Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference may be recorded. I would know like to turn the conference over to your host Ms. Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary. Ma'am, you may begin.

Thank you, Valerie. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Third Quarter 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 to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos corporate website at www.kratosdefense.com. It is also available on the SEC's website. Additionally, I'd like to remind our listeners that this conference call is open to the media, and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the company's website later today. During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance, and the potential impact of sequestration, federal government shutdowns and the constraints on the federal budget constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including those found in the risk factors section of our annual report on Form 10-K and our quarterly reports on Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including our annual report on Form 10-K and any of our other SEC filings for a more complete description of these risks. All forward-looking statements are qualified in their entirety by this cautionary…

Thank you, Deborah. Q3 was challenging for Kratos, and in particular KPSS, as we experienced a number of contract award delays, delays in expected starts for work already under contract and with existing customers, a number of Kratos' awards are being protested by competitors and other factors. However, in spite of these challenges, Kratos received a significant number of new contract awards in the third quarter. Our book-to-bill ratio was 1.2:1, including an $81 million award we announced today. We grew our backlog and our qualified bid pipeline increased 15% to approximately $7 billion, reflecting the increased number of opportunities we are pursuing. In Q3, KGS, which represents approximately 81% of our business, grew both revenue and EBITDA sequentially over Q2 and year-over-year, though not at the rate we had previously expected. Our KGS business has grown sequentially quarter-over-quarter throughout 2014, and we expect continued sequential growth once again for Q4 over Q3. In KPSS, our critical infrastructure security business, in July, we received a notification of the largest contract award in its history at $81 million. We should begin ramping in 2015, and we have just recently been informed that we have been selected for a new $9.5 million award and a $4 million award from 2 large mass transit authorities, and we expect to have formal contract documents completed by the end of the fourth quarter. Since the end of Q2, our critical infrastructure security business' backlog has increased, and we are currently pursuing several additional large new security system deployment opportunities in the business development pipeline. Overall, we expect -- we continue to expect Kratos' fiscal 2014 fourth quarter to be the strongest of the year, for both revenue and adjusted EBITDA, and for Kratos' second half financial performance to be higher than the first half of…

Thank you, Eric. Good afternoon. Our third quarter revenues of $217.1 million came in below our expected range, due to a number of competitor protests of contracts we had been awarded, which either resulted in a stop work order issued by the customer, a brief procurement of the award or a stop work until the protest was dismissed. On a sequential basis, revenues increased for our KGS segment from $165.7 million to $174.3 million. The sequential increase of $8.6 million or 5.2% in our KGS segment was offset by the sequential decrease of $20.8 million or 32.7% in our PSS segment from $63.6 million to $42.8 million. While we expected a sequential quarterly decline for PSS due to the sizable delivery of communications equipment of $13 million, which occurred during the second quarter, we did not expect the decline to be as significant. The PSS Q3 revenues were impacted by the delays in expected contract awards, including delays caused by competitive protest and reprocurement of an award. As a reminder, approximately 50% of our PSS revenues are typically generated by a large volume of smaller projects of $250,000 or smaller. Consequently, a good amount of PSS' quarterly revenues is booked and delivered in a given quarter. That does present challenges in forecasting revenues, especially when the larger procurement awards are delayed, which typically provide more visibility due to the associated backlog. On a year-over-year basis, revenues decreased 4.1% or $9.3 million from $226.4 million in the third quarter of 2013, with a year-over-year decrease in our PSS business of $9 million from $51.8 million to $42.8 million and a near flat year-over-year change in our KGS business, which declined slightly at $300,000 from $174.6 million to $174.3 million. Our PSS business was impacted by the delay in awards mentioned previously.…

Thank you, Deanna. With that, we'll turn it over to the moderator for any questions.

[Operator Instructions] Our first question comes from Mike Crawford of B. Riley.

Eric, there was a number of contract protests and other delays in this period. What made this period different from the similar types of protests and delays that we've seen over the past couple of years? And then the second part of that question is to what extent is Kratos itself protesting others' awards? And what are -- what is the fate, if any, of those actions?

