Kratos Defense & Security Solutions, Inc. (KTOS) Earnings Call Transcript & Summary

Okay. Good afternoon, everybody. It's Noah Poponak, the aerospace and defense equity research analyst here at Goldman. Thank you for joining us for the Industrials & Materials Conference. We're going to keep it moving with our next session from the defense sector. With me on the line here from Kratos is the CEO, Eric DeMarco; CFO, Deanna Lund. Eric and Deanna, thanks so much for being with us.

Good morning. Thank you for having us.

Yes. Thank you, Noah.

Yes. So I guess, good morning. Good morning, your time, and good afternoon, mine. Yes. So let's jump right into the programs. There are so many to discuss. And it seems like every time you hold an earnings call, you introduce 3 or 4 more that we didn't know about the last time. So I definitely want to touch on some of those new ones as well. But let's start on the Valkyrie because it's potentially one of the larger ones and seems to be on a -- one of the earlier contributors relative to some of the other ones. And I know the market's just really focused on it. On the call -- on the earnings call, it sounded like you thought you could see order action there sooner than later. So talk us through why you think that. And I know it's possible that it could be part of multiple different larger umbrella programs, if you could sort of rebase us all on what each of those are. That would be really helpful.

Sure. So last week on the earnings call, when Deanna and I were talking through -- on the Valkyrie program, I mentioned that we were in communications with the Air Force customer, and I also mentioned that we had received correspondence. And so we are in discussions right now with the Air Force on an initial contract. I believe that we will -- hopeful we're going to receive it in the next several weeks, maybe even the next few weeks, directly related to continuing the Valkyrie effort. In addition to that, I mentioned that I thought imminently a solicitation with the Air Force would be coming out or a communication from the Air Force would be coming out relative to a production contract. The Air Force made that announcement 2 -- 3 days ago on Monday that they are going to be beginning the solicitation for production in the next few weeks with production contract award sometime in August or September-ish. So from a customer standpoint, things continue to track for the platform to -- for missionization, operationalization, integrating systems on it, which is what we've been doing. And hopefully, we're going to be successful on this production opportunity. And the Head of Procurement of the Air Force said that he wants to start producing these in quantity by the end of this year for delivery of -- delivery next year. That right there is all under the Skyborg program, Skyborg. In addition to that Skyborg program, we are under contract on ABMS, the Advanced Battle Management System program. And on that program, the Valkyries will be flying in an exercise that was previously scheduled for April. It is now scheduled for August or September. It has been pushed to the right as a result of the DoD travel restrictions because of the virus impact. Valkyries will be flying -- and other Kratos drones, that's also public now. It will be the Valkyrie plus some of our other drones, will be flying with the F-22 and the F-35 relative stealth communication link capabilities. We look at that as just another representative data point that our airplanes continue to make progress to hopefully ultimately be part of the Loyal Wingman vision that the Air Force is pursuing.

Got it. I just want to make sure I'm clear on what, I guess, you -- the discussion you've had is you're waiting for an order. And you've even talked about spending your own capital on CapEx this year, about how you've kept any revenue from Valkyrie out of the guidance. And then if you got the order and you were on a percentage of completion accounting contract, you'd be able to start booking revenue that you could add to the guidance. The -- what you were discussing as -- the first thing you said, which is in the next several weeks or maybe few weeks, there could be activity versus the second thing you said, which is solicitation from the Air Force related to a production contract. Is the first thing you're referring to before solicitation related to production, is that first piece an order for actual units that could be booked -- that could be revenue-generating in the year?

Okay. So I don't know precisely what it will be as I speak right now. I do believe that it will be revenue-generating this year. It is possible that it will be a contract to continue to further the operationalization of the vehicle to get it ready for deployment with the warfighter. Let me put some meat on that bone. It very well could be for modular containerized systems, as you know, our Valkyries fit inside shipping containers, where the door drops, the rail slides out, the wings clip on, and it takes off. Strategically, that would be great if the contract we received was for -- I'll use the word infrastructure, launch infrastructure, recovery infrastructure for the airplanes. Because that's -- in my mind, that's a very important strategic block to a competitor if we start building some of those under contract and get some of that infrastructure deployed, all right? So it very well could be something like that, it may be for some additional units. I'm not clear right now that, that's being worked. The second piece is clearly for production units. The one that I mentioned the Air Force announced 3 days ago because that's what the Air Force has publicly said it will be. It will be for the Skyborg, the initial Skyborg drone aircraft and initial production on it.

