Good day and thank you for standing by. Welcome to the Kratos Defense & Security Solutions Second Quarter 2021 Earnings Conference Call. At this time all participants are in a listen-only mode. After the speakers presentation there will be a question-and-answer session. . I would now like to hand the conference over to your speaker today, Ms. Deanna Lund, Executive Vice President and CFO. Please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions second quarter 2021 conference call. With me today is Eric DeMarco, Kratos' President and Chief Executive 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, Deanna and good afternoon. Kratos has continued to execute on and achieve important milestones further positioning us for the successful execution of our stated mission, our business plan and our strategy. The organic growth we generated in Q2 including in our unmanned systems and space satellite and cyber businesses, we believe is representative of this execution. Additionally, Kratos' last 12-month, 1.2-to-1 book-to-bill ratio, which includes a 1.3-to-1 second quarter book-to-bill ratio in our space satellite and cyber business, which is our company's largest and unexpected very strong second half of 2020 bookings provides us the confidence in the forecast and the continued up into the right organic growth trajectory. Since our last report, we achieved a successful series of flight tests with the Skyborg autonomy core system or ACS. Abode Kratos' UTAP-22 Mako tactical unmanned aerial drone system at Tyndall Air Force Base in Florida, which was an incredibly important program milestone for the company. As reported by the United States Air Force, the 96th Test Wing took part in a series of test flights of Kratos' Mako, and inside the Kratos Mako, the Skyborg autonomy core system, where the brain of the autonomous aircraft made its first three flights for the Autonomous Attritable Aircraft Experiment. The ACS is part of the AFRL Skyborg Vanguard program, with Skyborg's goal to develop low-cost unmanned aircraft to provide increased combat capability by teaming unmanned droned aircraft with traditional manned fighters. During this demonstration flight series, aircraft controllers on the ground provided commands to the ACS and in the future, the plan is for direct manned, unmanned teaming via commands sent from a manned F-16 Fighting Falcon to the ACS onboard the unmanned aircraft. Related to the flight Brigadier General Scott Kane, the 96th TW Commander reportedly said the execution…

Thank you, Eric. Good afternoon. Kratos' second quarter 2021 revenues of 205.1 million were at the upper end of our estimated range of 195 million to 205 million. Our Q2 21 consolidated operating income was 3.3 million, up from the second quarter of 2020 operating income of 2.9 million, which includes second quarter '21 increases in stock compensation expense of 1.8 million, increased R&D of 4.2 million primarily in the space and satellite business, and increased depreciation expense of 1.6 million in the current period. As a reminder, over 80% of our total R&D is typically invested in our space and satellite business. Net income was 1.1 million for the quarter, which included a tax benefit of 3.6 million, primarily reflecting tax benefits related to stock compensation expense. GAAP EPS was $0.01 per share, compared to a loss of $0.01 in the second quarter of 2020. Adjusted EBITDA for the second quarter was 17.6 million in the range of our expectation of 14 million to 18 million, reflecting increased investments in internally funded R&D, primarily of our software defined OpenSpace and virtualized products, as well as the revenue and product mix and more developmental projects as we begin to ramp a new developmental program. The second quarter operating results include over 400,000 of negative foreign exchange impact resulting from an increase Shekel against the U.S. dollar in our Israeli-based microwave business. Excluding this adverse foreign exchange, the second quarter adjusted EBITDA was 18 million. In the second quarter unmanned systems segment reported revenues of 60.3 million, up 43.6% from the second quarter of 2020 due primarily the ramps in production in target programs, including the 177 and work performed on the Valkyrie program. Unmanned systems generated operating income of 4.1 million, up from 1 million in the second quarter of…

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

Your first question will come from Mike Crawford with B. Riley Securities.

Thank you, Eric. You talked about the markup to the on defense bill. Including first Skyborg, what how would you characterize Kratos's position within Skyborg versus competitors like GA and Boeing?

I believe that our position is far ahead the best. The press releases relative to the GA vehicle, as it's a surrogate vehicle. So the vehicle they're using is by -- I'm assuming by that word is not even the vehicle they're planning on -- finally utilizing, if it even exists. Boeing, there hasn't been a peep from Boeing --about Boeing or anything about Boeing since their first flight of their vehicle, I think at the end of February or early March. So we're coming up on five, six months, not a peep from Boeing. So I don't know what they're doing. We were first to fly the core. As I mentioned, we closest flown to a manned fighter in history that we did, or integrating Skyborg payloads on the new Valkyries now and we are extremely confident and comfortable with our position on this program.

