Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions First Quarter 2017 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 is being recorded for replay purposes. 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 first quarter 2017 conference call. With me today is Eric DeMarco, Kratos’ President and Chief Executive Officer; and Deanna Lund, Kratos’ Executive Vice President and Chief Financial Officer. Before we begin the substance of today’s call, I’d like everyone to please take note of the Safe Harbor paragraph that is included at the end of today’s press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today’s call. Today’s call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today’s press release, we have provided a reconciliation of these non-GAAP financial measures to the company’s financial results prepared in accordance with GAAP. With that, I will now turn the call over to Eric DeMarco.

Thank you, Marie. Kratos’ began 2017, right where we left off at the end of 2016, with strong financial performance. Deanna will speak to Kratos’ first quarter financial results in her prepared remarks. In Q1, Kratos’ satellite communications, cyber security, technology and training division, once again was the operational, financial and execution performance jewel of the company, which we expect to continue throughout 2017. This division which is Kratos’ largest had a book-to-bill ratio of 1.2 to 1.0 for fiscal 2016 and we are beginning to see the financial results from these very solid bookings, which have continued thus far into 2017. The DoD continues to expend considerable resources into securing and managing its terrestrial digital infrastructure of interconnected systems and the related challenge of securely connecting its space-based networks. The DoD and the Air Force in particular are under pressure from Congress to prepare for a potential war in space which is now being militarized by Russia and China. These are just some of the challenges and threats facing U.S. space-based assets and infrastructure which national focus and prioritization is currently providing a tailwind to Kratos’ satellite communications business. Directly related to this demand as related to satellite assured communications, Kratos’ owned and operated global satellite beam monitoring business, which we believe is the only commercially owned global system of its kind, continues a strong growth trajectory with approximate 61% growth in Q1 2017 revenues over Q1 2016, from both existing and new customers. Major satellite programs Kratos’ supports include wideband global, advanced extreme high frequency and space-based infrared among numerous others. Kratos’ customers include virtually every national security related and commercial satellite operator in the industry with Kratos’ satellite communication businesses products and solutions supporting approximately 85% of the satellites in the world space segment. Kratos’ training system…

Thank you, Eric. Good afternoon. Kratos’ first quarter 2017 revenues of $167.8 million were at the high end of our expectations of $158 million to $168 million for the quarter. Year-over-year consolidated organic revenue growth of 9.7% was driven primarily by our satellite communications, technology and training businesses, which were up 15.6% as a result of recent contract awards in these areas. Growth of 9.9% in our unmanned systems business, which also is driven by recent contract awards, and 21.9% in our public safety and security business driven by security system and related communication equipment, integration under a security system deployment program for a mass transportation authority. Our Q1 adjusted EBITDA of $10.6 million exceeded our forecast of $6 million to $8 million due to stronger than expected performance across each of our business units within our Kratos Government Solutions or KGS business segment, with a favorable mix of higher margin work in our satellite communications, technology, training and cyber related businesses and new awards in our modular systems business. Our adjusted EBITDA for the first 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 $1.2 million, which includes $700,000 of related severance and terminated employee related costs; also excluded from our adjusted EBITDA is $500,000 representing excess overhead capacity in our Unmanned Systems division. As production is expected to ramp up when we enter into low rate initial production on SSAT and the confidential program later this year, we expect the excess overhead capacity to decrease. On a GAAP basis, net loss for the first quarter was $10 million, which included…

Thank you, Deanna. We will now turn it over to the moderator for questions.

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

Thank you. Somewhat quick ones on the Unmanned Systems and then one on the budget. First, you talked about a 2.3 to 1.0 book-to-bill in Unmanned Systems segment, so that implies about $36 million of bookings in the quarter. Can you break that out in any matter?

The biggest part of that Mike was Option 13 on AFSAT with the Air Force. And then there was the $5.6 million one with the government agency we are unable to disclose at this time, and then there was the $1.6 million one on the brand new – it’s a brand new airplane and we’ve got the initial contract for the aspects I mentioned. Those were the primary pieces.

Okay. Thank you, Eric. Is that very new airplane or the same one that you call the world-class secret special programs group developed?

No, no.

No? That’s different?

Yes, this one is brand new. The other one is flying.

