reagan forum last year, when the Secretary talked about two new classified programs. And he said that all the other programs are substantially all of them would be feeders into those programs, and it was all going to be buttoned up. I mentioned that it was going to be just difficult for us to talk about stuff anymore unless we got approval. And that's one of the reasons we were able to put the -- what we put out today on the Valkyrie, we just recently cut approval for that press release. There is a lot going on in the CCA or tactical drone area, a lot, a lot, a lot. And as I indicated in my remarks, I think things are coming a lot and they're accelerating because of what's going on in the in the Ukraine with Russia. It's become a war of attrition, general high note recently of the Air Force recently had an interview about that it's a war of attrition. And I think that is what is, is causing momentum to start picking up here again.

Okay. Thank you. And then, in the space and satellite cyber business. So, is there any takeaway from the change in leadership at the U.S. space force? And then, I guess, the second part of that, is this one software delay? Is that related to the continuing resolution? Or is that -- is there some other reason given for that delay?

Right. So, let me take the second part of that first. It is not as we understand it related to the continuing resolution that, that program is classified. So, it's related our understanding to a separate item. That's why it's been pushed out. That's all I can say. It's classified. Relative to any changes in personnel like at the space force, et cetera, I don't believe that at best has anything to do with what's going on here or what it's going to have to do with the trajectory in the industry. The bottom line is that there are going to be fewer and fewer geosynchronous orbit satellites put up and there are going to be hundreds and hundreds of MEOs and LEOs put up. And there are all types of reasons for that technological reasons. Distributing the assets et cetera. And the more birds that are up there, whether it doesn't matter what size they are, the better that is for Kratos and our ground equipment, which is why we are seeing -- the traction we're seeing and we're still optimistic.

All right. Thank you, Eric.

Yes, sir.

Thank you. And one moment for our next question. And our next question comes from the line of Noah Poponak from Goldman Sachs. Your question please. One moment. Noah Poponak, your line is open.

Hey, guys. It's Gavin on for Noah. Can you hear me?

Hey, Gavin. Good afternoon.

Yeah.

Hey, thanks. In terms of the 10% revenue growth target next year, I think you'd said previously that doesn't consider too much upside and tactical drones. So, what are you expecting in tactical drones there? How much visibility do you have into that business returning to growth? And when do you think that returns to growth?

Yeah. So, you're absolutely right. The base case does not include any significant production at all of orders of tactical drones. It is, as I said, on the last call, buddy, it's a continuation of RDT&E and S&T initiatives, both that were on and future ones that we expect to get. And as I said, on the last few calls there's -- I'm not getting ahead of myself anymore on this. We have gone through it. We've got the right aircraft at the right price points at the right time. And we're going to hang around the hoop until we win. That's what we're doing. And so nothing significant, other than RDT&E and S&T.

Got it. And then in terms of the non-recoverable costs, I mean, what timeframe does that capture? I mean, does that capture your future expected cost growth? And is there any risk that that number just kind of continues to trend higher unless the DoD gives RBA relief?

Gavin, that does not take into consideration future cost growth, that is current period growth that we are not passing through to contract. So, we are absorbing that in the current period.

And relative to the future, as we've been talking about for the last few quarters, and I emphasize today, we're substantially firm fixed price. And we missed because as you said, the plant came out with another letter last week, and said there will be no relief on this on existing contracts. Well, as I tried to emphasize today, we've been winning a lot of new contracts, including the last two quarters. And we have been building into those escalates -- existing costs and escalators to capture future increases, most importantly, in labor and in the indirect rates, that that labor base drives. So, we've been building that in, and we think that point is going to start to cross in Q1 or Q2 of next year, and then we'll be okay. Unless of course, inflation goes to 25%, then we're fried. But that's our plan.

That's helpful. Thank you.

Yeah.

Thank you. [Operator Instructions] And our next question comes from the line of Sheila Kahyaoglu from Jefferies. Your question please.

Hi, guys. This is Ellen on for Sheila.

Hi.

Hi, Ellen.

Just a little bit looking at that 10% growth next year and a little bit more detail. I know you've mentioned 12% to 15% space and satellite growth. But are there any programs that you can walk us through that drive that?