Okay. And then, related, you mentioned OBSS, as potentially as transformational to Kratos as Valkyrie. And given that you're already a leader with these various other classes of drones, what is it that's, that separates OBSS from the rest?

Yes, there's very little publicly out there on this opportunity. Very little. But it is an attributable low cost system. And if we -- this is very competitive -- we are successful in receiving a contract on this. This has legs. This program has legs. And I really can't say much more about it, Mike other because there's only that one piece of paper out there on the program, but it's expected to be awarded very soon now.

Okay. So, well, hopefully you're one of the two winners of that down select. And then, final question just goes back to OpenSpace. What is it about Q4 milestones that you're expecting a bigger ramp in that quarter versus Q3?

Yes. It's the transition to the software deliverables. We've -- and it has to do with the bookings, including the big ones we just had in Q2, we're going to be delivering product in Q4. And it's more software intensive. And so the margins are higher on it. And we've been talking about this probably for about a year now and when we started releasing the product, I think in Q2 or Q3 of last year and the uptake by the customer community has been incredible. This is brand new. What we're basically doing is, we're taking the soft off the ground satellite infrastructure. Now my term from 2G cell phone network to 5G. We're going from legacy hardware based systems to software virtual systems. And we're first to market and the customers are, are buying it and we're going to be delivering it in Q4. And that's why we see a significant margin uptick in that quarter.

Your next question will come from Peter Arment with Baird. Please proceed.

Hi, good afternoon. You actually have Eric Ruden on the line for Peter today. Eric, just in terms of framing up the second half bookings, obviously, you're expecting pretty significant pickup at unmanned specifically, could you just provide any color around some of the big moving pieces there? And I know you mentioned book-to-bill, well, in excess of one, do you think it's enough to make book-to-bill for the year over one, given the softer first half?

Yes. So on the first part of your question, the space and satellite business forecast is extremely strong in Q3 and extremely strong in Q4. And as both Deanna and I said, it's coming off of the bookings that we had in recently, including, I think, 1.3 to 1 in Q2. And we're off to an extremely strong start in Q3 for bookings in that space and satellite business. And if we can get the people and we can deliver it, we're going to achieve it. We are going to do it. Now on your question on the second half book-to-bill. Across the company, we have some big programs we're expecting to book in the second half. So let me give you some example of them. One of them is an Air Force target drone program, we're expecting to receive a multi-year award, which would be base years plus options. I believe this is a sole source that'll carry us through. We're expecting a very large Navy target drone award in the second half of the year, that also we expect to be multiple years -- base year, plus options. There's a confidential program that I think is going to fall into Q3. There's that large international one that I've been talking about. I didn't mention in the prepared remarks today where we've received the contract. But with the change in administration, it was going through some type of a government review, we expect that review to be successful and we'll receive that award in the second half of the of the year. In the engine area, we have a very large contract, we are expecting to receive, I forget it's Q3 or Q4, that that will put our engine business in a positive over 1.0-to-1. So we got a lot of big ones that most of which are sole source, which is why we're so confident second half bookings are going to be so strong.

Okay, thanks. And then, on the just the comments about the rising case counts with COVID. And concerns about Delta variant. Are you anticipating or what do you think the biggest risk is there in terms of both the order environment and pace there? And then are you seeing any further delays on the testing ranges?

Okay. So last one first, thus far, as of today, we have not seen or been informed of any Test Range delays as of right now. Now, as I mentioned, and you probably saw, the DoD is starting to tighten up certain restrictions at certain locations, including at the Pentagon, those are not problematic right now. Now we are seeing some issues on the commercial side, on travel, the commercial SATCOM business, internationally, because, we've got over 80%, 85% of the global operators. So we're seeing some delays there. We've factored that into our range. This is one of the reasons we have a range. We've got put some dates all over the place. The primary issue I'm probably concerned about right now, based on what I see is that travel one, can we travel internationally to get the sign-off on certain things and we've tried to incorporate that in. Like all other companies, we're seeing delays in the supply chain. We're seeing price increases in the supply chain on new contracts; we can build those prices into our new contracts. On existing contracts, if they're firm fixed price, we just have to figure out how to be more efficient, so it doesn't impact our margin. So these are all the moving pieces we've got going on.

