Kratos Defense & Security Solutions, Inc. (KTOS) Q1 2026 Earnings Report, Transcript and Summary

Good day, and thank you for standing by. Welcome to the Kratos Defense & Security Solutions First Quarter 2026 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Marie Mendoza, Senior Vice President and General Counsel. Please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions First Quarter 2026 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, financial guidance and other forward-looking statements 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. Eric?

Thank you, Marie. Kratos' balanced business model of making internally funded investments, including property, plant and equipment and the rapid development and fielding of relevant products for the Department of War while also generating organic growth, increased profitability and value for all Kratos stakeholders is succeeding. The success is reflected in our Q1 results, including a 1.6:1 book-to-bill ratio, a record backlog of $2 billion and increased opportunity pipeline up to $14 billion, and the $14 billion is after the 1.6:1 book-to-bill, reflecting Kratos' accelerating growth trajectory. As Deanna will go through in detail, we significantly exceeded our first quarter forecast across the board, with EBITDA being particularly strong as a result of execution and product delivery mix with Kratos' Microwave Electronics, Turbine Technologies and Unmanned Systems businesses each having a particularly strong Q1. Based on our current program execution and delivery plans, both Kratos' Q3 and Q4 are also expected to have particularly strong profitability, including Kratos' OpenSpace satellite command and control and telemetry tracking and control software deliveries, which are forecasted to be meaningful in both Q3 and Q4. As I will discuss in detail today, with the current geopolitical and threat environment, Kratos' space and satellite business is incredibly well positioned, including with our OpenSpace software and our globally owned and operated space domain awareness system. I am not able to provide any details for security and other reasons, but Kratos' satellite business is active across the globe. The business is rapidly accelerating, including as reflected by a 3:1 book-to-bill ratio in Q1 for our satellite business. There are tens of thousands of satellites planned for orbit in the coming years, both blue and red, and Kratos' ground systems and software are the gold standard of the industry. There is a generational recapitalization of the U.S. industrial base underway. The Department of War is looking to nontraditional defense technology companies like Kratos to play a significant role, and we are committed to doing our part to ensure that the department and our country are successful. Our industries and Kratos' total addressable market is rapidly expanding with the fiscal 2027 national security spend currently projected to be $1.5 trillion, an approximate $411 billion increase above 2026. I will emphasize that there are a very limited number of defense technology companies like Kratos that are qualified today with real existing capability and products to address the significantly -- the significant and growing market opportunity. Building military-grade hardware and software products that must work every time is hard, and Kratos' recognized capabilities and affordability are competitive differentiators for our company, which is being reflected in our financial performance. As we have seen, the department is now executing multiyear weapon system production framework agreements, including with several of Kratos' partners on several Kratos-supported programs, including in the missile and air defense system areas, which is good for the country, the industry and is very good for Kratos. These up to 7-year framework agreements, certain of which are calling for increased production orders of magnitude greater than today's production levels are providing clear demand signals from the department to industry and what we believe are significant long-term growth opportunities for Kratos. The department's demand signals are real, they are happening, and Kratos, along with our partners are participating and stepping up to ensure Department of War success. Kratos, along with other successful defense technology companies in the industry are making defense industrial base investments now in property, plant, equipment and facilitization to address this demand and to position our companies for significant future cash flow and additional value generation. Since our last report to you, the department stated that they intend to spend 2025's entire $156 billion Reconciliation Bill related to defense in fiscal 2026. This bill, as you know, includes funding for Kratos' hypersonic, Valkyrie CCA, Solid Rocket Motors, jet engines for drones, missiles and loitering munitions and other Kratos programs. This is very important as only approximately $30 billion of the $156 billion had been obligated into April. As a result, we have increased confidence in our business plan and full year 2026 forecast, and we expect to see accelerating future growth throughout '26 and into '27 with both the funding and spend timing now both in place. We also have increased confidence in our forecasted year-over-year 100 basis point increase in our EBITDA margins for both '26 over '25 and for '27 over '26, including as a result of expected increasing production and revenue, the resulting leverage on our fixed manufacturing and other fixed costs and the mix of higher-margin products and software. Simply stated, as we grow, our profit margins are increasing. Since our last report, we have had several meetings with the Department of War leadership, and we are confident that Kratos' strategy, business plan and approach are aligned with the department's objectives. I have also had several meetings with congressional leadership on both sides of the aisle. And I am confident that regardless of which party controls congressionally, the future United States national security spend is increasing. As it is acknowledged that the global threat profile, it's not harvisan and doesn't care who's in charge, it's there, and both sides are familiar and aware of this. National security priorities include hypersonic systems, propulsion systems, space and satellite systems, unmanned systems, drones, air defense, missile, radar and counter UAS systems and microwave electronics. Each are primary business areas and core competency areas of Kratos and all of which are supported in the planned $1.5 trillion 2027 National Security spend. As a result of Kratos' alignment with the department, increasing funding and our relevant past performance qualifications, the number of opportunities that Kratos continues to successfully receive and the number of new opportunities that are being presented to Kratos continues to increase including as reflected in our opportunity pipeline, which now exceeds $14 billion. I will emphasize again that there are not enough qualified defense technology companies like Kratos to address the current and expected future weapon system demand of the department. We are extremely fortunate to have the team that we do and the uniqueness and scarcity value of Kratos' capabilities is clearly apparent. Kratos' affordability as a technology pillar is an increasing differentiator to both our customers and to our partners as demonstrated in our ability to rapidly design and engineer relevant products upfront for low-cost production at scale. This is a clear department requirement, including as reflected in the framework agreements and also as demonstrated by recent and ongoing conflicts. Additionally, Kratos' Better is the enemy of good enough ready to field today, and our first-to-market pillar is aligned with the Secretary's United States Arsenal of Freedom vision and is advocation for companies like Kratos to deliver 85% of the solution that exists today and now, not a maybe and potentially unachievable someday in the future 100% solution. Operationally, our major programs and initiatives remain on track, including on the Marine Corps' MUX TACAIR program, we are currently negotiating contractual terms of the expected receipt of what I will refer to as Valkyrie program LRIP Phase 1 this year, and we are moving forward with our plan to increase Valkyrie annual production up to approximately 40 drones annually by early 2028. Receiving new hypersonic program awards, certain of which we have now been verbally informed that we have been successful on. We have received a separate $1 billion-plus sole-source hypersonic program expansion, verbal award, which we now also believe we will be receiving shortly. And since our last report, we have had several successful Kratos hypersonic system missions. Kratos' hypersonic franchise is expected to be a key growth driver for our company for the next several years. We expect to begin small jet engine LRIP later this year for cruise missiles and powered munitions, and we are planning to produce several thousand engines in 2027 and further increasing this engine production into 2028. Accordingly, we are pulling together a detailed program plan, including with our suppliers to ramp up to annual multiple thousand engine production beginning next year, with supply chain we expect to turn on shortly. Kratos small jet engine business is expected to be a significant growth driver for our company with increased margins for the next several years. We have also now received a new multi-hundred million dollar directed energy weapon system program with Kratos as the prime. As I mentioned earlier, Kratos' OpenSpace software continues to clearly differentiate Kratos' satellite business with our customers as OpenSpace is a distributed, virtualized and open capability system that securely enables real-time processing of RF signal and sensor data at scale in a highly distributed cloud, ground entry point and edge environments. Kratos' OpenSpace software platform serves as the core networking capability supporting all Kratos OpenSpace solutions, including satellite C2, earth sensing and observation, space domain awareness, space control and SATCOM, and this is for Kratos' largest business, our space and satellite communication business and our space domain awareness business. Kratos' OpenSpace is a crown jewel of our company, and it's analogous to defense technology company, Anduril's Lattice software platform. Kratos satellite business recently won a $447 million U.S. Space Force's prime contract for the Resilient Missile Warning and Tracking program, a MEO constellation designed to detect and track ICBM launches in addition to dimmer maneuvering hypersonic missiles and threats. This contract award was a significant contributor to the 1.8:1 first quarter KGS book-to-bill ratio. This program is part of a broader missile warning and tracking architecture that is built being fielded across multiple orbits. I encourage you to think Golden Dome. On this new prime program award, Kratos will provide the ground system and software to operate the satellites after launch, including sending commands, receiving sensor data and processing that information for delivery to military operators. Kratos' space and satellite business is expected to be a primary driver of our expected increased revenue and profit margins in Q3 and Q4 of this year and is also expected for significant growth and margin expansion in '27 and 2028. Artificial intelligence is also a key element or differentiator of Kratos' space satellite and space domain awareness business, in addition to AI also being key to Kratos' unmanned systems business and our jet drones. Artificial intelligence is helping drive Kratos' business. Additionally, the dual commercial national security use of Kratos' software, hardware and offerings also continues to differentiate Kratos, including affordability as we spread the research and development over multiple defense and commercial markets. Additionally, Kratos' dual-use applications also accelerate our speed to market and both rapid technology development and fielding of relevant products as we move fast and efficiently as we are investing our own money. A recent dual-use example since our last report, we now expect to receive a separate new additional industrial gas turbine program for artificial intelligence-related data centers by the end of this year with another well-known global industrial technology company. Our hypersonic system integration facility, new Anaconda radar program facility, Helios hypersonic program facility, GEK turbofan engine facility and Prometheus' solid rocket motor initiatives are each tracking to be online either later this year or next, each of which we expect to contribute to continued future Kratos growth and value generation for all of our stakeholders. In closing, the department is providing nontraditional defense technology companies like Kratos a generational opportunity in rebuilding the U.S. defense industrial base, building an arsenal of freedom, participating in multibillion-dollar multiyear programs and generating significant value. Kratos is aggressively participating in the current build and growth phase of the Department of War's rebuild defense industrial base plan with Kratos focused on generating an appropriate rate of return for each investment we make and for expected significant future sustained cash flow generation when the critical mass of production programs is achieved on these initiatives. And as I mentioned before, based on the current global threat environment and our congressional meetings, we believe there is bipartisan support for continued increasing future national security spends for the protection of the United States and the deterrence of our enemies. Deanna?