And that -- remind me the time line of that -- so the solicitation is out. And then what's the time line moving forward here on when we have more information on who the awards are going to go to?

Right. So what the Air Force said in their announcement on Monday was that they plan on getting the request for proposal out in the next few weeks. So I'm assuming by the end of the month or so. And they want an expedited contract award process. They want contract awards no later than August or September. That is what they said. And so if they follow that time line and they make awards in, say, September. Now we'll go to part of the question you asked. If that is -- if we're fortunate enough to win that, as you mentioned, through communications we've had with our customers, we started building 12 airplanes. If we were to receive an order for Valkyrie aircraft as a result of that solicitation, Deanna, why don't you explain to the group how we envision that accounting would work for us.

Sure. So as we have incurred costs and they're currently captured in capital expenditures when we receive the contract, then if it's for an order for an outright sale of aircraft, then that would -- those costs would transfer to effectively inventory or cost of sales and percentage of completion revenue would be recorded on those costs that had been incurred through that date. So there would be, if you will, a catch-up at that time. If it's more service oriented, then it would be based upon the services performed under whatever the contractual terms are.

Right. Got it. And just so I'm clear, the production award that you're anticipating in August or September will be a single source, one provider?

I don't believe that's what it's going to be. I'm connecting dots on what the Air Force has previously said and what they said this week on Monday. It sounds like it's going to be a MAC award. That's what it sounds like, which would be great with us, fine by us because, as you know, we have 4 tactical drones that I can publicly disclose flying today, including the Valkyrie. I've got a hot production line that's in production building them. And so it appears it might be a MAC award or there might be several awards. But if that...

How many companies could even -- how many companies are even eligible for that MAC award?

Eligible, in my mind, right now, it would be Kratos, it would be Boeing. Now Boeing is building what they call the BATS, the Boeing Attritable (sic) [ Airpower ] Teaming System down in Australia. They say it will fly for the first time in December. The Air Force reported that Lockheed has indicated that they potentially would look at this with an exotic -- I think they said they have an exotic design out of their Skunk Works, which -- exotic to me means expensive. And so that would, in my mind, we would have an advantage there on the affordability side. And General Atomics has announced that they are thinking about building a suite of drones called the SparrowHawk series. They're on the drawing board right now. So they don't -- that's my understanding. And I am not aware of where Northrop is, if anywhere, on this right now out of their Scaled Composites business unit.

So you'd expect a MAC award and then -- I guess, moving forward, they would just task order out of that to individual contractors?

Exactly. That's what I'm...

And could they task order, the first task order at the same time as they do the MAC award in August or September? Or are we going to have MAC award and then have to wait for the task orders?

I believe it will be concurrent.

Okay. All right. Great. Maybe just update us on the Gremlins program. Is that -- that's obviously another one in focus for investors out of the tactical unmanned business. What's the latest there? Milestones from here and when we could start seeing production revenues from that program?

Right. So unlike the Valkyrie, where the range delays and flight delays have not impacted materially the production solicitation as we just talked about, because Valkyrie had completed its series of test objective flights. The Gremlins has not. It's publicly available. It's completed 1 flight. There are several additional flights in the series planned. They were scheduled to commence and continue in April. Those have been pushed out into sometime in Q3. And as you know, I'm not the prime on that, Dynetics is. So I can't get ahead of them. So the Gremlins program from a flight test objective standpoint has moved to the right several months as a result of the virus impact. However, from our discussions with the prime and our discussions with the customer, this class of drone, which is vastly different than the Valkyrie, much different capability, much different form factor, is -- appears to be in high demand by the service. We envision it will transition from the research agency, DARPA, to a service, most likely the Air Force by the end of this year, early next year. And our envision is -- the Valkyrie right now is tracking to a program of record in 2022. We're hopeful that Gremlins will track to a program of record in 2023.