Okay. So that was my second question was going to be on the secret one. You’re also saying that your investments in proprietary combat systems will be substantially done in 2017, and that includes this aircraft as well?

Absolutely.

And that’s in conjunction with some kind of formal RFP or is that outside of a program or record or how is that being done?

I’m not going to get into it.

Okay. And then last one is on spirals outcast, potentially 20 million spirals.

Yes, we’ve received two to-date.

Okay, that’s great. Then finally, in your 10-Q, very up to date language on the budget including the fact that the past passed budget bill, the Senate today approved the bill is required to be signed by the President today that you say you’re going to be, prudent on guidance until the budgets in place. So if we get a budget tomorrow does that mean that we would see different guidance or you intend to wait three more months until you change guidance?

No. As I’ve said, Mike, we will – if President signs it, our plan is to post a system is to communicate with our customers on how quickly these options that we have, on the contract that we have will be exercised. Once they’re exorcised what the production schedule under those options will look like and most importantly what the delivery schedule will look like. We’ve got – we’re going to have a lot of wood to chop because obviously we have a six-month CRA between now and the end of our calendar year and we just want to make sure that we understand all those parameters and what work we can get done between contract execution in the end of 2017.

Okay, thank you very much.

Yes, sir.

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

Hi. Good morning, Eric or good evening, Eric and Deanna.

Good morning.

Good morning.

Say, I just wanted to first – LCASD, I know obviously you’re on track for the test flight, I think you said second to third quarter or mid next year. Can you just provide an update on how that schedule is going and have there been any changes either positive or negative to the schedule in the last three months?

There have been no changes positive or negative to the schedule. However, in the last three months, as I mentioned in the prepared remarks, we had a program review very detailed multiple days with the customer, and it went very, very, very, very well. And we are more excited than we’ve been since we were awarded this contract on what the potential will be for this aircraft once we demonstrate it and get it flying.

Okay. And at the risk of getting too far ahead of ourselves on this one, assuming a positive flight tests next year, what might be the next steps or what should we look for in terms of next steps or major milestones on that particular program?

Ken, I’m going to agree with you, and I’m not going to get too far ahead of myself on this one; God willing, it’s tracking, we are on track and things are looking good. And as we get closer I’ll talk about that, but it’s too soon.

Okay, I can appreciate that. But let me try again similar question but on UTAP-22 and the Mako program. Obviously, you’ve got a major exercise coming up here, sounds like later on this calendar year. Assuming that goes well, what might be the outcome we should expect either in terms of milestones or sort of the next hurdles or gates on that particular program that would move through?

The DIUx’s charter is within 24 months of contract award to begin fielding units that have been successfully demonstrated to the field. We received this contract award at September 30, 2016. I am extremely comfortable that we are tracking to the DIUx’s strategy and their charter. And I – once we are successfully demonstrate what we’re going to be doing with the sensors at this exercise, the next steps are either going to be another exercise that’s already being looked at with the potential that maybe we will – we can we sell some airplanes.

Okay, okay.

I don’t want to get ahead of them. I don’t want to get ahead of us or Raj Shah at the DIUx.

Yes. Okay. No, that’s fair enough. And then just finally you obviously had a really nice – assets came through. It sounds like SSAT is on track. Is SSAT that’s really about getting the fiscal 2017 budget in place and obviously coming out from under the CR? And when should we look for the next major milestone on the SSAT program?

So I met with the Admiral very, very recently. And the plan is within 60 days to 75 days after we have a budget that our contract option is exercised. And we have already ordered long leads. We’ve gone ahead on this. We’ve ordered the engine; we’ve ordered a significant amount of composites. I believe we’ve also ordered some of the avionics and electronics. So we’ve primed the pump, we’ve got it ready. And so the next data points will be is exercise the contract, the option, and begin production. And as I mentioned, I believe that’s going to happen within 75 days.

Okay, that’s great. And just finally really nice to see the step-up obviously in the free cash guidance for 2017. I know you’ve said several times that the vast majority of the investment is to support the growth, largely are done – it sounds like this year. Is there any risk either if with any of these new programs that where the schedules could change that you could see some of this investment spill into 2018 or we could see any sort of incremental investments in 2018 or is it really leaves with what you’ve identified now that you’re pretty well scoped for completing most of that investment if not all in 2017?

