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

Good afternoon. Welcome back to the 2021 JPMorgan Industrials Conference. We're here continuing on the aerospace, defense track. And I'm Seth Seifman, the North America aerospace defense equity research analyst. We're very glad to have Kratos with us now and grateful to have CEO, Eric DeMarco; and CFO, Deanna Lund. Eric is going -- and Deanna are going to kick it off with a few minutes of presentation, which is available on the conference website, and then we'll move to Q&A. Eric and Deanna, welcome. Thanks for being with us, and I will pass it off to you.

Very good. Thank you, Seth, for having Deanna and I and Kratos present today. I'm going to go through an abbreviated discussion on the briefing today, because I know we have some Q&A we want to get to. So I'll call out some pages as we go. On Page 2, Kratos is a technology innovator for national security. And these are just some of the areas that we're focused, and the key thesis here is we are going after areas in the national security realm where we can be a force multiplier for the military. On Page 3, we are unique for a defense contractor that we have had significant venture capital backing in the past. Our Board is made up of venture capitalists, entrepreneurs as well as defense industry experts. And we believe this is very favorable in today's environment on rapidly bringing products and systems to the market. On 4, the top bullet point, at Kratos, affordability is a technology. In our core market areas that I'm going to briefly touch on, we believe that it's where the -- at the market first, we're first to market. And if our products are affordable, we will win. And one of the ways we do that is the last bullet there. We use proven, leading-edge technology and integrate it versus unproven bleeding edge, which significantly reduces technical schedule and financial risk for the customer and for the company. The macro industry environment on Page 5, as we all know, there's a significant pivot right now going away from asymmetric warfare and fighting terrorists towards peer threats. And very recently in the past few weeks, the new Biden administration and his confirmed appointees have made some very favorable comments relative to Kratos related to affordability, quantities, defense budgets. We need to buy more for less. And we need technology that's disruptive, all of which we feel plays right into Kratos' strategy and our business plan and our core focus areas. On 6, primary business areas. The key ones I'm going to talk about today are Drones, Space and Satellite Communications and what we're doing in the boost area particularly related to hypersonics. On 7, target drone area. We build some of the, if not the highest, performance drones in the world. They represent peer threats, peer aircraft, peer cruise missiles, other things, so the U.S. and their allies can exercise their weapon systems against them. We are the primary provider in this area to the United States Air Force, United States Navy and United States Army, the largest drone, target drone utilizers in the world. And we also have a significant international customer base. On Page 8. This is just a graph. This area is growing rapidly. And as countries recapitalize their strategic weapon systems, they want to exercise those weapon systems against representative threats, which is what's driving our business. On Page 9, tactical drone systems. We have 4 variants that we can talk about publicly flying today: the Valkyrie, the Gremlin, the Mako and the AirWolf. And roughly, these fall into the government's categories of attritables, which is the Valkyrie; reusables to Gremlin and the Mako; and disposables, which would be the AirWolf. We have won a significant number of programs in this area, including Skyborg, Advanced Battle Management System, we're on Golden Horde, IBCS, et cetera. Key differentiator for Kratos is our cost, $400,000 to approximately $3 million, $4 million per drone across the portfolio. And as I mentioned before, these are the highest performing drones in the world. And they are all runway independent, which is a primary requirement today of our Pentagon customer. Page 10, there's a shot of Valkyrie in part of our facility in Oklahoma. On Page 11, very importantly, Skyborg is looking to develop multiple drones. Skyborg is an artificial intelligence program, multiple drones for many missions. And then that sub headline the Air Force is looking for 2023 initial operating capability for the Skyborg drones. This was just recently released, I think, last month in February. And that picture shows, go to Page 12, the Kratos Valkyrie flying with both fifth generation U.S. fighters, F-22 and F-35. That's how far along we've come with our partner, the United States Air Force. Down below the Gremlins, a shot of a Gremlins, part of the Gremlins missions to be able to be air recovered or retrieved after successfully performing its mission. And we, with our prime partner, Dynetics, are looking to demonstrate that capability in the next few months. Page 13, Kratos are saying -- I like to say is We Ain't Them. We are the affordable manufacturer. One of the reasons we're so affordable is we don't build large manned military and commercial aircraft. We're specialists in affordable, high-performance jet drones. You can take a look at each of these. This is an area I would like you to keep your eye on, because these are the differentiators, and this is one of the reasons we are going to be so successful in the drone area. 14, Space and Satellite Communications, our largest business in the company today. Our space and satellite business forecast this year is about $270 million across the company, though, we'd probably do near 1/3 of $1 billion a year in Space and Satellite Communications. We are an industry leader in Command & Control and Telemetry, Tracking & Control Systems. There's an example, representative example of some of the programs we're on. I'll pick 1 OPIR, Overhead Persistent Infrared. This is a new program for us. It's ramping, and this is going to be one of our key growth drivers in the next several years. On Page 15, we released our OpenSpace, software-defined modem and communication technology last year. We are first to market with the software platform. These are virtual products that enable satellite operators to design their own fully dynamic ground systems. And this is one of the reasons why we are very confident in our growth trajectory of at least 10% organic in space and satellite for the next several years. On 16, Microsoft Azure recently announced that Kratos is part of their ecosystem on the ground. You can see that down below. We are involved with a number of initiatives like this. We are under NDA on most of them. Our space business, we're looking to be one of our highest growing next to our tactical drilling business in the next several years. Also on 17, OneWeb, very big customer of Kratos. I'm going to go through Microwave Electronics. Let's go to 19, missile defense and hypersonic systems. We are one of the leaders in [indiscernible] boost systems and rocket systems for payloads, including hypersonic payloads. If you go to 20 on the hypersonic systems side, just last week on the rocket system area, the military announced a very successful launch of a Kratos restack vehicle out of Wallops Island. And we were able to put a press release out with the video on that last week. And so I encourage you to take a look at that. We are one of only a couple of providers of these systems to the Pentagon. 21, next-generation turbine technologies. The #1 cost item in the bill of material in a jet drone and cruise missile or a powered munition is typically the engine, the turbo jet or the turbo fan. We are focused on this area where we are developing a next generation of these engines, and we hope to be in production on these in the next couple of years. We're looking to disrupt the market here, very similar to how we've disrupted the market in drones. And on 22, this recent contract award pretty well lays out what we're doing here. We are looking to optimize turbo jet engine technology for future cruise missiles and attritable UAVs and also powered munitions. I know there are a number of financial questions that are going to be asked, so I'll skip this area right now. And I'll conclude on the investment summary. We are truly a technology company in the national security area. Primary areas are drones, AI, space and satellites, hypersonics and BMD. Over the next couple of years, if we're successful, and we believe we're going to be, we think our tactical drone opportunity is going to -- really going to transform the company, including from a valuation standpoint for our stakeholders. And down at the bottom, 2021, this is a year of investment for us. We have won a number of very large programs that we are putting the infrastructure in now to execute on. We expect to win a number of additional programs this year. And we're looking for an accelerated growth trajectory beginning in '22 and beyond. And Seth, with that, I'll turn it over back to you for some Q&A.