Thank you, Eric. Good afternoon. As we have included a detailed summary of the first quarter '26 financial performance as well as the initial second quarter and updated full year 2026 financial guidance in the press release we published earlier today, I will focus on the highlights in my remarks today. Revenues for the first quarter were $371 million, above our estimated range of $335 million to $345 million, which estimate did not include the recently closed Orbit acquisition. Excluding the impact of the Orbit acquisition, revenues were $357.7 million, above our estimated range, which had included the Nomad acquisition as the transaction was closed at the time we provided our estimate. Q1 '26 revenues include consolidated organic revenue growth of 15.8% with the largest contributors to the overachievement in our Unmanned Systems, Defense and Rocket Support, Turbine Technologies and Microwave Products businesses. Notable year-over-year organic revenue growth was reported in our Defense and Rocket Support, Unmanned Systems, Turbine Technologies and Microwave Products businesses with organic revenue growth rates of 45.8%, 30.9%, 20.3% and 12.3%, respectively. Adjusted EBITDA for the first quarter was $38.7 million, above the high end of our estimated range of $25 million to $30 million, reflecting the contribution from the recently closed Orbit acquisition as well as the increased volume and a favorable revenue mix. Unmanned Systems first quarter '26 revenue was up $19.5 million or 30.9% organically, with the increase primarily driven by Valkyrie-related activity. KGS first quarter '26 revenue was up $48.9 million year-over-year from the first quarter of '25 with organic revenue growth of 11.8%, excluding the impact of the recent acquisitions of Nomad and Orbit, which contributed an aggregate of $20.6 million. First quarter '26 cash flow generated used in operations was $27.4 million, primarily reflecting the working capital requirements related to the revenue growth impacting our receivables by approximately $28.7 million and increases in inventory of approximately $14.7 million and increases in prepaid and other assets of approximately $26.5 million, primarily reflecting prepayments for long lead materials as well as investments we are continuing to make related to certain development initiatives in our Unmanned Systems, Rocket Systems and Space and Satellite businesses. Free cash flow used in operations for the first quarter of '26 was $43.1 million after reflecting funding of $19.9 million of capital expenditures and net of $4.2 million in proceeds from the sale of Valkyries, which were previously reported as company-owned capital assets and classified as capital expenditures and therefore, reflected as an inflow in investing activities when sold. As we planned, we are continuing to make investments to expand and build out certain of our manufacturing and production facilities in our microwave products, rocket systems, hypersonic and jet engine businesses to meet existing and anticipated customer orders and requirements and investing in related new machinery, equipment and systems. Consolidated DSOs or days sales outstanding increased from 121 days during the fourth quarter of 2025 to 130 days during the first quarter of '26, reflecting the 22.6% revenue growth impact of the acquisitions as well as the timing of milestone billings and contractual funding, certain of which were and have been impacted by the extended federal government shutdown and CRA. Our contract mix for the first quarter of '26 was 73% revenues generated from fixed price contracts, 23% generated from cost-plus contracts and 4% generated from time and material contracts. Revenues generated from contracts with the U.S. federal government during the first quarter of '26 were approximately 69%, including revenues generated from contracts with the DoW, non-DoW federal government agencies and foreign military sales contracts and 21% generated from foreign customers and 10% from commercial customers. Now moving to financial guidance. Our financial guidance we provided today includes our expectations and assumptions for our supply chain execution, the impact of employee sourcing, hiring, retention and related costs. Our second quarter and updated full year '26 guidance now includes the estimated contribution from the recently closed Orbit acquisition. As Orbit had previously reported its financial results under International Accounting Financial Reporting Standards, we are in the process of aligning its reporting to U.S. Generally Accepted Accounting Principles, or GAAP. Accordingly, we have included conservative estimates in our updated guidance at this time. Our second quarter '26 guidance reflects the estimated revenue mix and less leverage on elevated administrative, manufacturing overhead and bid and proposal costs that we have ramped in the business to support the forecasted full year '26 growth. Our second quarter revenue guidance of $400 million to $410 million reflects estimated organic revenue growth of 4% to 7% as compared to the second quarter of '25. Our updated full year '26 revenue guidance of $1.7 billion to $1.760 billion includes the estimated contribution from the Orbit acquisitions and includes an estimated organic revenue growth rate of 15% to 19% over '25 actual performance. And as you may recall, our ' 25 actual performance exceeded our original forecast. Operating cash flow guidance includes the continued use of working capital to fund our organic revenue growth, which includes the increase in accounts receivable and the impact of delays in contract funding to enable customer billings and collections and increases in inventory and related prepaid asset balances as we ramp production and procure long lead time materials for our target and tactical drones, solid rocket motors and our turbofan and turbojet engines. Kratos' operating cash flow guidance also assumes certain investments in our rocket Systems and Unmanned Systems businesses related to the procurement of rocket and related systems and our plan to begin producing approximately 40 Valkyries annually beginning by the end of '27 and into '28 as well as the completion of certain of our unmanned systems and related derivatives and vehicles. Additional forecasted investments in '26 include our funding of the Prometheus joint venture established last year, which we estimate will occur ratably throughout '26 for an aggregate for the year of approximately $50 million. Our Anaconda radar program, our Helios hypersonic and arc chamber program, our Indiana Hypersonic Integration Facility, our GEK and BladeWorks engine facilities, investments for additional machinery and equipment to enhance throughput and production at our recently acquired Nomad facilities and our Vulcan, Kraken, Elysium, Nemesis Hermes investments for certain drone-related opportunities and other initiatives. Eric?