Okay. So as we sit here today, I do not see any additional incremental investments at all. We’re funded now on every program except on the cost share on LCASD for the data rights. As Deanna said, we expect to be substantially complete with that by the end of 2017, yet it is possible that some of that could go into Q1 of 2018, that’s possible. But as of right now I do not see that being material if it were to happen. And so back to what we said in our prepared remarks, we don’t envision any material if at all, discretionary investments in 2018. And we envision getting back to every business unit will be cash flow positive, they all are now obviously, except unmanned. And we expect significant cash flow generation from unmanned in 2018 from delivery of AFSATs, from delivery of a certain customer we’re delivering on that I haven’t been able to disclose yet, delivering SSATs to the Navy and delivering to the confidential.

Excellent. Nice quarter and thank you very much.

Yes, sir.

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

Good evening. It’s actually Les in for Mike.

Hi, Les.

Hi. On the public safety, can you talk about some of the growth drivers and sustainability in that segment? And also why that the drag on margins, essentially gives us a little more color of what’s happening here.

Yes. So let’s talk about the growth drivers first because I like to talk about those. The number of security deployment opportunities continues to increase; and the verticals that it’s increasing for us are energy. So I think pipelines and refineries, education, schools, from grade school up to colleges are deploying significant amounts of security systems on their campuses right now. Healthcare, healthcare is ripen right now for us; and certain metro transportation, think of buses and trains. Those are the growth drivers right now where we have been booking for the past 15 months as I mentioned the work over 30%. The margin drag that we’ve had that is coming off is we are finishing up four very large security system deployments, underground for the most part for a massive mass transit authority. And we are going to have – I believe we’re getting two of them done in Q2 and the other two are done in Q3 and then we’re done tied with those are several millions of dollars of receivables, we’re going to collect the retentions to wrap them up. And so we’ve taken some reserves on these as we finish these up to make sure that we bring these in this year without any more losses or I should say margin degradation, is probably the better way to say it. So that has been the drag and that’s why we’re so confident that the margins there are going to be turning around because as those low or no margin deployments finish, they are being replaced by very high margin deployments that we’ve been booking for the past 15 months.

Got it, thank you on that color. A little bit further on the budget I guess, is there quantifiable upside risk to your guidance regarding to the budget passing assets? And also any thoughts on the $15 billion shortfall from the initial proposal?

Right. There is absolute upside to us for budget getting signed, whether the budget was equal to last year’s budget or where it is this year, including the $18 billion supplemental and the total budget obviously being $598 billion including BOCL. There is potential upside to us. If the budget was not signed, as you know, we have two programs that we’re dependent on that that happening. So that’s why we’re being cautious here. I know as you mentioned the Senate signed it today, is going to the President. I just hope the President signs it tomorrow or the next day and we’re off and running.

Great. Thank you, guys.

You got it.

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

Good afternoon. [indiscernible] what percent of that $30 million to $40 million which you expect in the first release could be realized as revenues this year? And secondly, what is the 2018 expectation from production on that one?

Right. And so Mark, right now we’re envisioning say $15 million to $16 million, $15 million to $18 million in this year. But this is why we’re being cautious on not taking guidance up at this time, because we want to make sure that we get the contract, we understand it all, because we’ve been at holding pattern under the CRA because as you know no new contract starts. So let’s say it’s a – thus we make round numbers easy. Whereas let’s say it’s $15 million, let’s say the number is $35 million, that means that $20 million would move over into 2018. Right now the fiscal 2018 by is looking like that number all in could be $50 million to $55 million. Part of that; the moment assuming we have a budget – 2018 budget, let’s say in January or February of 2018. The majority of that would fall in 2018 along with the $20 million of 2017’s that we didn’t generate in 2017. And then we would head into full rate production in 2019.

All right. [indiscernible] extended CR next year since you already have been initiated this year, you allowed to continue at fiscal 2017 rate?

Absolutely. Yes, sir. Yes, absolutely.

Okay. Second question relative to Lot 13, you’re talking about op tempo. Could you quantify what the 13 level versus what you saw in the prior couple of years and what are the implications for 14, 15 and 16?

Right. So the past few years the quantity has been $20 million to $21 million per year. It went to $25 million this year. And I don’t want to get ahead of the customer, but for 2018 and 2019 they’re looking at quite a bit more than $25 million.

