Ladies and gentlemen, thank you for standing by, and welcome to the Kratos Defense & Security Solutions Third Quarter 2020 Earnings Conference Call. [Operator Instructions] I would now like to hand the conference to your speaker today, Marie Mendoza, Senior VP, General Counsel. Please go ahead, ma'am.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions Third Quarter 2020 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, and good afternoon. In Q3, we continued to execute on our strategic plan, including being an industry leader focused on the recapitalization of strategic weapon systems by the U.S. and its allies to address the nation-state Russian and Chinese threats. Since our last report to you, we've made important progress, which we believe further positions the company for an expected and sustained up and to the right organic growth trajectory, which include -- we received from the U.S. Navy, the SSAT BQM-177 target drone full-rate production contract with an initial estimated total value of approximately $130 million in our Unmanned Systems division with the initial funding recently received for the first 35 target drones at approximately $30 million. We received from Northrop Grumman in our C5ISR business a GBSD contract Phase 1 award with an expected initial value of approximately $160 million to $200 million to Kratos; receipt of a $950 million ABMS MAC IDIQ contract award by Kratos' Space and Satellite Communications and our Unmanned Systems businesses. This ABMS contract award is in addition to the $400 million MAC Skyborg IDIQ contract award Kratos Unmanned Systems business previously received. Microsoft announced that it is working with Kratos' Satellite business on its Azure Orbital Space Satellite Ground System as a new service offering. It was publicly released that a new Kratos affordable, high-performance turbine engine is on the speed racer tactical system; and receipt of an award from an international customer for 20 Kratos target drone systems by Unmanned Systems business. Kratos' positioning as a commercial culture, venture-backed technology and product company, addressing that the national security market, is providing a competitive advantage for our company, we believe, as represented by our third quarter 1.8:1 book-to-bill ratio, our $873 million backlog and the $8.3 billion opportunity pipeline we…

Thank you, Eric. Good afternoon. Kratos' third quarter 2020 revenues of $202 million were as we forecasted and in our range of $195 million to $205 million. And adjusted EBITDA for the third quarter was $24.6 million, above our expectation of $17 million to $20 million, due primarily to a favorable mix of revenues, including certain programs and products and more mature life cycles. In the third quarter, our Unmanned Systems segment reported revenues of $53.5 million, up 17.1% from the third quarter of '19, due primarily to target drone programs, including the SSAT 177 program with the U.S. Navy. Unmanned Systems generated adjusted EBITDA of $5.6 million, up from $4.9 million in the third quarter of '19, primarily reflecting the increased revenues. KGS reported revenues of $148.5 million, up from $138.4 million in the third quarter of '19, reflecting $10.2 million from the recent ASC acquisition and organic growth in our Defense Rocket, Microwave Products and C5ISR businesses. This increase was offset partially by a net reduction of approximately $6.3 million in our trading solutions business, which was related to the previously disclosed reduction in scope of certain international contracts. KGS's third Quarter 2020 revenues also included a net reduction of $2.8 million in the company's KTT business, resulting primarily from COVID-19 impacts in our commercial aero business area, partially offset by increases in our federal turbine business. KGS third quarter 2020 adjusted EBITDA increased to $19 million from $15.5 million in the third quarter of '19, reflecting a favorable mix of revenues, including certain programs and products and more mature life cycles. Kratos' adjusted EPS of $0.14 per share was above our forecast of $0.08 to $0.10 per share for the quarter. GAAP EPS was $0.02 per share. Our Q3 consolidated operating income was $12.7 million, up from…

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

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

Eric, you talked a lot about investments that you'll be making in fiscal '21. I know you're not going to give guidance until the end of February or so for '21. But can you talk -- is there any way you can put more quantitative numbers around the investments in these various programs that you probably have better visibility into at this point?

Right. As you said, I'm not going to get into the details on '21. Mike, I will tell you that the number of opportunities, particularly in the space business, has increased substantially in the past few months, substantially, and including in the classified realm. Additionally, we're under an NDA with Northrop, but we are going to honor. But under GBSD, this is going to be one of the largest programs -- put tactical aside for a minute, the largest program in the company that we can see for a long, long time as this works through the first phase, which I gave the dollars on it, and it goes to production. And we have to make some investments there for what we're going to be building. These are massive systems we're going to be building. And so what we're looking at is definitely tied to contracts like GBSD, but I'm not going to get into dollars right now. I'm not prepared to do it. I'll have a lot more clarity with wins, et cetera, when we speak again in a few months.