Okay. That's helpful. All right. I want to try to dive into these, at least new to me, opportunities you have -- you brought up on the call, the things that seem to be percolating in your engine business. You spoke to Reaper replacement, and you spoke to some version of an unmanned follow-up to F-16. So let's maybe start on the engine piece. So you've made -- you've got the acquisition contributions. Maybe just give us all a little more detail on exactly what's come about there. And I don't know if it's possible to size sort of like where you could get on units per year through this, that would be really helpful.

Sure. So we are trying a very similar strategy in this class of turbojet and turbofan engine market that we are executing on the drone side. This class of engine, the technology that's in the vast majority of the cruise missiles today is from the '60s and '70s. This technology was in production in the '80s during the Reagan buildup. Then the wall came down and the United States began fighting terrorists, an asymmetric warfare. There was no peer threat so there was no need for those -- that technology to be enhanced or improved, no need at all. That has changed now. During that time, the market became substantially a monopoly with Williams. So we are pursuing a path where we have engines running now. You saw the announcement by the Air Force. We have not been able to announce it, but our engine is on the Gray Wolf cruise missile. The Air Force came out and said, straight out that it is a next-generation, very low cost, very high-performance engine. And in addition to Gray Wolf, it can go on a number of other platforms. In the tactical missile area, we are looking at 2 markets. The existing market, where the missiles like the JASSM is going to ER extended range. Or the LRASM, ER extended range harpoon, the missiles are going to extended range to be able to be launched outside the island chain and get in. There are certain breakpoints coming in production for different variants of those missiles over the next 3 years, where we're looking to get designed in and get a piece of that market. So those are existing platforms. Then there are new platforms coming. I mentioned Gray Wolf. There are a number of other new ones coming that, for competitive reasons, I'm not going to chat about here, that are greenfield that we're looking to get designed in on. I mentioned Black Condor. We have an engine on a confidential program. It is running. The vehicle will be flying later this year. It very -- it could go into production next year. That could be one of the first financial contributors to Kratos on the engine side. We are -- putting that one aside. We -- there are 7 programs, in particular, we're tracking. And over a 5-year period, beginning in 2022, if we are able to penetrate approximately 20% to 25% of the market of each of those, it's an $800 million opportunity for Kratos, just on those.

Okay. That's really helpful. Let's maybe try to do the same thing on the Reaper replacement you discussed and the F-16 piece you discussed. The -- maybe just give us a little color on how they came about. I know you described the limitations of Reaper on the earnings call, but for those that didn't hear it. And then on the F-16 side, I mean, we just had Lockheed on, and they're talking about a lot of international interest for the airplane. I'm guessing what you're describing is mostly domestic, but I actually can't quite square that. So on those two, why are they happening? And any estimate of sizing the same way you just did for the engine piece would be great.

Okay. So let's talk about the F-16 first. So General Holmes, the 4-starred Air Combat Command came out about 30 days ago, and he was talking about the Air Force of the future, in the next 3, 5 and 10 years. And the discussion was specifically on jet drones and how they don't have enough -- the Air Force does not have enough pilots. They're not going to have enough money to get to the number of squadrons that they want. They're not going to have enough money to get to the number of aircraft to take on the Chinese and what the plan is. And the General said, the first stage that they are looking at is to pre-block F-16s. So this would be Block 25 and Block 30 of F-16 that are coming -- that are expiring. Their airframes are reaching end of life, very old airframes. They've been extended with CLEP several times. And he was saying in the next 3, 4 years, those are going to start transitioning out, and that is where the Air Force has a -- it's called their cut in plan, where they are going to cut in, and I'm going to quote him, "low-cost attritable, high-performance Loyal Wingman jet drones." So that is what the Air Force is specifically looking at with Block 25s and Block 30s. And 3 years after that, the first wave of F-15s are going to start coming off the line, start retiring, and then he went into more detail on that. So that's the F-16 piece, that is new news, just came out recently.