Okay. Question on the microwave business, given the programs that are starting and you’re talking about step function. Does this business which was $55 million last year, could that be like in 2018 run rate that could be doubled what you did in 2016?

No, no, no, because these would be ramps. It has productions and then deliveries and the vast majority of what we do want in our microwave electronics business Mark we book on deliveries not on percent complete. And so I don’t want to give 2018 guidance right now, but our full anticipation as we head to the end of this year and we’re turned on on these and we have the build plans and most importantly the delivery plans we’re definitely going to – we’re going to signal that, and then obviously we’ll in-cooperate that. But I don’t want to get ahead, but if you are the numbers, $35,000 per Barak-8, we’ve got 600. $200,000 to $250,000 per Gripen, there’s 100 under order right now. You saw last week Belgium has said they’re going to go with the Gripen, they’ve said that. They’ve been – the Gripen has been down selected in India, it’s down to two planes, it’s the Gripen and the M16. The initial quantity is 200 Gripens there. So we are – and we’re designed in sole source. So we’re feeling pretty good about this program near- and mid-term.

Okay. Final question, Deanna, should efficient quarters’ share base be about 86.5 million shares?

Yes, that’s correct.

Thank you. And I apologize for my voice.

No problem, Mark. Thank you.

Hope you feel better.

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

Eric, you’re making me looking smart. That’s hard work. If you guys [indiscernible] on the quarter, man, it’s very solid all across the board. I want to dovetail on some of the questions on PSS. You guys obviously didn’t want a job fixing it, you refined it, you focused it and we’re seeing the results and awesome work with your whole team. As you look at this because we’ve you’ve had different feelings on this, is this a fixating keep and is this fixated itself?

We are going to this year increase and refine our focus on our core businesses, which is unmanned systems, satellite communications, microwave, electronics. And I got to tell you training, Eric, it’s ripen. it’s just ripen. And this has to do with readiness and the money that’s pouring into readiness. I don’t want to specifically address selling businesses, any businesses, I don’t think that’s appropriate. But we are going to focus on the core.

That’s great. And the second question is I mean because when you put out good results, I don’t really have any questions, you leave us flagged. But your CapEx jumped a little bit. Is that going to be sustained at that level for the year I mean I guess it’s a high-class problem, you’re on a lot of these programs, you’re going to have to spend the money. But $5 million on a quarterly basis is a pretty big jump. Is that sustainable or will it taper off towards the end of the year?

It will actually increase. I don’t know if you heard all the prepared remarks, Eric, but the CapEx that we’re forecasting for the year is $28 million to $33 million. So there will be substantial increases from that $5 million run rate in Q1. That’s primarily all related to – a significant portion is related to unmanned systems initiative specifically on LCASD where it’s approximately $15 million to $19 million of CapEx that we’re building our own capital targets – two targets as two aircraft as well as ground support equipment. And then the balance of the CapEx is related to investments we’re making in our satellite communications business. So it will continue at that level and actually increase.

I am sorry I missed that out. I was probably muted.

No problem.

I’ll do my victory lap. So I apologize about that.

No problem. No problem.

Have a great day and I really appreciate your time.

Thank you.

Thanks Eric.

Thank you. Our next question will come from the line of Josh Sullivan with Seaport Global. Please proceed.

Hi. Good afternoon.

Good afternoon.

Good afternoon.

Can you just expand on some of the investments you’re making in satellite training? I think you obviously had some nice wins recently. And I think you just mentioned training is ripping. What kind of technologies or opportunities are you investing in those segments?

Without getting into specific companies that were partnered with a lot of it has to do with virtual reality and the operators being inside the systems and with their helmets on they are seeing virtual reality of the same mission that, what’s going on going on, but when they looked around them, inside the system, lets say, they have two other operators next to them. The virtual-reality goes away and that cut way into the system. And so now they’re inside the helicopter or they are inside the airplane or they are inside the tank. And they can see real, real – reality what right next to them. They turn their head back and it switches back over to virtual-reality in the text that are coming at them. And so we’re making a significant investment in that virtual reality and the algorithms related to it.

Have you had program when its associated with that?

Yes. Absolutely.