Excellent. Thanks very much, and it's a good overview. You had mentioned at the beginning some of the positive signals that you heard from the new administration. And I wonder specifically what kind of signals you're getting with regard to some of these more disruptive programs like Skyborg and ABMS. I think we know the sort of strategy at a high level is very consistent with further development of these sort of programs. But just in terms of how they're going to move forward on a day-to-day basis, what's been your sense thus far?

Our sense thus far is that defense budgets are probably going to be around flattish. And in order to address the peer threats or the near peer threats our country is facing today, quantities are going to be equally as important, if not more important, than technological superiority. And so what we're hearing is -- from our customers is that our customers need to acquire more quantities of relevant systems for less. And this, in particular, is in the tactical drone area, certain of the Space and Satellite Communication areas and in certain of the hypersonic and missile launch areas that we're in. And we're also hearing about disruption and competition to the established providers that the customers want alternatives, they want disruptive alternatives and they want additional competition. And we believe in our 2 handfuls of areas that we can be very relevant to the customers here. And then lastly, Seth, you probably have heard many times that the Pentagon and Pentagon representatives talking about moving with the speed of relevance. Well, Kratos is industry-recognized as the guy that can rapidly develop, demonstrate and feel a system in a couple of 3 years, not a PowerPoint presentation, a system that works and that's affordable. And we believe that's going to be incredibly important going forward with the new administration and the threat profile we're facing.