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

[Operator Instructions] Our first question will come from Sheila Kahyaoglu of Jefferies.

Great quarter. Maybe if I could just talk about the -- if you could elaborate more on the strong start to the year and the fiscal revenue raise. Could you speak to where you see the most strength, Eric? I know you talked about it in the prepared remarks as well and maybe compare that to early results you're seeing from Orbit and Nomad?

Yes. So internally, as I said in the remarks, Sheila, our engine business, KTT, is ripping right now. It is ripping. And you can just think about the number of missile programs that are out there, the number of drone programs that are out there, the number of space programs that are out there. We're involved with many, many of these, and it's increasing. On the Microwave Electronics side, as you know, we're headquartered in Israel. And our 3 big customers, partners are Israel Aerospace Industries, Rafael and Elbit. And we know the conflicts that's been going on over there. We are designed in on virtually every missile and radar system over there. And all those stocks are being -- need to be restored and rebuilt, and we're involved in that. And it is very, very strong. And in Unmanned Systems, our Unmanned Systems business was particularly strong in Q1. This is on the tactical side that's joining it. We have a lot of stuff going on, on the tactical side. And we made some important execution milestones in Q1. On the acquisitions, I'll start with Nomad. Nomad is going to be incredibly powerful for us. They are in the Counter UAS area. They are in the SATCOM area, not C2 and not TT&C, but SATCOM area. And they are doing some very interesting things, let's just say, the missile defense area. And as Deanna mentioned in her remarks, we're going to be making some capital investments over the next 12, 18 months, and we expect them to be one of our strongest organic growers starting next year. And Orbit is a crown jewel, Sheila. It's in Israel, where we are, same customers, same programs. Their SATCOM is on unmanned aerial systems, unmanned ground systems, unmanned water systems, manned systems, and they are a very unique company, and their growth rate is going to be consistent with what we see for us. So Q1 across the board was particularly strong for us, Sheila.

Great. And maybe just double-clicking on the hypersonic revenue opportunity a little bit more, tracking to the $400 million this year and stepping up to $700 million next year, I believe, still. How much of that is coming from the Middle East conflict? And what's your visibility on the $700 million?

Right. I can't -- I'm not allowed -- I can't comment on the Middle East. I would think not -- go with not a lot, but I can't comment on that. The visibility on the $700 million, let me give you the pieces. In the reconciliation bill, which has now been -- now the Department has said they're going to fully obligate the entire $156 billion this year, there was $400 million in there for the MACH-TB program, which is ours. So there's $400 million of the $700 million click. On the 2027 defense budget that's being asked for, the $300 million is covered plus some. The testing requirements for hypersonic systems and not just the weapon platform, but guidance system, control systems, seeker systems, communication systems is incredible, and we're the ones that have the program on it. So we feel extremely strong on our forecast in our hypersonic business for the next several years.

And our next question will come from the line of Mike Crawford of B. Riley Securities.

