Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Fourth Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we will host a question-and-answer session, and our instructions will follow at that time. [Operator Instructions] As a reminder, this conference maybe recorded. It is now my pleasure to hand the conference over to Ms. Marie Mendoza, Vice President and General Counsel. Ma'am, the floor is yours?

Thank you. Good afternoon everyone. And thank you for joining us for the Kratos Defense & Security Solutions fourth quarter 2016 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.

Great. Thank you, Marie. Kratos' fourth quarter and full year 2016 came in stronger than expected with the company significantly exceeding both our revenue and our EBITDA estimates. Deanna will be providing all of the details regarding our fourth quarter and full year 2016 financial results in her prepared remarks. The macro U.S. defense and national security environment continues to improve and in particular as related to Kratos' in the satellite communications, cybersecurity and unmanned systems areas, which was a key factor for Kratos' return to growth in 2016 and for our expected continued growth trajectory in 2017. Kratos' largest business unit satellite communication, cyber, technology and training which generated $257 million in revenue in 2016 had a particularly strong year with year-over-year growth of over 10% significantly beating virtually all of our forecasted financial targets including having full year and fourth quarter 2016 book-to-bill ratios of 1.2 and 1.2 respectively positioning this business for even better 2017. Thus far in 2017, Kratos' satellite communications business has received a number of new contract awards totaling in the tens of millions of dollars including in the classified arena and awards we have not formally reported, which is providing us additional confidence that 2017 will be very strong for this business. Also very importantly Kratos' owned and operated satellite signal monitoring and interference detection and location business generated important traction in 2016 with new customer contract awards and we are currently forecasting in excess of 30% growth in 2017 over 2016 revenues for this high margin specialized business. Our signal monitoring interference, detection and location business, which we believe we are the only company that has this capability where we have significant Kratos-owned assets and infrastructure and sites across the globe and where we are monitoring literally dozens of satellite beams for…

Thank you, Eric. Good afternoon. Kratos' fourth quarter 2016 revenues of $182.1 million exceeded our expectations of $178.4 million with the year-over-year consolidated organic revenue growth of 2.6% driven primarily in our unmanned systems business which was up 59.6%, satellite communications, technology and training businesses which was up 5.9%, and in our Defense and Rocket Support Services businesses which was up 26.3%. Our Q4 adjusted EBITDA of $13.4 million also exceeded our expectations of $11.4 million due to a favorable mix of higher margin work in our satellite communications, technology, training and cyber-related businesses offset partially by unexpected increased contract cost growth of approximately $3.4 million on certain of our large legacy critical infrastructure projects in our public safety business, which are nearing completion in the first half of 2017. Once these projects are complete which is expected to occur in 2017, we will only have one remaining large critical infrastructure project which is expected to be in the build out phase for another five or so years out. If we would not have incurred to increased cost on the soon to be completed projects in our PSS business, our fourth quarter 2016 adjusted EBITDA would have been $16.8 million. Accordingly, we believe that we are making excellent progress towards our stated target business case for annual revenues of $800 million and annual adjusted EBITDA of $80 million. Our adjusted EBITDA for the fourth quarter is from continuing operations and excludes the following charges which have been reflected as adjustment consistent with our prior presentations since we either believe the items are non-operational, non-recurring in nature or meaningful for investors to understand our financial performance. Restructuring related items and other of $1.5 million, which reflects a $1.4 million non-cash write-down impairment charge of one of the facilities we shutdown in…

Thank you, Deanna. Focus has been the unmanned drone inside Kratos for a while now. So in closing, I want to give you an idea of how our focus has evolved, it's increasing and what it means for our assets, employees and shareholders. For those of you that have a long history with our company you will know that through the middle of 2012, we acquired a number of companies. This strategy held until the 2011 budget control act and sequestration impacting the 2012 defense budget, which marked the beginning of billions of dollars taken out of the defense spending between 2011 and 2016. As the old saying goes, pressure makes diamonds, in this very difficult period caused us to take a heavy look at our overall business and required us to define a company that could survive and thrive in such an environment. With our resulting new strategy, we wanted to create a business that makes our employees happy, provides them opportunity, and gives them a will to win as well as create a growth profile that has financial metrics that make our shareholders happy. The strategy change let us to the high performance unmanned drone market for contested environments where we saw an open market opportunity and where our natural strength and target drones, satellite communications and electronics can truly differentiate Kratos and provide a significant competitive advantage. Viewing the company through this lens, we began the process of identifying assets that did not match this focus or de-emphasis. As we wanted to ensure that we have a laser focus on those areas, we believe we can win at and that we could have the most meaningful impact to our company. Our program wins last year in the high performance unmanned aerial drone space and our book-to-bill ratio of 1.2 to 1 in our satellite communication area or evidence of wins. The corporate assessment process continues and we are reviewing ways to increase focus even more and win. Luck or not, the headwind that was defense spending is now becoming a tailwind and we believe that we have a product set that matches where NextGen defense spending is going. This turnaround of our company is a result of the dedicated effort of our employees and I want to personally thank them for that. We'll now turn it over to the moderator for questions.