Okay, appreciate it. I'll hop back in the queue.

Yes.

Your next question will come from Austin Moeller with Canaccord.

This is my first question here. So China is building 230 new ICBM silos out in the desert, how does this impact your Rocket Support contracts with Northrop for GBSD for the missile transporters? Do you think it's unlikely that we're going to get to less than 400 ground-deployed GBSDs because of this?

Yes, sir. Hey, Austin. So you're exactly right, in the past three weeks, satellite shots have identified two new Chinese ICBM fields in two locations over 100 each. And I personally believe that we, the United States, we're in the very early innings of the next Cold War and the next arms race. And I'm not going to get specific with certain programs or customers, but to answer your question, yes, I see what China is doing is going to be directly related positively to Kratos, our programs, specifically in the rocket area you talked about, which has to do with ballistic missile targets, hypersonic systems, potential hypersonic targets, launching payloads at affordable costs rapidly for our customers, all of this is a plus. And I don't think I've said it, Austin, in the remarks, but our booked and our anticipated launch schedule of missions for the rest of this year and through next year is very, very strong, and I believe it's directly related in part to what you're talking about.

Okay, great. And then you discussed that you have the two of the 12 Valkyries at the Oklahoma factory you're currently being outfitted with the Autonomy Core System. So is an Air Force contract to pay for those 12 aircraft contingent upon some forthcoming tests with the Valkyrie using the Autonomy Core System just like the Mako did or how should we think about that?

Right. So we have a number of those -- a number of the 12 that are coming off the line are already under contract. The two that I mentioned, those are under contract, right. So those are already spoken for. When the customers announced the quantities under -- and we're under two contracts now for Valkyries, for those 12 Valkyries, some of the 12, but we have two contracts. When the customers become public with the quantities and what they're doing, then obviously, we're going to talk about it. But those two I mentioned in the prepared remarks, those two are under contracts, and those are two of a number that are under contract of the ones that are coming off the line.

Okay. And just one last one, should we anticipate that there's going to be a Skyborg Valkyrie flight with the Autonomy Core System installed within the balance of the year here or should we install longer than that?

Yes.

Yes.

Yes.

Okay, well, thank you for the color, Eric.

Yes, sir.

Your next question will come from Joe Gomes with Noble Capital.

Good afternoon.

Good afternoon, sir.

So I just wanted to circle back here on the second half, and obviously, given the guidance that you provided, the fourth quarter is heavily weighted. And just trying to get your comfort zone, oftentimes here in the fourth quarter, we see a lot of political games around budgets and things of that nature, and, I mean, we're seeing it today, how confident are you that and what -- what's your worry level that things of that nature could impact fourth quarter?

Yes, the vast majority of our third and fourth quarter are in backlog. So the vast majority, this is not a book and burn situation. These are in backlog on funded contracts, it's execution. That's what this is. And the key parts of the execution are, I think we have approximately 300 open wrecks right now or something like that. And we have some strategies, including taking advantage of other companies that are having some programmatic issues, we're hiring their people, and we're so far so good on that hire side. The wild cards that I see are supply chain, okay. We have done the best we can to order in advance the safety stock amounts, but the safety stock ordering now is pushing out, I think we're at like six to 12 weeks and now some things are like 24 to 30 weeks. Deanna is nodding, but that's correct.

Yes.

So we're seeing things slide to the right, and there are global supply chain issues as we all know. So that's one. And the second one is COVID, two prongs. Does it -- do any of our major facilities get impacted where a number of people have to quarantine et cetera; I don't see that right now. And the other one is what the other gentleman asked on the DoD side, if DoD restrictions tighten up, in particular related to range access. But again, in our range, got our guidance, our range, we've tried to take all of that worst case to normal case to a good case in that range. And so that's why I'm very comfortable with how we've come at this and we're going to be rock solid in that range.

Okay. Thank you for that clarification. And on the turbines, you're talking about the ATTAM programming contract, and one of the things I think in the press is, is it talking about is affordability and given the huge amount of or the huge percentage that engines cost as part of a drone, I mean, can you kind of give us some example or details, what kind of cost breaking are you looking at here under the -- your KTT versus the existing engines?