Just to continue on the Unmanned Systems front, the 40 drone annual production rate for Valkyrie, is that primarily in Oklahoma? And can you just remind us where else you're building Mako and fire jets and derivative drones?

Yes. So Valkyrie right now is 100% in Oklahoma for the airframe, et cetera. The avionics and electronics are down in Florida. Mako is in Sacramento, California. The next big one that's going to probably be ramping, Mike, starting at the end of this year, next year with the Mighty Hornet program is the tactical fire jet. We have moved substantially all of that production to Oklahoma. And Mike, on that one, very importantly, we have now successfully -- we are successfully flying the tactical fire jets with Kratos jet engines. So we are totally vertically integrated on our tactical fire jet CCA right now. So we've driven costs down even more with higher performance. And Mike, I'm being told that Kratos is the only company in the world that builds the plane and the engine under the same organization. So those engines, Mike, they're built in Michigan. The tactical firejet engines are built in Michigan.

Okay. And then are you able to comment on how well you're competing against Beehive and that one Chelsea-based company for supplying engines to other tactical jet and crew -- low-cost cruise missile providers?

I believe that we have won the vast majority of the opportunities that have been presented to us, if not every one of them. This is why, Mike, we are -- Deanna and I right now are working with the team, putting the program plan together with the supply chain, getting ready to turn them on to build like 3,000 engines next year ramping to maybe 5,000 or 6,000 in 2028. These are all tied to programs. So we feel real good.

And that's on Auburn Hills. That GEK is completely different.

No, that's -- these are all -- this is 100% Auburn Hills, think 250 pounds of thrust on down, okay? Think the Air Force's family of affordable mass missiles, the FAM program. Think that program is for 30,000 missiles over the next few years.

Yes. One final question. Just I don't know if you can, but could you maybe just provide a little deeper dive into what kind of SATCOM miniaturization IP from orbit you might combine with your preexisting microwave electronic capabilities to provide a new solution?

Yes. Yes. So the vast majority of Orbit's antennas, this is, for example, Mike, right now are parabolic. So I think very little parabolic antennas like a DIRECTV antenna shape, but very small that are on drones and airplanes and unmanned boats and stuff like that. And we are going to electronic antennas. We are Kratos, our microwave business is already building electronic antennas. So I think flat panel phased arrays and AES's advanced electronic scan array antennas. So we already have the customers. We have the platform. We have the program. We're going to slowly transition with our microwave electronics business to the electronic antennas, which have far more capability than the parabolics.

And our next question will be coming from the line of Peter Arment of Baird.

Eric, there recently was a successful flight of the JDAM-LR, the long range, which I guess was renamed from the Tower JDAM. Can you maybe talk a little bit about how you see this ramping up? I know you talked a little bit about a lot of engine production out of TDI. How quickly should we expect the ramp up on that platform?

Yes, you saw that. So that is now the GBU-75. That's the official name. And the program of record is currently for 25,000. It's expected, Peter, to go much higher, several tens of thousands more. Now I have to be careful because I'm not the prime, Boeing is the prime. There was significant funding for that in the reconciliation bill, which is now fully funded with the money being obligated. So this ties into our plans getting ready for LRIP next year and then full rate production for the following year. And so now without talking about that specific program, I just can't, that program and several of the other ones that you all are aware of that I've walked you through before, several of these are expected to go into LRIP later this year, no later than next year. And Peter, this is how we're getting to maybe 3,000 engines next year, 5,000 or 6,000 engines in '28 and even more in '29. And these are platforms we are designed in on. We're already on them.

Yes. It's incredible. Could you talk a little bit about -- or what can you say about on Florida Turbine's involvement in competing for, I guess, it's the sea-launched cruise missile and some of the opportunities there. I know Kratos is one of a few players there. I don't know what you can say, but you're in the engine business now, Eric.

Yes. Okay. So let's talk about what's publicly out there. We have been -- Kratos has been selected for the development of the engine for the submarine-launched cruise missile nuclear. So we've won SLCM-N, okay? As GE announced -- GE and our partner, GE announced, we have now been selected for the engine for the next class of attritable and extendable CCAs. We've been down selected on that, right? We were just informed in the past week that we -- us and GE, we just won another one. Now this next one, I'm going to say very carefully. The 7-year framework agreements. You've seen 7-year framework agreements on missile systems. We have been selected as the engine of GEK -- we have been selected as the engine for the expanded production. I think it's going up 4x, I think, is what the announcement was 4x current production for 2 of those missile platforms already.

Terrific. Lastly, just staying, I guess, with GEK. Should we anticipate the fact kind of you're moving in that direction and higher thrust that we could see those starting to be incorporated into future Valkyries, how you're thinking about that?

I can't talk about it. I'm getting -- I can't. I can't talk -- I'd like to, but I can't talk about it, I apologize.

And our next question will come from the line of Noah Poponak of Goldman Sachs.

Depending on your location, it all feels the same at the moment. Eric, can you guys size even if very roughly at this point, annual revenue that is from the hypersonics business and that is from power and propulsion. And obviously, there's some degree of overlap between the 2, if you could express that as well.

Yes. So for the total public information that we've provided for our hypersonic business, which is our Defense and Rocket Support business, the expectation for 2026 is $400 million. And then for next year, the expectation is for $700 million.

And then so think of those, Noah, as primarily right now solid rocket motors for the hypersonic business right now. Next year, I'll be talking to you about air breathers, but not right now. On the cruise missile engines, we're talking about, these are air breathers. We're currently on the smaller ones, our current run rate annually, I think is about $10 million. And so we're talking about thousands of engines and think of selling price depending on which engine of $40,000 to $60,000 each.

Okay. Okay. That's all helpful. I will keep trying to triangulate that as it's evolving. Can I ask about the 2Q outlook? It would require the strong pace of organic growth that you've been on to slow and a step down in the EBITDA margin and even the absolute dollars before then all of that picking back up in the second half. Can you just detail what's behind that?