Right. Right. Excellent. Okay. And then when we look at the program that I think people most identify with the company and that kind of fits into that disruptive category, it's Valkyrie. And so maybe you could give us an update where are we in testing, where are we in production? And what's sort of the plan for production and for deliveries in 2021?

Okay. So we are on Valkyrie aircraft. We are working under a number of funded programs right now. We're working under Skyborg. We're working under LCAT and LCASD, under ABMS and some others I can't discuss. As I pointed out in one of the slides, the Air Force has said they are moving towards initial operating capability of the Skyborg drones by 2023. Obviously, that means a lot is going to happen in the next 12, 18 to 24 months to support our customer to get there, okay? We have, as I mentioned, 4 variants flying today: Valkyrie, Gremlins, Mako and AirWolf, all of which are going to be performing a significant number of flights starting today over the next rest of this year. I'm not sure we're going to be able to disclose many, if any of those. Hopefully, our customers will. But we are supporting our customers right now on payload integration, mission integration, concept of operations, et cetera, moving towards that IOC date, which is publicly stated, but also some other dates that our customers have shared with us, milestones that they want to hit. So things for us in the tactical drone area now are accelerating, and we expect it to continue to accelerate over the foreseeable future.

Okay. Excellent. And then you mentioned the issue of payload integration. And I think we saw, a couple of months ago, the first AI-piloted Air Force aircraft. I think it was a U-2. But before leaving the Pentagon, the former Air Force Acquisition Chief, Dr. Roper, had talked about potentially deploying the same type of AI system on a Valkyrie. I don't know if there's anything that you can share with us there. But also, and thinking more broadly, there's the development of the system, which Kratos has done. But how do we also think about the payloads that are going to need to be integrated there and the time scale for developing those kinds of mission systems for the Valkyrie drone?

Right. So on your first question, I cannot comment on that, and I cannot get ahead of the customer on that, what you talked about with the -- that AI package. I can't get into that here. On payload integration, et cetera, Seth, what I will say is that is all happening as we speak. And a number of the flights we're going to be doing is going to be demonstrating the capability of the payloads and the integration of those payloads into the drones. This is one of the advantages Kratos has against all the competition, being first to market with these drones. We're far ahead of anybody getting payloads, all types of payloads integrated and demonstrated into the planes, which I think is going to remain a significant competitive advantage. And I'm hopeful that as we successfully demonstrate some of these that either will be able to talk about or our customers will talk about it. And I'm going to leave it at that.

Okay. Okay. And then in thinking about that competitive landscape, there were 4, I guess, 4 awards initially for Skyborg. Other than the Valkyrie, there's been one other offering that's been, I guess, somewhat high profile. But if -- can you talk about the advantages that the Valkyrie has versus the competition in the tactical drone area?

Sure. And so the competition right now is Boeing with their batch, the Boeing Airpower Teaming System flew for the first time a couple of weeks ago down in Australia; and General Atomics and the Avenger. And if you take a look at both of the BATS and the Avenger, you will note that they are -- they both have wheels and they're tied to a runway or they're tied to a long paved highway, which may or may not be accessible in certain deployment operations areas. Kratos' drones, as you know, are all runway independent. This is a very important requirement of the customer set, true runway independence. This is to be able to disperse the assets, to discourage targeting things of the enemy, et cetera, et cetera. We believe this is a critical differentiator for us in the area we're going for. Another area is the cost. Irrespective of what other people may say, I've gone into in detail because of the hundreds of target drones we built a year and leveraging of the supply chains and the production we already have, we know what our drones cost. There will be no baton switching with Kratos with the government on it. And the government knows that. So our affordability is a key element for us. Then probably most importantly, as the customer has said, and if you can see this in the video if you go to YouTube and U.S. Air Force Skyborg, there are going to be many, many different types of aircraft, and there are going to be many suppliers. This is going to be a multi-multi-billion-dollar marketplace. A lot of that was discussed just in the past week relative to quantities. And there are going to be lots of providers, including Kratos. We intend on being one of the primary providers in our areas of attritables or reusables or disposables. And we are partnered with the Air Force. So we feel very, very comfortable, probably more comfortable than ever today about our competitive position.