We had planned in our forecast for Q3 and Q4 a number of new opportunities that we were bidding on, which we won. One -- I'll name a few in detail. One was a $46 million radar contract, which I believe the run rate was -- is just under $1 million a month. And we were awarded, I believe, very early in Q3, I think before we even announced Q2. It was immediately protested and it's going to run the whole -- entire 100-day GAO period. We had planned on winning and we did win. Our critical infrastructure deployment in a very large mass transit authority on the West Coast. It was protested. The protest was thrown out. I believe it was protested again, and we still haven't received formal notification on it, and the critical infrastructure work is immediate book and burn. We had been protested on a large equipment delivery order that we just recently got cleared by the GAO. In addition to that, we have a number of awards in our pipeline that we have gone through orals. We have received very good feedback, and we believe we're going to win. They will probably be protested, because some of the guys that have protested us previously, very recently, we're competing with here. And so that's given us cause up on -- caution on when to schedule them. So we had a significant ramp in our forecast, which included a number of new contract awards. The vast majority of which we won, a significant number of them were protested. That is the difference. Now to the second part of your question. We have tried not to protest historically, unless there was valid reasons to protest. It appears though, from a competitive standpoint, as I just mentioned a minute ago, if you protest and it has any type of basis at all. If you're the incumbent, you can keep the work for the 100-day run period. And if you're the loser, you protest because there are so few new programs coming, you really have nothing to lose. We have not aggressively previously done this. However, we have made the decision in the past couple of months. We are going to be much more aggressive offensively on the protest side going forward, because that's what the competitive landscape is demanding.

Okay. And then on this AFSAT test flight that you did in, I think, September, what is the scheduled pace there, as you move from development to preproduction to potential production?

I'll comment on what's publicly available on that. And there was an article that came out recently on this. We are scheduled for a number of additional test flights throughout 2015. And if we are successful on those test flights, which I believe we will be, then we are currently under contract with production options. And we will move into low rate initial production subsequent to that, and then full rate reproduction after that.

So the low rate in 2015, but not full rate?

No. Full rate production would be out. Low rate initial production, right now, it's approximately across -- the 2 options is approximately 100 aircraft, I believe, across both of them. And that would be for a couple of years then once you qualify, you satisfy the requirements in LRIP, then you go to full rate production. That's on that one program.

Okay. And then last question relates to the hiring of a bank to pursue alternatives. If the company were to consider selling the Public Safety & Security business, what are some of the attributes of that business that would interest buyers? And what comp transactions, if any, could you point to?

Right. So what would interest buyers, hypothetically, on that, hypothetically is why we're so interested in that business, is because the demand right now for critical infrastructure solutions is extremely strong. We are seeing additional competitors come in. We are seeing that. We are seeing protests now when we win. We are seeing that. But there is a very strong demand for these types of very specialized systems on strategic assets and critical infrastructure in this country. And it is clearly a growth area. And as you know, this business has been a strong growth engine for this company the past few years. It's one of the few areas in the security space, where there are significant growth opportunities from a market standpoint. That is why it is very important to us. And in my opinion, that's why it would be very important to a potential someone else who would want it.

Our next question comes from John Nelson of State of Wisconsin Investments.

Congrats on all of the awards, and my sympathies on all of the protests and the delays. The -- you had mentioned you plan on changing your strategy on the protest side. And will that result in substantial increase in legal costs that we should project for the coming year?

That's an excellent question. The answer to that is no, sir. We have put together the plan where we are going to use our internal resources. Our Senior Vice President and General Counsel will lead that with her existing staff, and that is our plan. We will be doing this virtually all -- substantially all with internal resources.

Okay. And do you think that a couple of competitors might get the message if this goes on?

No.

Or do you think it really is just a constant struggle?

I do not believe that it is going to abate, in any way, any time in the near future, and it very well may increase, as a result of competitive pressures and there are so few new large program opportunities. And for example on the defense side, if you're bidding on a multi-year radar-directed energy program and you lose, you're out for 5 years, if it's a 5-year contract, and people are being very, very aggressive. Also, John, what a dynamic that's happened, and I know you're aware of this, is because of the change in procurement philosophy under this administration, customers really don't choose contract winners anymore. Contracting offices do, behind the customer. So when you protest, you're really not ticking off the customer anymore, because it's out of his hands, especially when there are low priced technically acceptable awards, and the contracting office opens the bids, goes to the low-price, if it's barely technically acceptable, he awards it. So the protest goes that route now and so I think people are calculating that the risk of pissing off a customer and that customer remembering that later on has really abated, because of the change in procurement philosophy.

Interesting. Okay. Do you think the change in the -- with the latest series of elections, do you think that, that will bring any significant changes to your outlook or the outlook of military spending over the next year or 2?

I am -- I, obviously, don't know, but I am worried. I'm concerned, that in the near near-term, that with the Republicans now having both the House and the Senate, that they may, for a while, just present things to the President for him to veto, to build a veto record. That's -- I don't know anything. That's just -- I'm concerned about that. So it's unclear. We're going to see a lot -- we're going to know a lot come, I think, it's in December 11 or 14 when the CRA expires. Are we going to put in place another CRA? And then will that CRA go through January? Then when the new Congress sits, then will we have a budget? So I think over the next 3 or 4 months, this is going to become a lot clearer.