Yes. So part of it -- so on the margin piece, part of that's related to the mix that is expected. So we did have quite a favorable mix in the first quarter. The other piece of that is we have been ramping infrastructure costs, manufacturing costs bid and proposal costs. So that is not being absorbed as much in the second quarter just because of the ramp that we're building up for the production and the growth for the second half. As far as the revenue step down, if you will, from Q1 to Q2, some of that's in our unmanned systems just based on the timing of some production and shipment in the first quarter as compared to the second quarter. That's primarily the biggest change, if you will, from sequential quarters.

Yes. We're trying to be conservative. We are. The issue out there in the industry right now is on the government side, the program offices and the contracting offices. The amount of money they are trying to get obligated and under contract is incredible. I just told you now there's an additional $120 billion that they're trying to get obligated between now and the end of the fiscal year. And so we're trying to be conservative. It's all lined up. But if we don't get the awards, if the DE250s aren't done, we can't execute on it. And we're cognizant of that backlog right now in the government program shops.

Okay. That makes sense. Appreciate that. And then I guess just maybe talking a little bit more about margins over time. You have an interesting go-to-market and an interesting model that would seemingly allow for your margins to go higher. And over the last few quarters, as the organic growth has accelerated, the margins have tracked. What's the latest thinking, I guess, on where margins go beyond this year and what the potential is over time?

Yes. I would go with what we put out there for now. We're looking for year-over-year 100 basis point increases. So '26 over '25, 100 basis points, '27 over '26, 100 basis points. You can probably pencil in if you want to, '28 over '27, 100 basis points. And we're pretty confident in this. And the balance, as you know, is we have so many opportunities right now. Our bid and proposal costs we're being told if you bid, you're going to win, which we're winning are significant millions of dollars. But we are putting in the money on the bid and proposal to win like this recent space program, $450 million that we were encouraged to bid. We bid it, we won it. That was a very expensive bid. And so we're balancing those costs against making sure that we hit the 100 basis point increases every year.

Okay. Yes, I would think at some point, you would achieve some escape velocity of leverage with -- you've invested so much in the business and then you get the revenue growth. But it sounds like for the time being, still just reinvesting back into those opportunities, so that makes sense.

And our next question will be coming from the line of Ken Herbert of RBC.

I wanted to follow up on your comment around timing and some of the challenges in actually taking funding levels into contracts. As we think into -- heading into fiscal '27, there's obviously quite a step-up more broadly in funding for drones and you think about the Defense Autonomous Warfare Group and funding levels there. How do you see -- 2 questions. How do you see that broadly impacting sort of opportunities across your portfolio, not only for the Valkyrie or other systems, but on the engine and other side? But then second, I guess, more importantly, what's your confidence level that we see sort of the kind of step-up they've talked about in drone and counter drone funding and that it actually happens in a timely manner, I guess?

Yes. So on that funding, as you know, right now, the placeholder is $56 billion over 5 years. That's the program you're talking about, DAWG. And when you talk drones, I'm going to talk drones and loitering munitions, which both fall underneath it. Our confidence on the engine side, we'll start there, is extremely high. If you triangulate the missiles they're talking about, I named one program with 30,000 of them. And you take a look at what's going on in the world and the attrition of our exquisite missiles right now and how long it takes to rebuild them and how expensive they are, we are highly -- we Kratos are highly confident that on the small jet drone, jet loitering munition, jet missile side, we have great confidence in our in our step-up forecast. Very good. All right. Now let's go to the drone side. We are being very careful. We've made the decision we are going to be the merchant supplier of engines. So we are going to be -- our plan is to be on every other system provider's missile or drone or loaded ammunition, be a merchant supplier. What does that mean? We are picking and choosing our spots very carefully where we are going to actually build the entire system. So we're not competing with our merchant supplier partner on the engine side, okay? So there are 1 or 2 that we're involved with right now where we're comfortable we're not competing or going to cause a problem on the merchant supplier side. But Ken, our primary focus is it's better to have part of something than all of nothing. And our part of something is to be on everybody's engines than to bid on DAWG systems where there are 10 guys bidding. And even though we think we're the best always, we might not win because the government is trying to rebuild the industrial base and rebuild different competitors.

That's helpful. And if I could, how do you think about the fact that a lot of the funding for DAWG in particular, is coming through expected reconciliation relative to base budget? And are you handicapping those any differently as you just think about fiscal '27?

Right. Yes. So obviously, for '26, I'm all happy. That's all bolted in at what, $1.150 trillion. So as you know, on the $1.5 trillion that the department is going for '27. The base budget piece is $1.150 trillion and the reconciliation bill is $350 billion. Very importantly, if that makes it, I believe it's going to make it based on my recent meetings, as I talked about on the Hill. The new baseline for the base budget is $1.150 trillion which never goes down. The only time it ever went down was under Obama and sequestration. And so you take that $1.150 trillion base and that goes up 3%, 5%, 6% a year. The DAWG program will be adequately funded as a new program that we'll be able to successfully execute our business plan, even if there are no future reconciliation bills.

And our next question will be coming from the line of Jonathan Siegmann of Stifel.

A lot of progress on a lot of vectors. Maybe one you didn't talk about as much was Prometheus, the solid rocket JV. You mentioned $50 million of CapEx this year. Just wondering, there was some earlier Defense Production Act Title III money for that campus. Does that change the level of investment that Kratos and the partner is putting in? Or does that represent opportunity to increase the scope of that facility?

Great question. Yes. So the department of -- so we had the Prometheus groundbreaking earlier this year, I guess, a few months ago. And the day after the groundbreaking, the department came out with its own press release that they're putting in $100 million into the camp, the Energetics campus on their own, which was great. So right after we put out a groundbreaking press release, the department put that out. Continuing on your question, there is absolute opportunity here for Prometheus, Kratos and Rafael with the department for significant additional department funds to be put into Prometheus to both pull production to the left and increase it for existing platforms that we're on and new platforms they want us on. Prometheus, in my opinion, is going to be a grand slam home run for the United States, the Energetics business and for Rafael and Kratos. The department is with us, our customer is with us, and we're planning right now, we're going to have first fire next year -- first fire next month, yes.

That's great. And then maybe I'll just add on one. You touched on it with Orbit Tech. Just looks like a great acquisition and a really strong final quarter as an independent company. And if our math is right, your revenue in Israel now is approaching about 10%. And last year, you upgraded your manufacturing facility. Could you maybe talk a little bit about the prospect of the enlarged business there? And how much exposure does it have to a munition restock that will unfold given the conflicts there?