Okay. Given the transition in the space and satellite business, when you acquired Integral Systems in 2011, I think it was much more of a hardware business. And so now I think maybe revenues are probably maybe not growing, but EBITDA margin would be. Is that the case? And is there like a revenue and EBITDA margin-type profile that you can share that, that business is at today within government systems and where that could be in a few years from now?

Yes. And so, Mike, to your point, and we talked about this over the past year or so, there's been a transition going on from geo -- synchronous orbit satellites and the large monolithic ground stations that were dedicated to them, that we were involved in, that were very hardware intensive. That transition has been going away from that to, as you absolutely spot on said, to software-defined ground equipment. We are crossing that point right now where the downdraft on the revenue is about over, large systems, and now it's increasing. So as we go forward, both revenue in our space business and margins are forecast to increase, including in the current quarter, going into next year. And then starting in the second half of next year, as some of these things I talked about today we start working on and delivering, we see it ramping significantly, revenue and margin late next year into '22. We're looking at minimum growth, minimum growth rates in the space business, and I'm going to exclude some very large binary opportunities that, if they hit, would dramatically increase this minimum top line growth rates of 10%, minimum, with significantly increased margin rates expanding because it's software.

Okay. And then last question. We're all eagerly awaiting developments on the tactical combat drone side, but -- and we're pleased -- very pleased to see the full-rate production on SSAT. What about full-rate production on other confidential target programs? Is that something that you're still trying to get? Or are you not able to even comment?

No. And Mike, I may not have been clear. I mentioned in my prepared remarks, everything is on track. We're -- we will get that next year. We'll get into full-rate production on some other ones, including the one you're talking about as well.

Our next question comes from Ken Herbert with Canaccord.

Eric, I just wanted to follow up on the tactical drone -- or, I'm sorry, the target drone question. Is it fair to assume that now that you've got the full rate on the SSAT and visibility on the other programs, that, that business should still get to sort of $250 million run rate? Is that the right way to think about it? And if it is, what's the time frame we should think about?

Absolutely. Absolutely. We are tracking right to it. The only flex point, Ken, the only flex point in this is the continued timing on budget and continued resolution because we're an LRIP, low-rate initial production 2 on certain programs right now. We've been awarded LRIP 3 in my example, which has substantially increased quantities and money. We can't get LRIP 3 until we get a '21 budget, okay? We can't move into full-rate production on certain things until we get a '21 budget. And so, Ken, we are absolutely moving right toward the $0.25 billion that we talked about. And the international award was part of that. We got it. The second international award I talked about, which we've won, but now it's in U.S. government department review. And next, I see it no later than '22. It's just...

So if we get obviously a '21 budget in some point in December, barring any other sort of major change, the run rate for '22 sounds very reasonable.

Yes. We need to get -- we'll need to get -- for the final piece, we'll need to get the '22 budget. We'll need that because there are 2 programs that are either new or one of them we're in production on that's going to have increased production tied to '22, which, as you know, begins October 1 of '21. So we'll just have to see where that one falls, and we'll get there.

Okay. Great. And if I could, just one follow-up on the tactical side. I know there's probably not a lot you can say around the Valkyrie, but you continue to sound very confident in an initial production contract. The Air Force has obviously expanded the number of companies involved in the initial opportunity here and the program, Skyborg in particular. How are you viewing the competitive landscape and any change there? And then also, how do you view -- from a technology standpoint, it seems like there's risk that the hardware side could be held up by the ability of AI and other aspects of the program to really move forward at the pace that the hardware is at. Is that a fair way to think about the risk? And is that something that you think could be a concern moving forward?