Okay. All right. And then on the UCAS program. The -- has that gone according to plan, as far as your progress? And is there anything additional that you can share with us about that, since that's one of your long-term strategic initiatives? One of your big ones, big, big ones.

Yes, sir. As we -- right now, everything is on track. We are tracking to the integrated master schedule that we have for the aircraft and then the integration of the various systems into the aircraft with either our sponsors or our customers' equipment toward the demonstration flights in the latter half of the late 2015. We -- very importantly, we -- our aircraft in simulation is going to be in a very important war game next month, which is -- this is very important for us. And we have received word very recently that if that goes successfully and our demo flights goes successfully, that it's possible -- probable, that in 2016, a number of our UCAS aircraft are going to be included in actuality in another very large war game. So thus far, knock on wood, things are tracking.

Okay. I haven't asked this in a while, but who are your major competitors in the target drone area?

In -- historically, it -- historically, was Northrop Grumman. And Northrop Grumman -- we/CEI, we defeated them, and that's why we are, right now, the primary target provider of the U.S. Air Force and the U.S. Navy. On the supersonic target side, supersonic, Orbital Sciences is our competitor. And then internationally, we're the big player, but we run into EADS. I think they changed their name to Airbus now and Make it [ph].

Okay. And then just one more question. On the -- for example, on these latest big wins that you had on the KPSS side, anything besides price that really swung you to the win?

Yes. On the one we announced today? It was our technological solution that won. It was very -- we're very pleased at that. It was -- we won with our technological solution on that. And actually, the one at the -- on the West Coast, at the large MTA that's been protested a couple of times, that one, by my understanding, is that also was based on our technological solution, not on price.

Our next question comes from Sheila Kahyaoglu. One moment. I apologize, our next question comes from Mark Jordan of Noble Financial.

Eric, question relative to the service gross margin drop down 300 basis points sequentially. Is that a function of both the change order, in essence, reserve that you set up? And then also, was there some amount of inefficiency due to kind of bench time relative to the delays of the receipt of the business?

Mark, this is Deanna. Most of that decline was related to the Public safety business on those change orders, where we recorded the cost and not the estimated revenue yet, until we actually receive those change orders in hand.

Okay. So then it would be -- one should assume that the profit -- the gross profit margin of service should bounce back smartly with the absence of the change order reserves and start of some of the new business finally being received?

That's correct.

The 2 lines in the reconciliation to adjusted EBITDA with the 8.9, you implied that those were fairly transitory, so that they should be back down to a much more modest level in the fourth quarter? Is that correct?

Yes.

Okay. And then, I guess, final question I have is, you have a number of contracts for unmanned targets in the foreign military sales area. And I guess, I contrast that to the aircraft and the work you're doing trying to develop a craft that will survive in contested airspace. Should we assume that those foreign military sales or export sales would ramp much more quickly because those are finished, in essence, established technical platforms, and that she should be able to -- there wouldn't be a development cycle relative to those?

Yes, sir. Exactly. Yes, sir.

Our next question comes from Sheila Kahyaoglu.

In terms of government profitability, how should we think about the R&D profile of the business, and as you ramp up on, maybe your increased sales effort for UAS?

Sheila, this is Deanna. So on the R&D efforts, we do expect that it's -- to still be at a heightened level in the fourth quarter and to probably be at that elevated level, at least for the first half of 2015, as we continue work on a number of these areas where we have seen some designed-in wins in this area, but there are additional opportunities we are working on. So we do expect that elevated R&D level to continue, at least, through the first half of '15.

Okay. And then, I guess, sticking to the profitability profile. Within Public Safety & Security, just to make sure I understand it correctly, the conversion of the cost-plus contract was about $3.2 million, and that was all within that segment, but you also didn't recognize any revenue, whether it was $10 million to $15 million for that segment. So it's not like -- the margins do snap back quite immediately. It's not like you're going to break even in Q4. You do get -- as you get the top line, you should go back to normalized load in mid-single-digit margin level?

That's correct. And the actual -- the adjustment related to the change orders is $2.2 million.

Okay. Got it. And then, in terms of the $81 million contract you announced today -- congratulations. Just, would that make -- should we think about that when modeling it out $15 million per year. So this could be -- would this be your largest PSS customer?

Yes, and yes.