Yes. So Deanna, are we near 10%?

Yes.

Yes. So we're near 10%. We have very large exposure to munition restock. So just think Tamir on Iron Dome. Think Arrow, right? We're on those. I can keep -- think Barak, Sling of David. We're on all of them. And it's us and Orbit on a lot of stuff, too. So we expect -- we are forecasting and expect significant growth in our Israeli business for the foreseeable future for the restock and for new systems that our big 3 partners, Rafael, Elbit and Israel Aerospace Industry are working with us on. As I think you know -- I believe, I think we're the largest independent merchant supplier of microwave electronics outside of the United States and it is growing rapidly. And as I think you also know in the U.S., we're back in the game in the microwave business. It is growing incredibly fast also. And this is where some of our highest margins are because a lot of this is catalog pricing. It's not subject to [ PNA ] which is normal. And this is one of the key aspects tying into Noah's question on margin expansion and why in the future, maybe we can do better than 100 basis points as our merchant supplier businesses get bigger relative to the system businesses.

And our next question will be coming from the line of Joe Gomes of NOBLE Capital.

I apologize, I just joined the call, so I missed a lot of it. I was on another one. And if I ask any questions that have been asked already, I apologize in advance.

No problem.

So I wanted to ask kind of start out with -- you talked about all the opportunities, Eric, and all the things that you're bidding on. And basically, you said, hey, people are coming to us saying, if you bid on it, you win it. How is that impacting your ability to employ -- get employees for these programs that you're winning? Is the labor situation gotten any better? Has it gotten worse? Maybe you can provide some color there.

Yes. Okay. So it's gotten better in the past year, 6 months, but it's not great especially in turbomachinery engineers for propulsion systems. They don't exist. It's very hard in the turbomachinery area. We -- you heard -- you may not have heard. In my prepared remarks, I talked about we've been verbally told we're going to receive another industrial -- very large industrial gas turbine program at the end of this year, beginning of next year by another company. This industrial gas turbine area for power generation, it's an incredible opportunity right now. And if we had the people, this is an area we could accelerate our growth even more, Joe. We really could. But these are the same guys that are working on our cruise missile programs. They're working on our hypersonic air breathing programs. They're working on our space programs. And I don't want to say guys, guys and gals, of course. So our #1 operational challenge right now as a company is obtaining and retaining qualified people. And then if they need to be able to obtain and retain a security clearance, that adds another layer on it, especially in certain states where marijuana is legal to smoke because you can't get a security clearance if -- and I'm not passing judgment here, if you like to do that. So that's the dynamic. It's not as bad as it was 1.5 years ago, it's better, but it's not great.

Okay. And then one more. Obviously, a lot of the questions deal with the military side of things here. But you and I have talked a lot in the past about some of the more commercial, the truck platooning, logistics automation and kind of release or 2 of that in the last 6 months or so. I'm just wondering where does that business stand? Are you going to be able to grow that business here in the near term with all the focus on the defense side?

Yes. So our unmanned ground system business is doing great. As you know, we're in the soybean; farms, we're in the sugar beet farms. We're in the timber land. I think we're in 15 states now driving unmanned on the roads. It's doing very, very well. But as you said, there's just so much going on, on the national security side. It's not a strategic focus area for us. But because our technology is so good and so cost affordable, they're coming to us. Joe, we're in discussions right now with a global farming equipment company. You would know who they are. And it's possible by the end of the year, we're going to get a contract with them, and we're going to turn their farming equipment into unmanned systems out on the farms. So it's happening, but I cannot tell you that it's a major strategic initiative because it's not, and I apologize.

And our next question will be coming from the line of Pete Skibitski of Alembic Global.

Guys, on the growth in KGS in the first quarter, I'm just trying to figure that out. Was that mostly MACH-TB driving the growth there? And then the $1 billion sole source, I think, addition that you mentioned, Eric, I think in your opening remarks, was that an increase in the ceiling of MACH-TB? Or was that something different?

Go ahead.

Yes. So the organic growth in KGS is it's partially driven by MACH-TB, but also in our microwave business as well as our KTT business. So it was across those 3 divisions within KGS.

Yes. On the other one, I can't get ahead of the customer until they announce it, but we've got 3 separate very large initiatives going on the hypersonic side, 2 of which we've been verbally told we're winning. The third one, I think we're also going to get. I want to wait until the customer comes out on it until I say anything just because I don't want to get in front of them. And it should be very soon on 1 or 2 of these.

Okay. Fair enough. And then I guess last one for me, maybe for Deanna. Just on the $160 million in CapEx this year, just what's the best guess that you think we should model in, in terms of how that profile is going to look in kind of through the midterm? It seems like a lot of the spending here will continue for some time, just judging from the amount of initiatives you guys have underway.

I think it would -- and obviously, we're not giving any guidance for next year, but I think the elevation of CapEx will continue. I don't think it will be at that level. But just with the initiatives we have going on, I think it will be -- continue to be elevated in '27.

And our next question will be coming from the line of Austin Moeller of Canaccord Genuity.

So you mentioned the win on the $447 million contract for ground management integration of the missile warning and tracking satellites in MEO. So at this point, you now provide ground station capability across all 3 orbital inclinations, LEO, MEO and GEO. So should we think that Kratos has a place competing on the recompete of SCAR with OpenSpace? And do you think there's an opportunity there for both the flat panel phased array antennas and the parabolic?

That's a very, very insightful question. You're exactly right. We are across all 3 of those orbits. And we're also -- I've been learning -- also I've been learning a lot about Cislunar orbit lately, too, because we're now in Cislunar orbit also. But to your question on SCAR. So obviously, we were partnered with AeroVironment on SCAR. We delivered all our stuff out previously. So the recent termination for convenience didn't impact us at all because we had already delivered out our piece. When it comes out, if it comes out, we will definitely take a look at it to see if we -- it's something we want to prime or do we want to partner again with AV or partner with somebody else. We'll look at it. I just don't -- I don't know right now enough details on it. But to the next part of your question, on a parabolic antenna versus an AESA antenna or phased array antenna. Here's my opinion, okay? I go back to what the Secretary said on November 7 in the Arsenal of Freedom speech. Bring me 85% of the solution now that I can field now, not something that I may or may not get 2 or 3 years from now. [ Mike Tummy ] tells me that parabolics will win there. That's what -- but I don't know, this is my opinion, just based on what's coming out of the department.