Very good. On the international side, we've seen -- and the Boeing effort is in Australia. We've seen some discussion of Loyal Wingman type of aircraft in the U.K. Are you having conversations with international customers about the Valkyrie? And how do you think about the prospects on that front?

Yes. So the answer to that is yes. And we have approval from the applicable government agencies to have discussions with certain international customers on the Valkyrie, which we are doing. Here, again, being first to market with the flying aircraft is a critical differentiator for us. Kratos shows up in the U.K. or France or Australia with a flying airplane, not a PowerPoint, critical differentiator for us. And I believe it's going to be even more important going forward in flattening defense budgets, not just in the U.S., but internationally, because there's going to be less development dollars by the government. And since we are far ahead with flying aircraft already. That's going to be another impediment, including internationally, for the competition to try to catch us.

Okay. And then maybe moving on from -- to one of the other tactical drone programs and Gremlins. Can you give us an update on that program? What are the next milestones we're watching for there? And what would be the path for Gremlins to become a program of record?

Yes. So as you know, we are the subcontractor to our prime partner, Dynetics, Leidos-Dynetics, excuse me, and we are responsible for the aircraft. So I'm going to stick here to what has been publicly stated, either by them or by the government customer, DARPA. There are a number of additional -- there's a series of additional flights scheduled in the coming months -- within the coming months, including the captive-carry of a number of Gremlins back inside the mothership. As DARPA has said -- the DARPA program manager has said just in the past several weeks that once that is completed, the program is looking to transition to a number of services now. So I think the Air Force, Navy, et cetera, they didn't specify which ones, but they said there are a number of services interested in the aircraft transitioning to them. I believe the government also said that once transitioned, it will be -- it initially will be acquired or could be acquired, Skyborg or potentially Golden Horde. Additionally, a government representative went on and, for the first time that I've seen publicly, talked about the concept of operations of both a concept of operations of both the Gremlins and the Valkyrie. Talking about Gremlins would go into a contested environment first and exercise their mission. Valkyries would go in next into the contested environment and exercise their mission. And then demand or higher-valued assets would follow thereafter. This has all happened and been disclosed publicly in just the last several weeks by the government customer. So we are feeling very, very good about the Gremlins positioning, similar to the Valkyrie until a couple of weeks ago. There's no flying aircraft out there right now anywhere near the capability at the cost point of $1 million or less for this. And similar to the Valkyrie, over the next couple of years or so, we are looking for this to be a primary program and platform and value generator for Kratos.

Excellent. Okay. And the other part of the unmanned business is your target drones, where the company has been the leader for a while. We're in the midst of a ramp-up on those platforms. How much further do you see ahead in that ramp up? What's sort of the key driver? And then among the major platforms that you have in target drones, how should we think about the growth trajectory for each one of those?

Okay. So for our current under contract programs, the ramp-up is going to continue for the next several years, driven by the Navy SSAT program, which is currently in LRIP, Low Rate Initial Production. But we've already received the first 2 years of full rate production, which I believe begin next year and that will go in to '22 and '23 as it ramps. We are -- we have a confidential program that is going to as planned on achieving full rate production sometime in '22 or '23. We have won a number of international awards. And Deanna can talk with you if you wanted to get into it about the accounting on this, where they're probably going to be under unit of delivery instead of percentage of completion. So we're going to deliver those units in '22 and '23, which will further that ramp. And so under contract programs, we see the ramp for the next several years just with those ones I just mentioned to you. Then in addition to that, there are 2 new target drone programs that we're pursuing domestically. Both of them are expected to be very large. Both of them we expect to win. And if we're successful on those, then this ramp will continue for the foreseeable future, which all ties together with the recapitalization of strategic weapon systems, and you need to exercise those against threat representative target drones.

Right. Okay. Yes, I guess when we think about the driver of that demand, and I guess in the target drone area, I've kind of thought about it as the development or the growth in the F-35 fleet and probably also some of the missile defense systems, and like you said, the need for those aircraft and those missile defense systems to exercise. I guess if you thought about it, let's say, 3 or 4 years ago and you thought about the demand pull from that -- from those drivers and the pace at which that's happened and the magnitude of which it's happened has it been kind of similar to what you thought? Has it been -- it's on the trajectory, but it's taking a little longer? Or it's on the same trajectory and it's happening faster? How would you sort of characterize the way that, that's played out thus far?