Thank you, sir. [Operator Instructions] Our first question will come from the line of Mike Crawford with B. Riley & Company. Please proceed.

Thanks, Eric. Relative to your UTAP-22 opportunity, can you talk about first the status of the DIUx and the SCO under the new administration and then separately maybe frame how Kratos can handle increasing production volumes in its unmanned systems business given the $150 million or so of revenues over the next few years that layers in from the SSAT and the related confidence of program given that you might have UTAP, LCASD and Gremlin's vehicles being built as well. Thank you.

Absolutely, Mike on the DIUx in Secretary of Defense Mattis' confirmation hearings, he was specifically asked if he supported the DIUx and he crisply stated that he absolutely did and he has made additional comments since then. I personally speak routinely with the head of the DIUx and the SCO and they are both fully supportive of innovation in a particular what we are doing with the UTAP-22. On your comment on growth, right now we believe that our current facilities in Sacramento can handle the volumes we foresee through 2018, 2019 that's what we currently see. We have already moved out and this will most likely be in states other than California to identify new state-of-the-art production facilities that are going to be heavy and robotics in additive manufacturing techniques for the manufacturer of all of our tactical aircraft. So that process has already begun and I believe we have narrowed it down to two potential sites already and over the course of this year we'll be making the major decision on those.

Okay. Thank you. And then final question, relative to your satellite command and control business here, you have some recurring revenue business that's growing in Colorado, but you mentioned MOUS, WGS, AEHF constellations, but are you also monitoring military traffic over commercial networks as well with that unit.

Absolutely, absolutely.

That you're saying is growing 30% from one base?

I'm not going to get into the details on that, Mike, but it's not insignificant.

Okay. And thank you. And then just a final question as you kind of said in two ways during your prepared remarks, once you said you're considering other certain steps to extract value and then you also said your corporate assessment process continues. So I take that to be referring to non-core business and possible divesture there. Is there any unit that you might look to divest first or can you comment any further on that regard? Thanks.

In 2017, we are going to very specifically take steps or attempt to take steps to refine and increase our focus in our core business areas for this company.

Okay. Thank you.

Yes, sure.

Thank you. Our next question will come from the line of Ken Herbert with Canaccord. Please proceed.

Hi, good afternoon, Eric and Deanna.

Good afternoon, Ken.

I just wanted to first ask the incremental investment you said you made in the SATCOM product offering, can you just provide anymore I know you went through this in some detail, but any more detail on maybe this specific opportunity that addresses and maybe what your view was perhaps some of the revenue opportunities from the new investment or I guess the new product or service push there?

This company and the technology and its products are focused on VSAT and the tens of thousands of VSATs that are deployed and that are continuing to be deployed. And they have technology and capability that we believe no other commercial company has to be able to very quickly and precisely identify issues with traffic into VSAT networks and on specific VSAT themselves. So this is a very sophisticated signal monitoring type of technology, it's on the border of signal intelligence technology and we haven't announced it formally yet, but with them in the past couple of months we have won a multimillion dollar opportunity already over $10 million and we are pursuing several other ones. So this little tuck-in technology acquisition we did, this is going to be a grand slam for this company in 2017 and beyond.

Okay. That's helpful. It sounds like it really helps to round out the portfolio to an extent and very complementary to the existing businesses?

Yes, it is absolutely complementary, it is a tuck-in of a technology that fits hand and glove with what we have and our guys are very, very excited about it. I believe if we go to our Web site, you can -- there is some additional information on the company, the name of the company et cetera at right now.

Okay, great. Thank you very much. And then, if I could it sounds like obviously we're waiting for the 2017 budget clearly seem to be some incremental upside relative to expectations from what the President announced today in his intentions. Can you just Eric walk through assuming we get these kind of numbers of the $54 million they talked about and obviously Congress will have to work on that? But where aside from AFSAT and maybe some of the obvious ones, where else could we expect to see maybe some of the most near-term impact assuming we get a much more significant step-up in fiscal 2017 and I think a lot of us had been expecting.