Yeah. Absolutely. Sentinel, comes to mind immediately. We're in development on Sentinel. Our partners are GBSD. Our partner of course, is Northrop Grumman. They're often an outstanding partner, by the way. And we are ramping right along with Northrop on Sentinel. I mentioned the SSAT program, and the target drones. As I mentioned in Q3, we achieved initial operating capability with the United States Navy, we're in full rate production, and it is ramping significantly now, significantly. So SSAT is going to be a very, very big driver. We've announced a number of space and satellite programs. But in addition to the ones we've announced, there's a number that we have won that we can't talk about. Those are all ramping for us in Q in 2023. And as I mentioned, that's tying directly to what's going on with the off tempo in the space and satellite area. And the other one that we're doing is in C5ISR business. I mentioned a couple of them, like SHORAD and IBCS effect to a lesser extent next first half of next year, but ramping. We are on some big new programs of record that we've won. And they are -- they're beginning to go. And the last area is in the hypersonic area. We are the absolute leader in the industry and affordably putting something in the right place at the right time at the right speed. And as the hypersonic off tempo picks up, we are going right along with it because we're the guy that can do it. Those are the primary areas and then to a lesser extent, the B52 reengine program. It's big. It's several tens of millions of dollars. That's also ramping, but to a lesser extent than say GBSD.

That's helpful. And then, as we think about some of the contract changes you're putting into place, is there a path back to double-digit margins in the next couple of years? Or how do we think about profitability?

Yes, there definitely is. Because as I've mentioned before, and I'll mention it again, now the government on the new contracts, on new contracts, and on options that were pricing now they are fine with escalators and cost increases, so long as we give them a reciprocal, that if inflation turns out to be transitory, what -- or it goes back to 3% or 2% next year, that they can have relief on the other side. That's literally what's happening here. And we are absolutely amenable, that's a very fair offer by the government. And we are building that in. So, we're very confident, we're going to -- our rates will start getting back up next year. As I mentioned, as our contract mix moves more to the newer ones, the more recent ones, with higher costs built into them.

That's helpful. I hope back in the queue.

Okay. Thank you.

Thank you. One moment for our next question. And our next question comes from the line of Joe Gomes from Noble Capital. Your question, please.

Good afternoon, Eric.

Good afternoon, sir.

I guess a quick kind of big picture type question. Seeing is, some of the announcements today with some of the contracts that have been pushed out, or there's no more funding for them. You previously talked about some business, the self driving trucks that you're doing with Min-DAC, the truck mounted attenuators. Where did those types of products stand? And could they potentially be a growth driver here to help cover our -- some of the projects that have gone away? Thanks.

Yeah. If you could see me if I was on a video, you would see both Deanna and I are smiling. We -- obviously we haven't been talking much about that. But it is progressing. And revenue there in that area in 2023, is going to start to become material to Kratos. And then in 2024 and 2025, as we roll out these kits to convert the existing manned trucks and vehicles to unmanned at a very low cost with our technology, this is happening. Don't quote me on this on the -- in the state work we're doing I think we're in approximately -- our trucks are on the road in 10 states now, with certain states now coming back for production orders. So, it is moving. It's happening. And I want to re emphasize our target market is the one that is being ignored by everybody else. We're taking the existing trucks and the existing vehicles, the millions of them that are out there. And because of the incredible driver shortage, and I think I saw like a million truck drivers are retiring and aging out in the next eight years. There aren't going to be enough. So that's where our technology is coming in. And we're focused on the agricultural, the mining and the middle markets right now.

Great. Thanks for that, Eric. We look forward to it. Thank you.

Thanks for asking the question.

Thank you. [Operator Instructions] Our next question comes from line of Pete Skibitski from Alembic Global. Your question, please.

Yeah. Good afternoon, Eric and Deanna.

Good afternoon.

Guys, can you talk about the sensitivity in your guidance to a further delay in the 2023 budget? We've got the CR through mid December, and there's probably a 50-50 chance that we maybe go into January. And I'm just wondering if that would impact guidance at all.

All right. So, the way the 2023 budget fits today, okay? If it is approved substantially in its current form, say by the end of December, early January, we're okay. All right. If it has changed significantly, if content has changed significantly, and we have another six months continuing resolution like we did last year, then we're going to have to analyze what that budget looks like, what the timing of getting those funds obligated under contract looks like. And then we'll map that into what we think.