On the second part of your question, I believe you are spot on, on the AI. The AI is an absolute critical component of Skyborg and these other programs. And that can be -- that can definitely be a gating factor on timing, depending on that -- how that comes along. As you know, on Skyborg, for example, Leidos is the system design agent on the AI. And we have an -- as you know, we obviously have an outstanding relationship with them. So your point there is good, is right on. That's -- it's not a concern of mine because it kind of is what it is, but that can be a gating item. I'm not focused on that. Now on your other question on the competition. We are playing our game. We -- as I've gone through, we have multiple jet drones flying today. We have active production lines, so we know what our costs are. We know. We're not going to speculate and guess and then say, oh, we're wrong and give a change order and do that to the customer, all right? I believe our programs, all having U.S. government sponsors and being built in the U.S.A., is an incredibly important differentiator, incredibly important, all right? The fact that the Valkyrie has been flying for over 1.5 years now, the Mako has been flying since 2015, we're doing payload integration, payload test, all of this is giving us space ahead of the competition, all of it, in my mind, okay? And I think, most importantly, price point and cost point. We are the affordable provider. We know that. They know that. And so the customer, of course, is going to be objective, and they're going to make their decision, and we totally respect that. But we believe we are extremely well positioned to take part in what we see is going to be a giant, new market across expendables, reusables, attritables. I don't think we're going to get into the exotic category. I don't think we are. And as I indicated, our ghost works is doing something very interesting relative to repo replacement.

Our next question comes from Peter Arment with Baird.

Maybe a question just to focus a little bit on the top line guidance kind of range for the year. You reaffirmed that, but it implies kind of a bigger swing factor in the fourth quarter on the top line. Maybe what are some of the puts and takes that would put you at the bottom end or the top end of that range?

Okay. So the biggest factor that we've been looking at relative to this is the following, okay? Obviously, we're in the CRA that goes to December. That's number one, all right? We have an election coming. We don't know what's going to happen with that. That has brought in that if things don't go according to some people's plan, maybe there's going to be a government shutdown. We don't know that, all right? Now let me give you a very important one, okay? Timing of customer sign-off on our products, okay? The COVID restrictions have been significantly impacting travel, including customers coming out to sign off on products so that we can execute delivery or revenue; and also, our ability for our people to travel to customer sites, in particular international, where they're not letting Americans in without a quarantine period. So if we deliver a large space system, which we have several that we're supposed to be delivering, we deliver them. We have to go there and get it signed off, and that has been an issue. And so we've tried to map all this out relative to our range in Q4. And I know it's rather large, but there are some big moving pieces in here, and we wanted just to make sure that we encapsulated them all in what we provided.

Okay. That's helpful. And just on the quarter specifically under KGS operating margins, 9.5. I think that's kind of one of the highest margins we've seen in many, many, many quarters. And it sounds like you view this to be sustainable and maybe even transitioning into the double digits. How does ASC signal kind of impact margins going forward?

Right. And so we had a -- you're right. The margins there were very, very strong, and Deanna mentioned the maturity of certain of the programs we're on. So we are on certain weapon system programs, which had some certain, I'll say, deliveries or execution in the quarter that were very, very favorable to us. But now to your sustainability question, okay? I believe that number is going to be reachievable and sustainable for us once we get going on GBSD, okay? We're going to be making some investments, as Mr. Crawford mentioned, that we have to start now because we've been awarded the contract, and we've won. And so I don't think -- I could be wrong because the team is doing great. We're going to execute at that margin level in the next couple of quarters, few quarters or so, okay? However, we've got some programs we've won that once we get going, we're going to get right back there, and in the future, we think we're going to exceed it.

Right. And then just lastly, you talked about the international kind of training headwind potentially for '21. I think it was $35 million you mentioned. When will you know on that in terms of the time line?

Okay. So right now, the current contract we're on, assuming there's an option that is supposed to be exercised that I believe is going to be exercised, we are good through January on the current vehicle, okay? Assuming we get that option, and that's supposed to come very soon now, we're good through January. The reason why I'm -- I said that this is high risk is -- versus other ones that we're involved in is because there is no intellectual property, technology or product differentiator on this one, okay? We have some things in our favor. For competitive reasons, I'm not going to get into them. But because we don't have those differentiators, which we do in our -- in 90% of our company, the products and technology business, it's risky. And I wanted to make sure I was very clear on that with the group.

Our next question comes from Michael Ciarmoli with Truist Securities.

Nice results. Eric, maybe just to stay on kind of Peter's question there on the fourth quarter. What about the EBITDA range? I mean even at the low end of your revenue guidance for the fourth quarter, it seems like EBITDA is going to be down. Is that -- is anything changing in terms of mix or anything that's influencing EBITDA in the fourth quarter?