Right. So Ken, let me answer your question this way. First of all, I believe that even if there is not though I do believe there will be. Even if there is not a significant increase in the defense budget, there is a significant shift going on within the defense budget to strategic systems. Our country basically has been at war fighting terrorism since the first Gulf War of 1991. And there has not been a capitalization or recapitalization of strategic systems for the last 25 years. In fact, I believe the F-35 contract was awarded on October 26, 1991. And certain peer and near peer adversaries have caught up particularly in the space area, the electromagnetic spectrum and somewhere is in the unmanned systems area. So I believe there is a significant shift going on. We're seeing that now we saw it in 2016. We're seeing at 2017 particularly in our satellite communication area and in our unmanned area where funding is increasing. Now, on top of that as you just pointed out, the President came up today and he says he is looking to significantly increase the defense budget. I don't know how much it will go up. But my tummy tells me defense budgets are going to rise. And in my opinion they are going to rise in some of the areas we're in, satellite communication, unmanned systems, and microwave electronics. And relative to our targets business, you'll hear about readiness and improving readiness. I mentioned in my prepared remarks that our largest drone customer just in the past, came to us and they said 2017 buy, we're going to significantly increase it and they are looking to increase the quantities for the 2018, 2019 and 2020 buys that's our understanding. I personally believe that ties right into increased readiness, operational tempo that's the sweet spot of our business where -- which one of the larger parts of our company. So we're feeling real good about it right now.

Okay. That's very helpful. And then just finally, we get the free cash flow guidance for this year and the investments you're making, I know obviously it depends on the pipeline and your success rate, but is it fair to think right now what the visibility you have that this is probably the peak year -- fiscal '17 is peak year in terms of cash -- free cash flow usage and we should see an improvement in the 2018 and beyond or how do we think about moving out of 2017 in the free cash flow.

Yes. It's absolutely, Ken. As I said in my prepared remarks the forecasted use of cash flow is both to fund the near-term growth, top line growth of $31 million to $51 million to the range of our guidance of $700 million to $720 million, but more importantly it's to fund LCASD investment and other initiatives within the unmanned systems areas, which is comprising about $28 million to $33 million of that cash flow usage. So we do expect that to decrease significantly going into 2018 as the first flight is scheduled for LCASD in the beginning of 2018 in the May timeframe. So we would expect the significant amount of that investment to be behind us by the time we move into 2018.

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

Okay. Thank you, Ken.

Thank you. Our next question will come from the line of Mark Jordan with Noble Financial. Please proceed.

Good afternoon, everyone. Eric, I'd like to talk a little bit about how funds might flow on the SSAT program, as you stated I think in multiple conferences over the last couple of months, but you saw first year funding on that program of $40 million to $45 million and second year funding in the $55 million range. If we are to get a budget here in end of April or early May and you received your first year funding by midyear, how much would you be able to realize the revenue of that first year $45 million of funding, $40 million to $45 million of funding. And if you said only could realize a portion of that? Would that carryover into 2018 and the addictive to the year, to funding so 2018 will be a major step up because we have part of 2017 fundings and then the full year funding for 2018.

Yes, sir. So Mark, I met with our customer last week and so I have first-hand real-time information on this. The customer is ready to go and is ready to initiate at lower end initial production one. If let's say by April 28th, the end of the continual resolution, we have a budget or we have a funding vehicle that allows new contract starts which we're hearing the best what's going to happen. We envision within 30 to 45 days we will be under contract to begun production. We have already placed orders for the most material long lead items, those marked primarily are the engines and the electronics and the avionics. And then, thirdly is the composite material. So we're getting all of that locked and loaded. So if we're under contract by the end of June, we're looking at somewhere between $17 million to $20 million in revenue incremental in the second half of the year. And then, exactly as you indicated the remaining piece, let's say its 20 to make the math easy for me, the remaining piece of $20 million to $25 million would then though in the calendar 2018, but then in calendar 2018 we expect to be under LRIP2 which right now they're talking about 45 aircraft or so. And so LRIP2 would be overlaid on top of half of LRIP1 and so the beginning of 2018 and then into the second half of 2018 would be another significant step function of growth on that. So that's how that's laying out right now.

Thank you. That's clear. And want to assume that the one class fight program that's running in parallel to the SSAT would have a similar topography?

Yes, it's -- envision maybe is -- on that confidential program maybe it starts 60 days later for certain reasons, but the similar topography.

Okay. You mentioned that [didn't] [ph] propose a pipeline of $5.7 billion, two questions related to that, when do you expect those bids to be out on the street and the second question, I think more importantly for me is, on that $5.7 billion, what percentage is for programs where you currently are -- you're active in that you are -- for example that would be the follow-on's of programs that you're currently control.