Okay. And then if we talk about drone dominance for just a second, on future gauntlets, do you expect other drones in the Group 2 to 5 category will be requested and procured at scale? And do you think Kratos is in a strong position given your manufacturing scale to ramp production and take greater economics on future production loss for gauntlet 1 and other gauntlets?

On your first 2 questions, yes and yes. So yes, yes and yes. We -- we're in source selection right now on something related to that, so I can't get into too many details. But as I think I said on the last -- I think I said on the last call, but if I didn't, I'll say it now. On Phase 2, we got some real compelling solutions on Phase 2. And what I understand on future phases, we have some really super compelling solutions. So we'll see. But Chris, the answer your question is yes and yes.

And our next question will be coming from the line of Andre Madrid of BTIG.

Deanna, could you maybe provide a split of Unmanned Systems sales between Valkyrie and Target? I know Valkyrie drove the strong growth, but I wanted to see just how much was between the 2.

Yes. The tactical revenue for the quarter was about $20 million.

And that $20 million was almost exclusively Valkyrie? Or was there some other stuff?

It's predominantly Valkyrie.

And I know you built a lot of those Valkyrie kind of ahead of schedule. I guess just when we think about Valkyrie sales again or tactical drone sales in isolation, just how should we think about the cadence through the rest of 2026? I mean, is 2Q going to be a step down? I know you kind of already alluded to that a bit, but like -- I mean, just like, I guess, how significant should we expect of a step down and then kind of a rebound through there at the end of the year?

Yes. The step -- there will be a step down. We haven't given guidance for the break between KGS and unmanned, but there will be a step down. As far as the produced units that we've been building as capital-owned assets, it's going to depend on the configuration of what we have built and what the customer is ultimately ordering. So if it's the same configuration and we get the contract for that, then if those are complete units, then that revenue would be recorded immediately. If they're 50% complete, then we would record revenue at 50% at the time of the award and the remaining would be as it is completed. If it's for a different configuration other than what we have in inventory or in fixed assets, then it would be based on that build process and the revenue would be reported accordingly.

Got it. Got it. That's helpful. And then one more. I mean, when I -- Eric, maybe this one for you. You mentioned this directed energy down selection as a prime. Historically, I haven't thought of this as an end market that you guys play in directly. Is that true? Is this like a new entry? Or is this something that has been -- you've been actively supporting for some time and has just been more behind the scenes and just not directly addressed?

Kratos has been involved in directed energy weapon systems and laser weapon systems for years and years and years and years and years. We -- I just -- I haven't talked about it. We -- over the past year, internally and tied in with an acquisition we've made, we try to go 1 plus 1 equals 4. And this is a counter UAS system. It's mobile. We're the prime. It's several hundred million. It's going to start ramping next year. It should be very big in '28. And this is an area where probably now that we've won this one, it will open the door for us to win more.

And our next question will be coming from the line of Michael Leshock with KeyBanc Capital Markets.

Apologies if I missed it, but I wanted to ask on the backlog and the significant growth there in the quarter. Did you see any impact from the government shutdown delaying some awards that could have potentially driven your backlog even higher?

Yes, we did, and we're expecting to see them in Q2. Right now, Q2 backlog is looking -- bookings, pardon me, is looking real good right now because it's freeing up.

Great. And then one on hypersonics, just given the very strong environment there and the new awards you mentioned, it sounds like the demand is clearly there. Is there anything that could potentially drive revenues above the $700 million target in '27 that you've talked about for that hypersonics franchise, whether that's additional investments or alleviating any bottlenecks? Anything there that you could call out to drive even more growth in hypersonics?

There is absolutely the opportunity for us to be well ahead of that in '27. Here's what it is. It's the supply chain. It's the engines and the materials for the glide vehicles and the air breathers. This is what -- this is it right here. As you know, we have under order now, I think, 120 motors that are starting to come in Q3. And this is also one of the reasons, Noah, why there's a slight dip in Q2. And then we're going to integrate them with the front end and then they're going to be launched. And we have the launch manifest for '27 and '28. But what's the most important part, it's the one you don't have. And so all the subelements have to come in to be able to get the systems out on the range and get them launched. So there's clear -- the demand is there. The funding is there. The customer intent is there. And this is a great question on why the U.S. department is rebuilding the industrial base. It's not there to do what they want to do, and that would be the inhibitor for us.

And our next question will be coming from the line of Cashen Keeler with BNP Paribas.

Just starting on capital deployment, you obviously upped the CapEx guidance a bit and completed some acquisitions, but you also raised a good amount of equity in the quarter. So as you look ahead, how are you thinking about capital deployment here? Is it mainly just going to be focusing on those organic investments? Or can we expect that you'll be active with M&A moving forward as well?

Yes. On the -- clearly, let's do the easy one first. Clearly, the growth opportunities we have, we are in a great position now in the eyes of our customers to execute on what we have and to the additional awards they intend to give us. So think the engines, for example. Probably in Q3, we're going to start placing the orders for the components and the subsystems for a lot of jet engines, which we will have programs for and contract for, which we'll start selling in '27 and '28. Those are the -- there's the solid -- 120 solid rocket motors I just mentioned to you. We've made some payments on those. We're going to have to continue to make payments on those. Those tie right into the $400 million revenue for hypersonic this year and the $700 million next year, got to have the motors. There's cash going to be deployed. So -- and I can keep going, but I can give you the programs to customers where the cash for working capital will be deployed, but then we'll get it back in revenue and then receivables when we collect it. On the M&A side, we are not aggressively pursuing anything, nothing, 0, all right? However, right now, there are a couple, 3 small companies where they're retiring. This is very similar. They know us. They've come to me. They're thinking about retiring. What they build it's exactly consistent with what we do. It's not like hand grenades. It's our sweet spots. And we are talking with these gentlemen and their lives. And if it makes sense, we'll do something with them, but these are small. So we have no plans right now, nothing on the radar screen or anything significant. That could change. I never say never, but that's where we're at right now.