Yes. So we had our engine businesses, it's a range. There are certain engines, we're looking at orders of magnitude, three, four, and five times less costly. Other ones we're looking at 30%, 40% less costly. It just depends on the type of the engine. Most of these are turbojets and turbofans and the application. Now the -- on the first part of your question I do want to comment on, the decline of the U.S. industrial base, especially for engine technology related to Space Systems is really bad. And the ability and there -- in the past couple of weeks, there have been a number of articles on the ability of U.S. companies to build very specialized machined or cast subsystems and components for rocket engines, it's that. We have that capability. You've heard me say in the prepared remarks, we're under a number of contracts, we're under NDA, but people that are going to space, people that are launching things, we're probably under contract with them building engine components for them. And that business is ramping very rapidly right now, number one because of the demand, but number two, the competition, there's not a lot of people out there that can do it anymore. We've lost that capability in the country, and so we're looking at it as a business opportunity and a national security opportunity.

Great. And one last one for me, if I may. And just perusing the queue before the call, I saw that you had a nice increase in the commercial revenue in KGS segment. Is that related to open source or is there other things behind driving those commercial revenues higher for the quarter?

That's a big piece of it is on the commercial SATCOM piece.

Your next question will come from Pete Skibitski with Alembic Global.

Hey, guys, I want to follow up on the engine line of thoughts. Just Eric, you mentioned in the second half of the year a potential, you called it a large engine contract, and when I just want to get my expectations in order because I think of what your KTT business in the past is getting a lot of task orders maybe $5 million to $10 million for development type, what are we talking about in the second half, are we talking about a production contract or are we talking about maybe an advanced development contract that's more? Okay, go ahead.

It's multiple 10s of millions.

Okay. Is just like an LRIP type contract?

I can't -- I cannot get ahead of the customer, but it is several, several 10s of millions is the size of the engine contract.

That's a nice breakthrough for the business, I would say right?

The business is doing great, and the opportunity that the number of new missiles and powered munitions for the range that has to be achieved in the Pacific is incredible.

Will we see a press release when you get this or is this too close all kind of a thing or?

I believe I'm hopeful the customer will announce it, I'm hopeful.

Okay, okay. Last one for me on KGS, I just want to, I feel like maybe I need to understand this business better. On the EBITDA margins at KGS, when we talk about, they're in kind of the upper single digits for the first half of the year, I guess, due to space R&D. What I'm wondering is, is every business within KGS in normal times, can that be or is it kind of a mid-teens type of an EBITDA margin business that generates free cash and it's just being suppressed right now because of space R&D or is there a big range there and some businesses are maybe more important than others?

So across the board, there are different margin rates within the businesses. So on the space and satellite size, those are on the higher end of the range. On some of our -- we still have some legacy services business and right now our engine businesses, most of that's in development, those are on the lower end of the margin rate range. So it's a blend right now. And what we're expecting for the second half is that, that space and satellite business is going to be more software focused, which would lift those margins in the second half and more specifically in the fourth quarter. So that's what we see driving some of that margin uptick for the second half.

Okay, if we say more so on the mid-term, it is my last one, I apologize, but if we think more in the mid-term with engine getting a larger contract with space maybe moving more so into production type of stuff on the new space stuff. Is your expectation that KGS in the mid-term can be kind of a mid-teens margin business or is that too large?

As you know in our C5 business with GBSD, which I believe the announced contract with something like the developed -- it's a development contract before production is $180 million and we've got a couple of other ones in there. Those development contracts margins are typically lower than production. I think in the second half, we're going to win, we're going to be awarded another large multiple 10s of millions dollar weapon system contract for development that will then go into production. So those are going to offset a little bit some of the margin increases we're seeing like in the space and satellite area. So to crisply answer your question, once if everything gets into production like we predict and there were no more large development programs, it could be a low-teen business. But hopefully, we're going to continue to win development programs that put us in position for additional programs to drive the organic growth. You know what I mean, it's a cycle.

And at this time, there are no further questions. I would now like to turn the call back over to Eric DeMarco for closing remarks.

Great. Thank you very much for joining us and looking forward for our next report. Thank you, sir.

This concludes today's conference call. Thank you for participating. You may now disconnect.