Okay. So it's quite a big -- we should assume quite a big bounce in PSS for next year, in terms of the top line.

This does start to ramp with next year. Yes, it absolutely does.

And Sheila, I think the first year ramp will probably not be as large as the year is going out, because the first year ramp will be based mostly on engineering and design-type work that we will do up front. So I think you'll see a larger ramp from '15 to '16.

Our next question comes from Eric Still [ph].

Given the misguidance and the fact we're halfway through the quarter, can you -- first off, tell me how much conviction you have in hitting that fourth quarter guidance? And then secondly, give us the big drivers on the $15 million drop in the fourth quarter guidance?

Right. So the biggest drivers in the fourth quarter were a contract that we won that was protested. And that protest will not be resolved until 2015. It's a second contract that we were awarded that was protested, that was thrown out, that was protested again and we still have not received that award. The third one was a contract that was -- we won in Q2. It was protested. This is a hardened structure type of a contract that we've just received word that our award was sustained. We won. We will not be able to execute on that now until 2015, relative to Q4. That $46 million contract that was protested, that remains in protest, that was scheduled to go through Q3 and into Q4, that is impacting us there. And on -- you asked about conviction. It is possible. We have a few other new contract opportunities. We believe we're going to win, that they could be protested. And that could move things out to the right again out of Q4. It is not of the magnitude of the opportunities that we had in Q3. So if they were to get protested and the protest were to be honored and stop-work orders are issued, it could impact us. But it is, once again, it's not of the magnitude or the number of opportunities that we had in the third quarter.

So I know you're not giving 2015 guidance, this is a several-fold question. Generally, you're looking for some top-level positive and negative impacts on sales and EBITDA. And then, to dovetail off that last question, how confident are you that you're going to resolve those protest in 2015? And should we assume that, that lost $15 million in EBITDA comes back in '15?

The contracts that have been -- that we've been awarded that have been currently protested, as I mentioned, the typical GAO period is 100 days. So they should all be resolved one way or the other early in 2015. If we are hit with additional ones between now and the end of the year, they could run into depending on when we were hit with them late Q1 or early Q2. So it's hard to say, based on that.

But either way, we'll know in 100 days?

We will -- on ones that have already been protested, we will know within 100 days or less. If we were protested -- like on this one, we were protested, like, in July, late July. We should know on that one soon enough.

Okay. Got to love the litigious society we live in. Looking at PSS, if you sell it, what are you going to use the proceeds for? I mean, I know that your covenants are pretty tight, but what could you see doing with those?

We would either net down or pay down debt. We are not acquiring anyone. There are no acquisitions at all. So it will be either a net down or a pay down of the leverage.

And no shareholder-friendly stuff?

No, no. If we're successful, over the next few years, on some of these programs, that will take care of itself.

Okay. Great. And then, I'm new to your name as you know. Looking at your book-to-bill, it moved from 1 to 1.2. I'm assuming that does not mean your revenues are going to grow 20% next year, but how should we look at your top line going into next year given -- I know we've got a Republican Congress, but I don't think that we're going to make big moves on the budget. But in a static world, the government doesn't do anything positive or negative, how should we look at that book-to-bill coming through your top line?

We are -- I always like to answer all of your questions very directly, but on this one, because of the change in Congress we just had, because we're in a CRA position, and it's unclear, I would like -- I'm going to wait until we have more clarity, like I explained a few -- a little -- a few minutes ago, before we comment on next year.

Our next question comes from Michael Ciarmoli of KeyBanc Capital.

Eric, just most of mine have been answered. Just one, for clarity purposes. You guys had a number of the unmanned award or contract opportunities that you laid out last quarter. It think they came close to $120 million. Can you give us a sense of how much of those revenues or those contracts you can expect to expect to flow through the top line next year? Just for modeling purposes, can you kind of give us a sense of where we are? How we should be thinking about that?

Yes. So on the $75 million opportunity that we have negotiated, and I believe we are going to receive that formal contract award this month, that's what we've been told by the customer, that will be approximately $25 million or $30 million next year, $25 million or $30 million the following year and then the balance, the year after that. On the $30 million international, it's just under $30 million one, if we get that one early in the year, we will substantially execute that in 2015. Substantially. If we get it in the second quarter, maybe it's 2/3 or 3/4, and then the balance in the next year. We did receive the -- from a separate U.S. government agency, an order for 20 aircraft. I would model in '15, approximately $6 million or $7 million for that in '15.

I'm showing no further questions at this time. I'd like to turn the conference back over to Mr. Eric DeMarco for any closing remarks.