Okay. So for example to the last second part of your question, in that pipeline would be AFSAT years -- production years 2014, 2015 and 2016 with the U.S. Air Force that is where we are so sourced because we own the design package on the airplane. As I indicated in my prepared remarks, we're going to be -- for getting negotiations with the air force this year and we expect by the end of this year we will be awarded those three production years and so there is very, very good clarity there. Similarly in that pipeline is what we're pursuing for SSAT with the navy and so there would be two years on somewhere up near $100 million of revenue that we have very good clarity on. This is very similar in our satellite communication area and our satellite communication area, this is the crown jewel of our company and these are the best guys from the company right there. Now, they are executing incredibly. They have this all mapped out by program, by customer set, most of these were designed in; we have relationships with the customers. And as I indicated their book-to-bill was 1.2 for the year end and Q4. So they are pretty much bolted in as well. And then, our microwave electronics business literally Mark they're $50 million to $60 million of revenue for 2017 is in backlog, a 100% in backlog. We win additional programs, when they go into production; we're going to get an upside. On your proposal submitted, $1.3 billion of that pipeline has been submitted, okay? And I want to mention one other thing relative to your question, we are assessing, pursuing a new tactical opportunity in our unmanned systems division which is right in our sweet spot, it is not in our pipeline, it's a multi several $100 million opportunity, it's a billion dollar plus opportunity, RFPs are expected out later this year and contract award is expected later this year and I think we're going to go forward and that's not in our pipeline.

Okay. A question, there is an RFP out from the army for replacement for the Streaker, is there any update to that and could that be potential 2017 incremental revenue that's not in your model?

We are absolutely looking at that and depending on how the cards fall and timing; it absolutely could be a significant upper.

Okay. A final question for me, now that you're into the LCASD program a little bit, do you have any clarity with regards to potential spirals that might be realized in 2017?

Yes, yes, sir. We have very, very good clarity on the spirals; our customers are very sensitive on these. So I just not going to get into it here, but crisply said yes we do.

Okay. And is that in your current budget?

No sir.

Okay. Thank you very much.

Thank you, sir.

Thank you. Our next question will come from the line of Michael Ciarmoli with SunTrust. Please proceed.

Hi, good afternoon guys. Thanks for taking my question. Eric, just looking at the budget environment, obviously there is a laundry list of positives out there even what Ken was alluding to. But what are the potential obstacles or road blocks in the near-term. I mean sounds like we could get a CR that might be referred to full year, but we're allowing new start to maybe some growth, that's some upside. But we potentially move into maybe a government shutdown discussion, I'm sure, there its going be bickering back and forth in DCM, just trying to get a sense of any sort of risk to your guidance. Certainly it sounds like there is much more upside, but is there a downside scenario, you see for this year. I mean you're guiding to 6% top line growth and I think you said depending on the timing of a deal, there could be upside, but what sort of the other side of that coin that you could see as an obstacle?

We try to be very, very conservative when we put out our guidance. And very candidly the reason we did not take our guidance up today is because of not knowing precisely when the 2017 funding will be taken care off. Michael exactly as you said, we are hearing that 2017 maybe a full year of continuing resolution, it maybe a full year continuing resolution up 5%, so up $30 billion or $40 million that would allow new starts, okay? Everything we're hearing is that new starts are going to be allowed because it would be so negatively impactful to national security. However, to your question, the downside to the model would be if there is a full year continuing resolution in 2017 and there were no new starts awarded and so those two programs don't get going forward, okay?. I believe based on the way we model this, we still hit our target, we still hit the range, that's how confident we are in the business plan right now. We'll still hit the annual guidance we've got out there even if those don't happen.

Got it, okay. That's helpful. And then you're talking about that target model again $800 million of revenue, $80 million of EBITDA, but can you elaborate, I think you mentioned I may have missed it, what would be addictive to that model and would you specify sort of the potential upside to the longer term model?

Yes, absolutely. So the biggest one that we see right now is LCASD. That's a single award contract. Publicly Michael, there have been two high performance jet unmanned combat aircraft procurements in the normal solicitation way, LCASD and Gremlin. Kratos is on both of them. And there is nothing else out there, there is nothing else inside. And so if you take a look at who you believe is going to be the loyal wingman aircraft that's going to a company our fourth and fifth generation manned fighters, it's LCASD.

Okay.

And that plane as Deanna said is going to fly in Q2 of 2018. As I said in my remarks the potential customers and users are lining up already and we are having discussions with them which ties into the spiral question Mr. Crawford asked. And I have continued to see the DoD establishment put out, make public statement as what reiterating the quantities, hundred, several hundreds, thousands of these planes add $2 million to $3 million a plane.