Okay. That's helpful. And then on Valkyrie, there were just some comments in the press out of one of the industry trade shows about Valkyrie and the [indiscernible] Air Program. I think one of them was just on whether or not they're looking for conventional takeoff and landing STOL or VTOL. So just curious if any of those decisions impact your ability to ramp to the 40 units a year? Or are your production lines fairly modular that you can adapt to those requirements?

That's a great question. Good for you. So you saw that. Yes, that -- that's very relevant to the question asked earlier on the revenue recognition on the Valkyrie. So 5 years ago, 4 years ago, because of the war games that were performed, runway independence was it. That was the winner. That was 5 years ago, the winner 6 years ago. Had to be runway independent, Chinese are going to blow up all the runways. Valkyries launched off a rail, go get them. So we started building our Valkyries on a rail -- runway independent. Kendall comes in as Secretary of the Air Force. Halfway through his term in 2022, we're going to do the Agile Combat Employment program, ACE, where we're going to have all these little bitty runways all over the Pacific, so runway independence doesn't matter. We want wheels. So now what you've just seen is it moving back to runway independence. Take a look at what Shield AI is doing. They're building the X-BAT, which is a runway independent, superduper [ Cooper Scooper ] drone. I'm going through all of that with you because with our current customers, we have orders and we're going to receive orders for a certain mix. We're going to build those and we're going to deliver them. But along the way, the wind could change. If that Marine Corps thing you talked about, it talked about both runway independent and CTOL versions. And so it's still kind of influx now. And thank God, we have 3 versions that we can build, rail launch, take the rail launch one, put it on a trolley, launch it off a runway. So runway capable, rail launch and then full CTOL, conventional takeoff and landing with the landing gear internal. This is why when I initially said last call that we -- I think I said we're going to do 35 to 45 a year or something like that. I said depending on mix. The 40 that we're going to get up to by the end of '27, beginning of '28, if it's all CTOLs, it might be 30. If it's a mix, it will be 40. It just depends on the mix. And I'm not trying to obfuscate this. I'm telling you that this is happening real time. We have an inventory of a handful left of the RATO launch ones, the rail launched ones. We're building right now numerous CTOL ones, numerous that will be ready next year. And as the hand of cards comes out, we'll let you know as soon as we can what -- by customer, what it looks like.

And our next question will be coming from the line of Brian Dobson of Clear Street.

So earlier, you were describing a generational recapitalization of the U.S. defense industry. You mentioned some conversations that you have on the Hill. But beyond that, what gives you confidence that this can endure through multiple administration changes and perhaps several budget cycles? And to that point, how do you see Kratos evolving and growing to meet the needs of the Department of War over the next few years?

Yes. So on the first part of your question, like I said, I spent a lot of time on the Hill since our last call, both sides of the aisle with senior leadership. So the Chairman and the ranking members, HASC and SASC then on down from there. There is no doubt in my mind defense national security spends are going to continue to increase because of the threat profile. Is it going to be $1.5 trillion or $1.3 trillion? I don't know. Under the [ DEMS ], are there going to be reconciliation bills? Or is it all going to be in the base budget? I don't know, but it's probably all going to be in the base budget. But they're going to -- but then the DEMS, I'm not saying this negatively, this is policy. They're going to require equal discretionary nondefense to go up too. So there might be different mixes here, but I -- unless global peace breaks out based on what's going on geopolitically, the trajectory is up and to the right for national security spending. And now tying into the second part of your question, and I said this twice on the call because it's very, very, very important. You have the 5.5 traditional drones, 5.5, okay? Then you've got Kratos. You got a lot of new defense technology companies that are coming and they're coming, but there is a massive supply-demand imbalance right now. There is an incredible demand for military-grade hardware and software. Kratos has military-grade hardware and software, and we're the low-cost guy. And that isn't going to change for multiple years. It's not like we're having to take share from anybody right now. The pie is growing. The total addressable market, '27 over '26, for example, looks like it's going to go up $400 billion. So our primary focus is execution. We must execute, deliver products that work every time at an affordable price in large quantities. And we are going to do fantastic as the financials are showing. We're going to let the financials and the growth rate, the organic growth rates and the margin expansion do the talking. That's our plan.

And our next question will come from the line of Gavin Parsons with UBS.

Eric, Kratos is already pretty fixed price heavy, but I'd love to hear your thoughts on the White House executive order last week on fixed price contracting, if that has any competitive implications.

Right. There are colors of fixed price. So fixed price production contracts are extremely beneficial for the government and for the contractor because as you go down the learning curve as you're producing, you become more efficient, so you can make more money. And at the same time, you can lower your price to the government. So your margins can go up and their cost of paying you can go down because you're getting so efficient. Fixed price development contracts, we don't do those. Those are scary. So this is why Boeing gotten so much trouble over all the years. They took fixed price development contracts, building something that had never been built before. And if you can't get it to work, you got to keep going. We don't do fixed price development contracts. We're not big enough to be able to handle it. From our direct discussions with the department on programs, we are clearly the low-cost provider. We are looked at as a low-cost provider. Let me give you an example. We recently had multiple successful ballistic missile target launches, Kratos. I can't get into the details. It wasn't announced, but we had multiple. Our ballistic missile targets, so these represent adversaries ballistic missile targets, decoys, chaff, flares all kinds of countermeasures, et cetera. Our most expensive all-in one, I think, is $15 million a shot. I think the competing one is $100. Now the competing -- now go back to the Secretary. I'll take 85% of the capability now at a very reduced cost. So I'm making this up because I don't know what the right thing is. We can do 95% of what the $100 million one can do. So we're looked at very favorably for that. Same with our engines, same with our drones, I can go on and on. So our focus on very capable military-grade systems that are affordable, not exquisite is our sweet spot, not low cost, not exquisite, but very capable military grade that works. That's our focus.

And I would now like to turn the conference back to Eric DeMarco for closing remarks.

Great. We appreciate your time and all your questions, and we truly look forward to briefing you in a few months on the second quarter. I think we're going to have a lot more exciting things to update you on. Thank you.

And this concludes today's program. Thank you for participating. You may now disconnect.