Yes. So number one, in our C5ISR business, all right? We had some big -- as Deanna said, on some big programs in the state -- where they're at in their life cycle, at the end, things like that. It was very strong in Q3. That's not going to happen again in Q4. It's going to make a lot of money, but that I don't see that happening again. Now as you all have chatted with Deanna and I about on Q3 and Q4 before, typically in Q3 and Q4, we, in our space business and our cyber business, we get a number of orders from customers. I believe it's because it's around the federal fiscal year-end and obligation of money and spending money. If we, as we have in the past, get a number of those in November and December, those are extremely profitable because this is very specialized software, and that would be significantly additive to the EBITDA. So that's a swing factor, what happens on that. And we don't typically know about those until December, okay? Those are the ones.

Okay. That's helpful. What about the -- the order flow, obviously, very strong; the backlog, up significantly. Was there any contribution to the backlog from ASC?

That was about $30 million, $35 million, Mike.

Okay. Perfect. And then just last one, Eric. I know you're not going to guide to '21, but you talked about a number of the individual markets and product lines being in a position to grow organically. Do you still see -- even if the training loss goes against you, that protest goes against you, do you have enough confidence in the other product lines that you can grow organically next year? And I guess even just thinking about kind of level setting expectations, I mean you talked about the NRE on GBSD, the other investment. Should we think about just margin expansion and free cash flow being a bit tempered in relation to all those items?

I -- on the second part, I would, and it's because of the nature on some of these big programs that we've won and the profitability of them early on because of the related investments that we've -- we're going to be making. To the first part of your question, let's say that the training goes against us. Yes, we absolutely believe we will still grow '21 over '20, and it will be important. It's not going to be like $5 million. It's going to be a lot. So we've got some good stuff coming. And if we get the CRA done and we get the '21 budget and we get movement on that stuff, second half of next year, when that kicks in, it will be strong.

Our next question comes from Sheila Kahyaoglu with Jefferies.

I wanted to just follow up on the backlog, Eric. You had a pretty nice sequential step-up. How do we think about that conversion? And any changes to duration? And I don't know if you noted it, but was the September award for GBSD in the backlog?

Yes.

Yes, it was. And again, we have to be -- you saw how we talk about that. We're doing that with guidance from the prime. Think of a bell -- think of -- and again, that's Phase 1. That's the development phase. Think of a bell curve. It's development for the first year, 18 months, but the bell curve is going up. Then you start delivering some things in that development, and the bell curve goes up big in the middle over that 6- or 7-year period, so, say, starting in year 2 or 3. And then the bell curve starts coming down. But that time, hopefully, Phase 2, which is production, the entire team would be successful on.

Okay. And then I'm sorry if I missed this as well. I think earlier this month, you received the BQM-177 full-rate production Lot 1 contract. Can you just go over the time lines of main production programs and where you are in the life cycle and maybe potential volume step-ups?

Absolutely. So on the one you just mentioned, on the Navy SSAT, we've been in LRIP. We're going to be finishing up LRIP over the next few quarters or so. And then we'll be moving into production on full-rate production year 1 sometime later next year. And then that will go for 3 years. We were awarded a 3-year contract, sole source, a base year plus 2 years. And so that is why when we were chatting about one of the other questions earlier, 2022 and 2023 are looking very, very strong because of that full-rate production on that one. We have another contract. It's confidential. It is in LRIP. It is scheduled to go into FRP next year. If all of that timing holds, and I believe it will, we will see a significant uptick on that one late next year, no later than '22. On the Air Force, we are also sole source there. We are currently in production year 7 -- excuse me, 16. We are negotiating the next 5 years production, sole source. We expect to be awarded that middle of next year. We do not see any break in the production line, all right? And based on what we're seeing relative to that, we expect that to step up not a lot, but step up in '22 going forward. This one that we just announced with the international customer for the initial of '20, we're going to be getting going on that next year. We'll start delivering ghost probably in the second half of next year into '22. And as I mentioned, that customer has indicated they're going to be doing similar annual buys with us, which is great. So we've got -- and I think there are some other ones with the U.S. Army. They're buying dozens of target drones from us right now. If you're interested, pull up the IBCS program, and you'll see about a month ago, out of White Sands, the Army shot down -- I think they announced 10 of our target drones. There's also new anti-cruise missile systems going on the East Coast and West Coast. It's been publicly disclosed. They've been shooting down our target drones with a certain customer. So Sheila, the target drone business is doing great, and it's ramping.

Our next question comes from Joe Gomes of NOBLE Capital.

Most of my questions have been asked already. But not only during the third quarter, but also in the year-to-date, you mentioned a little bit, you've seen a pretty, percentage-wise, big increase in R&D spending. And I was wondering if you could give us a little more color to that. And how long do you think that is going to last?