I guess, just one switching over to the drones. On the international customers that you mentioned, I think you said activity was conducive to a long term relationship. Is there any way to quantify their potential long-term needs, maybe how many drones they currently use or potentially would need on an annual basis?

Absolutely. So currently they are using no drones that represent 4 or 4.5 generation threats. So think of 4.5 generation fighter aircraft or 4.5 generation or fourth generation cruise missile. They are not using them. This country they have developed and then about the field and number of new weapon systems, including surface-to-air missile systems and air-to-air missile systems. So they want to exercise these new weapon systems that they have diligently [ph] developed against the highest performance unmanned target drones in the world, which are ours. So to think of the launch equipment, the ground equipment, the command and control equipment the equipment to clear the range of electronic of course maintain clearance on the range. All of that equipment goes in and it’s all custom-designed for our target drones. And so one SSAT investment they have made is and what we have seen. I’m not aware of any customer that has switched to any other competitive drone system, once they have made that investment and they have flown our drones. We are going to be looking at this in addition to the initial buy, every 1 or 2 years depending on shoot downs several millions of dollars, additional every year or two or to replenish their drone inventory

Okay, thank you.

Thank you. [Operator Instructions] Our next question will come from Sheila Kahyaoglu with Jefferies. Please proceed.

Hey guys, thank you for the time. I’m just if you do that is, okay. I know the microwave backlog was up in the quarter. And I just wondering if you give the growth rate for that business as well as may be depends on market for that segment , if you can? I don’t know if you mentioned it earlier?

We don’t break them out because they’re part of our government solutions segment. And so we have not broken – we haven’t broken out, but that trailing to what Mr Jordan asked as he said that he rightfully said that in 2016 the microwave electronics business was $55 million and he said what do you expect that to happen and I said it expects that to assuming we actually get these production awards on these platforms that have been awarded. We expect that to do a growth function going forward. And in the second half of this year, once you get those awards God willing, we will give specifics on that growth.

Okay. And then in term of the PSS business, I know you mentioned you’re working on or majors of system deployment. How do think about our return to profitability, which you expect that in 2017?

I’m fully expecting a return to profitability in Q2. And I’m expecting that profitability to increase significantly second half of 2018 or 2017 over first half of 2016.

Okay.

So, I’m expecting full clean profitability in Q2 and that increasing into the second half.

And is that sort of revenue run rate we should consider going forward for that business?

Yes. I would use that number and here is why. Because those 4 programs are rolling of Q1, Q2, Q2 and Q3, so revenues going to come off from those say $5 million or so. And is going to be backfilled by higher margin revenue. So right now net-net level will think flat, but actually there’s some growth in there because those ones are falling off.

Okay, that make sense. And then just in terms of taking on profitability for the overall business gross margins were up over I think 300 basis points in the quarter versus last year Q1 2016. Just thinking about the mix what drove that was that like government systems

Yes, it was primary and so government systems clearly. Organic revenue growth of over 6% I think I’ve mentioned that the overall financial performance was above our expectations across the board in each of the KGS segment. So it was but the revenue growth and the favorable mix on certain of the areas as well.

Okay. Thank you, Deanna. And then Eric, one more for you, if you don’t mind with macro, what is the first like expectations, is that when is that or the demonstration by far in the second half with the first line also being the second half?

Right. So it’s that like shark. I understand that I understand it’s a killer shark, it’s a killer UAV. Yeas it’s the expectation, Sheila it would be a series of flights by a number of our aircraft and there are currently scheduled for the third quarter. And they would occur over the period of a week to 10 days. And they’re going to be specifically related to a loyal wing man. Type of scenario, with manned aircraft and ground systems and other systems taking control of them than sending them out, on a controlled a semi autonomous in an autonomous mission with very sophisticated sensor and other packages integrated into the UAVs

Got it, okay. And this is the last one actually I promise. In terms of profitability of that business would it you also as you see as step up in revenue do you see step up in profitability in the second half?

Yes, absolutely.

Okay, thank you very much.

You got it.

Thank you. There are no further questions. So now it’s a pleasure to hand the conference back Mr. Eric DeMarco, President and Chief Executive Officer for closing comments and remarks. Sir?

Thank you all for joining us this afternoon, and we will be circling up with you. And in July early August for Q2 call. 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.