So that's not -- just so I make sure I have that squared with the companies who discuss their content, upgrading these older jets. It's not so much that what you're describing is at odds with upgrades of the fleet. It sounds like it's more the oldest things that were going to be retired then from a fleet structure perspective are backfilled with unmanned as opposed to necessarily unmanned accelerating retirements in that fleet structure. Is that -- am I reading that correctly?

Correct. I believe so. I do not believe drones right now, today, are accelerating the retirement of anything. I don't believe that. But as you said, there's better demand, there's the natural retirement that's coming. On Reaper. Out of the blue when the 2021 budget was submitted, the production line was cut, no additional orders, and money was put in the 2021 budget to shut down the line. And then the Air Force came out and they said we're doing this because the Reapers cannot survive on a fight against Russia or China, they will all be shot down. And right after that came out, Dr. Roper did an interview, and he said, we are going to begin a solicitation next year for the Reaper replacement. It will be a jet drone that can survive in anti-access/area denied environments. And so we -- obviously, we looked at that as great. There's another data point, a validation data point for the market that we're pursuing.

Got it. How many units are we talking about here?

They haven't come out and talked about that yet. But as we know, there are hundreds of Predators and Reapers deployed. There was debate just yesterday on the Congress floor on this. On -- the combatant command is talking about we need ISR, we need Intelligent Surveillance and Reconnaissance, but we need the platforms to be able to survive in contested airspace. So this is -- this was not a one-and-done type thing. This is -- this appears to be happening [ frequently ].

Got it. Before I keep moving on, 2 logistical items. One, Eric, it may be my line, but your line from what -- the way I hear it is cutting up a little bit if you could slide your chair 6 inches over or shake your headset maybe.

Okay.

It's not bad, but just a little bit. And then I forgot to mention at the onset. For those listening in, if you have questions, you can -- on the webcast there, you can submit them, and they'll come through to my screen. And I'll be happy to ask them of Eric and Deanna here. So with that, the BMD and hypersonics target programs, you had -- you were kind of giving us all the detail of those, every earnings update for a bit there. And the one that went to Northrop caused some volatility. Maybe it's just me, but I guess, I've a little bit lost track of where they all are, if you could just kind of level set us on that opportunity set and the time line. Did I lose you by making you shake your headset?

There, there. So right at -- yes, I shook it too hard. So right at the end of the third quarter and the fourth -- beginning of the fourth quarter last year when we were unsuccessful on that opportunity, we did win a Navy opportunity for 30 vehicle launches. And I say vehicle launches because it can be a ballistic missile target launch, it can be a hypersonic launch. It can be, I'll just call it, a orbital research launch for this call. And we have received a number of orders already under that single-award MAC, that single-award IDIQ. So -- and those launches, we had several scheduled beginning in Q3 of this year. As I mentioned on the call, some of those have now been moved to Q4 into Q1. The launches, the financial impact we've incorporated into our guidance because as we build these, we generate revenue on percent complete and then there's the launch. So we're working on that one. There is another very large opportunity that has now been pushed out. It was going to be in the second half of this year. It's now been officially pushed into the first quarter of next year. And I don't want to talk too much about that solicitation because it's -- the solicitation has gone up again, and it wouldn't be appropriate for me to. On the hypersonic side, we have responded to a number of RFPs by the government and by certain primes to put their hypersonic, I'll say, front end or vehicle in the right place at the right time, at the right speed. I am hopeful, cautiously optimistic that in the second half of this year, we will receive some of those contracts to put those hypersonic vehicles in the right place at the right time at the right speed. And so that business is doing very well right now, and the opportunity set is increasing. And just based on what's going on in the world of hypersonic vehicles, there are going to be hypersonic targets and hypersonic testing. I envision that will be pretty solid for quite a while.

What Kratos product puts a hypersonic missile in the right place at the right time with the right speed?