That's a great...

Any detail there would be appreciated.

That's a great question. So that is our space business, and these are our software-defined products. And this is why we've been announced with Microsoft. This is why I said we're under NDA, but we're with some other big guys. This is what's driving our 5G. This is why I -- when I was addressing a question earlier, I said our space business is going to grow. It has begun, and this is going to be long term, and it's not pie in the sky, I don't believe. I believe this is going to need to continue because our space business is now truly turning into a technology play. It's going to have higher margins. It's going to have good growth, organic growth. And we're going to need to spend R&D to make sure we stay ahead of everybody else, where I believe we are today with these software-defined products.

Okay. Great. And then just I know I've asked this in the past. I just kind of like to keep abreast here. But a couple of quarters ago, you mentioned how you were looking to hire over 200 people. And I think I asked a question last quarter, and you said it was going well. Just wanted to get an idea of given the state of the labor markets out there, how confident are you, guys? Or how is that progressing and getting up the number of employees you need to increase the production going forward?

Right. Also another great question. So recently, some very large companies have either announced or they are laying off thousands of people in the aerospace industry, including -- even though they don't highlight it, in their defense businesses. This is providing us a significant opportunity pool of guys and gals that are outstanding, that have experience, particularly in our drone area and in our system development area and system design area. So that is helping us, and we're being able to help people that are getting ripped because of other companies' issues. And that is helping us. And so I'm not saying this is easy. It is not, okay? But that, recently, in the past few months, has definitely helped us out here. We have -- I don't have the number in front of me. We have several hundred reps right now, big ones in the drone business, in the space business, in our C5ISR business. It's -- I think it's over 100 right now that we need to hire. And we're going to be -- I've talked about the investments. We're going to be opening entire new facility to build the structure, to build these systems.

[Operator Instructions] Our next question comes from Seth Seifman with JPMorgan.

I guess in terms of the several growth opportunities that you outlined for next year, if you were looking at the magnitude of those, what would be maybe the top 2 or 3 that you would highlight in terms of what would contribute the most in '21?

Unmanned Systems, Valkyrie, target drones and other tactical drones is number one, okay? Number two, our space business. Our space business is looking great, okay? Number three, and this one, it's just going to depend on timing, our Rocket System business. We have -- I can't give you the precise numbers. We have over 25 launches in the next 30-something months. That's how strong this is. And that ties into that -- Deanna, what was that contract we got last year? Was it 30 rocket motors?

Yes.

We got a contract last year we talked about for 30 rocket motors. They're all spoken for.

All right. Okay. And then maybe as a quick follow-up. When you think about -- you've talked for a while, and you mentioned kind of reaching that $200 million to $250 million level on the target drone business. When we think about the F-35 in particular and the wider range of international customers that, that continues to get sold to, should we think about that as a market that has kind of reached a full rate of production at that point? Or as you look at the international marketplace and the growth of the installed base, is that a market that continues to grow?

It's going to -- that's the right question. It's going to continue to grow because as the international customers buy things like F-35 or buy -- they buy Aegis or PAC-3 or they buy Standard Missile 3 or Standard Missile 6, they want to exercise those weapon systems against the highest threat profile target drones in the world, which are ours. On the BQM-177, which is now going into full-rate production, countries wait until the U.S. goes into full-rate production on it, and they start deploying it to the field of the fleet, then they start buying them, which is going to now start happening, all right? And to your point on other or additional markets, this was publicly available. That's why I'm going to say this to you. There is a new hypersonic projectile that was reported, which shot down our target drones that were representing something somewhere in the past few weeks. That's an entire, new market now for us, these new hypersonic weapons. They need to practice against the threats. We build the threats.

Our next question comes from Michael Ciarmoli with Truist Securities.

Eric, can I just put you on the spot? When do you think you get the Skyborg order? Where do you think we are with that?

We are in source selection. I am sorry.

Do you think anything's changed from like the previously communicated time line? You think the CR has anything to do with it, election, anything else, anything pushing it to the right at all in your mind? Or...

I think you have put me on the spot, and I'm sorry. The program is in source selection. I'm not saying a word.

I'm not showing any further questions at this time. I would now like to turn the call back over to Eric DeMarco for closing remarks.

Very good. Thank you for all joining us this afternoon, and we look forward to communicating to you again -- with you all again as soon as we can. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.