Okay. No, I appreciate the color there. And then, also want to ask kind of where are you guys at now, if I missed this in terms of your labor target? How far away are you on the labor target and kind of what the go forward goal is? And associated with that, I thought I heard you guys mentioned people leaving because of COVID compliance. And I thought the government dropped that provision that defense employees get vaccinated. So maybe, kind of clarify that.

Sure. So that was earlier in the year when we had those requirements that the government had not dropped. So that was part of the attrition that we saw earlier in the year, Pete. So our targets -- this specific target that we're all focused on, is in our C5ISR business. The target was to have a net increase of 100 heads by the end of this year. And we're currently down net 14. So, we've -- that target is, obviously, going to be pushed out into the first quarter. We've recently seen some stabilization in the attrition, because as I've mentioned, we have been able to hire just about 96 people, but we've had net reduction, it's just because of all those different factors. With the market, I think stabilizing, we are seeing some more recent -- more positive trends in that arena.

And let me add on that, that the people we have, they're all trained up, and they know how to work and they know how to do it, and they're on a learning curve. And then they leave. And then we have to hire new people and get them trained up. And that takes time. And that generates incredible inefficiencies, which also increases cost. And so it's a multi dynamic thing. We've been dealing with. Why it's been so important that on the new bids and new opportunities, we're building in higher rates. So, we can be competitive. For example, some of these new space companies that are paying very, very high rates for people, these are the guys that want to go to Mars, and we can be competitive there.

Okay. And this is GBSD that's driving a lot of the hiring needs in C5?

It's in C5. It's multiple programs. It's not one in particular, it really isn't. It's multiple programs. I mean, like pick a missile system or a radar system. Typically those guys or gals, they need very high security clearances in that manufacturing environment. And we're finding people refuse for multiple reasons. They don't want to get security clearances these days to work on a missile so surface to air missile system. That's another aspect we're dealing with.

Okay. Appreciate the color, guys.

Yeah.

Thanks.

Thank you. One moment for our next question. And our next question comes from a line Austin Moeller from Canaccord Genuity. Your question please.

Hi, Eric and Deanna. Good afternoon.

Hi, Austin.

Hi, Austin.

Hi. So, I guess, just my first question here, it seems like on the tactical drone side, the two horses that are sort of the closest to the end of the race here are the Valkyrie and the Air Wolf. So I mean, you kind of touched on, there's three potential customers for Valkyrie, and that we could have some kind of production contracts happening in the next few months. So, do we expect a production contract? Or do we expect an outlined program in the fiscal year 2023 budget? Or is this all sort of pushed to the right? And you're now going after in bidding on cloud or combat aircraft, which is not expected until like, 2024, right?

Right. So, as I said up front, Austin, it's going to be very cautious. I'm not -- I don't expect anything anymore until we get it in this area. But the customer has been very, very fickle. Okay? There are -- in addition to, I'll call them that -- I can't say a lot about them, because they're highly classified. The kindle programs, which are -- when people think of CCAs, they think of the kindle programs. In addition to those, there are multiple other drones in the jet class that are going to be out there. I'll call them all CCAs that are not related to what I'll call the kindle programs. We are -- have to be careful in how I say this. One would think that we are actively involved in all of those other programs. That's how -- that's all I have to say.

Okay. That's helpful. And then just another question. The satellite program that was delayed and pushed out of Q4, was that one of the three big contracts that you guys had been talking about as necessary for the guidance at the end of the year? Was that a different program?

Yes, it was. It was an aspect, an aspect of one of them. The program has not -- programs moving forward, it's revenue generating, that was an aspect that's been deferred.

Okay. And then just one more, if I may. Are you still expecting some Sentinel revenues in Q4 on the development side? I know most of the ramp is next year, but I think you had said some of it will start coming in the fourth quarter.

Yes. We are expecting. Some in the fourth quarter just not as much as we originally had forecasted.

Okay. Great. Thanks for all the detail.

Thank you.

Thank you. This does include the question-and-answer session of today's program. I'd like to hand the program back to Eric DeMarco for any further remarks. End of Q&A:

Thank you. Good afternoon. And we'll talk to you shortly. Thank you.

Thank you ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.