Yes. So we have exclusive perpetual rights to a solid rocket motor stack called -- which -- part of which is called the Oriole, like the bird, the Oriole, and we integrate other solid rocket motors together, maybe a Terrier or a Castor, maybe all 3 for a 3 stage, depending on the mission and the payload. ATK, under an exclusive agreement with us, builds those for us, and we have exclusive rights for ballistic missile targets and hypersonic vehicles for that Oriole stack. So we don't make it, but we have the rights, the exclusive perpetual rights to it.

Does your Microwave Electronics business have content potential in hypersonics systems?

No. Not at this time, no. They do not.

Okay.. So it's from a propulsion perspective and then a target perspective?

It's from a propulsion and a target and ground equipment. So as you know, Northrop announced that we are doing part of the ground transport system for Ground Based Strategic Deterrent. And that could be a several hundred million dollar opportunity for us if that works out. I'm really rooting for Northrop on this one. That type of technology or system on the ground very well also may be applicable for NGI, next-generation interceptor, and also for certain of the hypersonic vehicle systems.

You're not on the Boeing team?

No. We are not. Are you're talking about on ground...

GBSD, as a strategic leader.

Yes. We are not, not.

If Northrop wins GBSD, when could that program become a meaningful revenue contributor to Kratos?

I'm under a very tight NDA with Northrop. They're a great partner. The Air Force has publicly said that they expect to award the contract to Northrop in August or September. Hopefully, we would receive our contract, say, shortly thereafter by the end of the year. So potentially, this could begin contributing to Kratos in 2021.

Okay. All right. Maybe update us on your space business, I mean, space is broad, and a lot of what we've talked about actually it sort of theoretically can be defined as space. But I know you have the command and control business in there and some other drivers. I think you spoke to OPIR on the call. But that -- I think that had already been driving growth for the prime. So is there a -- did you gain content there? Or I don't know, maybe just kind of give us the handful of biggest growth drivers in the space business for Kratos.

Okay. Our space and satellite business is on the ground. We are not on the satellites. And we do -- as you indicated, no, we do command and control systems and communication modems and things like that. Big programs that we are on, space-based infrared; SBIR; WGS, wideband global satellite; AEHF, advanced extreme high-frequency satellite; the big constellations that are in production right now. OPIR is augmenting SBIRS, SBIRS High. We just received, as you indicated, our initial contract. We're sole-sourced on what we do on overhead persistent infrared. And this is the constellation that looks for missile deployments and launches. So we kind of track them and take them out. That program will -- we envision is going to be ramping in the -- begin ramping in the second half of this year, and that is going to be one of our largest -- forecasted to be one of our largest programs starting next year going forward. In addition to that, as you know, we own and operate a global sensor network. We own it. We've built it, it's ours. And we just announced a contract recently. I think in the last month with the military, we monitor [ beams ], we monitor space assets, we can geolocate where anomalies are coming from. And we hand that information to our customers so that anomaly source can be neutralized. That business is growing very rapidly. I mean you may have seen just recently, I think it was in today or yesterday, it's irrespective of coronavirus, Russia and China space activities and space offensive weapon capabilities continue to ramp. And...

They didn't slow that down because of the coronavirus?

No, they didn't. They said, no, we're not going to worry about that. So yes. So that business is -- monitoring, is one of our fastest growers. And then what the new space agency is doing, putting up LEO constellations and MEO constellations instead of big exquisite geosynchronous orbit satellites that are great, big juicy targets for the bad guys. There's a next-generation of LEO, low earth orbit, and mid-earth orbit satellites have started going up. They're not as exquisite. They're not as expensive. But because they're lower, you need a lot more of them to get global coverage. That's driving a whole new generation of ground command and control equipment that's software-based because instead of building exquisite hardware just to talk to 1 satellite that's going to be up there for 25 years. These new satellites that are going up can hand off to each other, think of a cell phone. A cell phone roams, you can go to different networks, you can go to a rural, you can go to a local, you can go to a national. That technology exists, Kratos has it for the space segment. That's why I've been talking about our command and control and TT&C on the ground is turning to a software-defined radio model for space. And that -- you can pull up the different -- the various different constellations that are going up in LEO and MEO. We're on the ground on those, and that market is also looking like it's going to be a good grower for us.