Got it, okay. That's helpful. Last one from me, obviously there is a lot of opportunities you guys are spending a lot of money, you mentioned kind of looking at the strategy, obviously potential divestitures, how are you thinking about your overall cap structure you've got a significant amount of investment thinking about leverage, do you have a target leverage model with or target leverage ratio with that long-term model?

Until we win into this investment mode in the unmanned area and very candidly also in the satellite communication area where we've significantly ramped up our IR&D, which is paying off in space, look at the growth rate that team is generating. We believe with the growth projections we have and what we see might be up some months here or there, but 2017, 2018, 2019, this business is going to grow significantly. No question about it, it's going to grow significantly. Deanne and mine's historical targets have always been in the three to four times level area for a defense company and a big backlogs, big pipeline, that's our target, no pun intended.

Got it. Okay, very good. Thanks a lot guys.

Yes.

Thanks.

Thank you. Our next question will come from Sheila Kahyaoglu with Jefferies. Please proceed.

Hi, good evening guys, Deanna. Eric, you could give us any detail for 2016 in terms of the government solutions business and sort of what each of the pieces contributed whether its microwave electronics modular system or just the full year growth rate if you could?

Absolutely, so in my -- Sheila in my prepared remarks for government solutions I talked about are satellite, cyber and training business was approximately $255 million, $260 million in revenue, our microwave electronics business is $50 million to $55 million in revenue and our government services business and our ballistic missile targets business you may have seen we had a very successful ballistic missile target launch an intercept a couple weeks ago is right around $95 million to $100 million, those are the pieces.

Understood. Thank you. And in terms of the acquisition you did, could you just disclose what the potential revenue contribution could be in 2017?

We are not disclosing that quite yet. We very well may going forward because some of the bids that were going off to a very, very large and they would demand that, but right now since it was just the small technology by, we're not -- we just folded it in.

Okay, understood. And then, just so I'm clear on this, Deanne, would it be possible for you to repeat the free cash flow guidance for the year and in terms of thinking about it for 2018 would be sort of assume the CapEx tabs and how the investment goes away, if you could just maybe go over that one?

Sure, Sheila. The estimated CapEx is $28 million to $33 million, of which $18 million to $23 million is related to unmanned system. Then there is also is included in operating cash flows. There is an estimated investment of $7 million to $10 million part of the LCASD platforms. So that's the non-capital investment related to LCASD if we recall we took a loss accrual of about $18.6 million to $18.8 million in Q3. So that's the cash spend of that for 2017. So the total free cash flow estimate for 2017 is a use of $26 million to $31 million, which includes the estimated cash interest of $30.5 million, cash taxes of $3 million to $4 million and then the CapEx of $28 million to $33 million.

And Sheila, we are building a number of aircraft, UTAP-22 is right now for the big exercise in the second half of this year that will drop off in Q3 assuming that flight schedule holds. So that part of the CapEx will drop-off it is not expected to be repeated. And as Deanna said the LCASD will be flying that in May, with that CapEx is not expected to be repeated and so there will be a significant reduction in CapEx and a significant increase in cash flow as those investments drop-off and obviously we're making those investments because we're going after some big opportunity.

Sure. And then in terms of the second half ramp in unmanned systems, is that mostly SSAT or are there other revenue contributor in that?

So the biggie is SSAT, okay? That's number one. Number two we were awarded that large foreign international contract in Q4 that one is ramping. As I mentioned, I think in the next 60, 90 days we're going to awarded another multimillion -- tens of millions of dollars new customer, new international one that is going to ramp in the second half. I mentioned an existing customer we have that is flying one of our airplanes they are very interested in the separate line of our air planes, I think we are going to get that order in the next 60 to 90 days that is going to significantly ramp. And then, very importantly, Deanna talked about our unmanned system division in the second half of 2016 and in Q4 was very, very strong because we delivered a number of air force aircraft, okay. I just mentioned or get and going on production like 2013 now which has increased quantities. We will start delivering those and building those out in the second half of the year. So we are going to have a dip in the first half, but in the second half its going to ramp significantly for AFSAT and the 167 including the additional target drones that customers indicated they want.

Perfect. That makes sense. Thank you very much.

You got it.

Thank you.

Thank you. Ladies and gentlemen, this is all the time we have for questions today. So, now at this time, I would like to hand the call back over to Mr. Eric DeMarco, President and Chief Executive Officer for closing comments and remarks. Sir?

Excellent. Thank you very much for joining us. And we truly look forward to speaking to you again on a couple of months when we report the first quarter. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect. Everybody have a wonderful day.