Okay. Okay. So a lot going on there.

Yes.

Very helpful. Deanna, I want to bring you in on a few questions below the programs here.

Sure.

The margins were down year-over-year in the first quarter. If I go to the high end of your EBITDA guidance for the year, the margins would be sort of flattish for the rest of the year. What happened in 1Q? And then as we move forward here, there's just a question of if you have a lot of volume growth, you can have overhead absorption. You guys have kind of capacitized yourself in certain areas that obviously aren't 100% full yet, so that can help the margins. But then oftentimes, new programs are dilutive to the margin. So does the Kratos margins expand or decline beyond 2020?

So beyond 2020, we expect it to expand as we are moving out of development since we are in development on a number of -- some of the tactical programs, specifically in unmanned. So that was one of the reasons from the mix perspective for Q1's margins being down year-over-year. So as we are moving out of development and into production, we expect those margins to expand, precisely for the reason you said with the overhead and G&A absorption on those fixed costs.

Okay. Okay. Yes. I guess actually -- so 1Q '20 was down from 1Q '19, but sort of barely in unmanned, more in KGS, although, I guess the 1Q '19 KGS was just a bit abnormally high. So actually -- okay, so that all makes sense.

It was, Noah.

Okay. So you would expect 2021 both segments have -- basically are into the double digits on the adjusted EBITDA margin.

We would expect them to expand. I don't know if I would give a particular number, but we would expect them to expand, yes.

Okay. I mean, in order -- well, in order to -- it looks like unless the mix between the 2 segments margins is going to change significantly this year, it would look like unmanned will be just under 10 for the year. But yes, we can go at that expansion comment for now. And then shape of the year, I mean, why is the shape of the year so back-end loaded from a revenue perspective?

Sure. That's based on the production schedules that we see, and it took -- it's in a couple of our business units. So in unmanned systems where production ramps that we're expecting with the Navy and the Air Force. And some of our target drones also in our C5 business as well as Microwave business with the productions, especially based on the bookings that we realized in the first quarter and that we expect to realize in the second quarter. That's based on those production schedules as well on our space and satellite business where some of those programs that we're expecting to contribute more in the second half like OPIR and some other space-based programs. So it's based on the visibility that we have in our backlog and our bookings and our pipeline for some that we are expecting to book in Q2 and Q3.

Are 3Q and 4Q pretty even? Or is it a pretty 4Q-loaded year?

It's a little more heavily on Q4. But so it will -- we see a ramp in Q3 and then an additional ramp in Q4.

Okay. Got it. And then on cash flow. Your cash flow from operations, if the guidance is achieved this year, would convert your adjusted EBITDA to cash flow from operations over 50%, which is -- I'm sure you want to be higher than that over time, but is a nice step-up versus a little bit more investment-intensive history. When can the company get to converting EBITDA to free cash flow at a 50% or higher clip?

It should be in the next few years, and that is going to depend on the size of production contracts because, as you know, especially on the unmanned side, depending on the size of the production award, there are a number of long lead items that we -- are required to order 15 -- 12, 15 months in advance, and there are deposits required on that. And depending on the terms that we can negotiate from a progress payment and milestone payment perspective, that could impact when we achieve those longer-term free cash flow goals. It's going to depend on the growth curve and the payment terms that we can negotiate.

I guess to the extent the cash flows are strong, but CapEx is high for growth or working capital is a use for growth, I suppose, for this growth company, that's not so bad.

Yes. Yes.

Okay. Super. Well, we've gone a few minutes over our allotted time here. I know you guys have some meetings to get to. So let me just thank you so much for your time. Really appreciate you joining us. A lot of really good detail there. So thank you so much.

Thank you.

Thanks, Noah, very much.

Thank you.

Okay. Have a good day.

Thank you. Bye-bye.