It's playing out pretty much as we forecast based on discussions with our customer set, except for the weapons range impacts and some production-related impacts of COVID, which did push some of our programs to the right just out of following DoD travel restrictions and DoD social distancing restrictions and common-sense restrictions and things like that. So other than that, there have been some puts and takes with budgets and continuing resolutions. But overall, pretty much as expected, because we're very close to our customers. They told us what was coming because of the evolving threat. And we put ourselves in a position to be able to support them.

Right. Excellent. Okay. And then moving on to the issue of accounting for some of the international drones that you talked about. I believe there's a number that are going to be built this year and, as you mentioned, delivered over the course of '22 and '23. And so I guess, Deanna, maybe we should think about the revenue and the earnings showing up in those later periods. Is the cash coincident with the revenue and the earnings too? Or do you get some of the cash sooner as you're building the drones?

Yes. We try to aggressively negotiate the best payment terms as possible, but there typically will be cash outlay in the beginning, especially with some of the long lead materials such as the engines, which are roughly 30% of the bill of materials and there's typically -- and that's typically 12 to 15 months out that we need to place those orders, which typically require a deposit. So we try to negotiate some milestone payments upfront. But there is still a disconnect as far as the cash outlay, especially in the onset of a project versus the revenue, especially in this case, where it would be under units of delivery method?

Right. Okay. Okay. And so we can think about this year an opportunity to collect, there is some collection opportunity this year to finance the work that you're doing. But the bulk of it -- of the cash collection will come in the future, closer to or in line with the deliveries?

Correct. Yes.

Okay. Okay, great. And then I definitely want to get to some of the other stuff outside of unmanned. But one final question. I guess if you could give us an update on the build-out of your facility in Oklahoma. And specifically on the last earnings call, you talked about the range, and you have a range and port for testing. And what that means for the ramp-up in tactical drones?

Absolutely. So the build-out of the facility in Oklahoma is substantially complete. We have been and are now inviting customers to both of our manufacturing facilities in California and in Oklahoma, so they can see what a true low-cost manufacturing facility looks like. As I said in my opening remarks, everything we do has affordability and low-cost in mind, including the robotics we use, the 3D printing that we use, the special composite materials and layout approaches that we use, et cetera. So we are in production of the 12. They're going to start coming off the production line very, very soon now. And we are positioning and ready for any increases that our customer set may ask us to do. Seth, what was the other part of the question?

The port and range.

Yes. So we -- as Deanna and I talked about a couple of weeks ago, we have now received all the appropriate clearances at our new range facility in Oklahoma, where our drones will be flying very, very, very soon. For certain of our drones and our programs, including internally funded programs, this is going to be another very important arrow in our quiver on the rapid development and demonstrating and proving out of systems, where we will not have to utilize government ranges and tie down government resources. And very candidly, where we don't have to pay the fee, the appropriate fee to utilize the government range. So it's going to be a cost saver. So this, I call it the Kratos test and development range and our ghost works is using it. It's going to be another big differentiator for us going forward in our rapid and low-cost thesis.

Yes. Okay. I used up a lot of the time on the unmanned, but I think that's kind of inevitable, because it's very important. I want to ask you about space as well, though. And you highlighted the opportunity and kind of the, I guess, software-defined modem for ground stations that the company has developed. I wonder if you could flesh out a little bit more what that means for Kratos and how the market opportunity for that evolves. I think you mentioned on the last call some fairly significant opportunities and whether you see customers moving ahead with selections and purchases. Is that something that starts here in 2021? And kind of how we can think about that going forward?

A key pillar or element of Kratos' strategy is to be first to market. We were first to market with our next-generation target drones. We were first to market with our tactical drones. We have been first to market with our low-cost, solid rocket systems, including for interesting payloads, like we launched last week. And in Space and Satellite Communications, we are first to market with the truly software-defined command and control virtual system, where you don't need the monolithic, old hardware that's dedicated to a satellite to fly it, command and control it, telemetry and track it. It can now be done all virtually on the web or on COTS servers by our clients. And being first to market has enabled us to land a number of very important customers, most of which we're under NDA on, some of which we haven't announced, but the customers have announced like Microsoft Azure. We're working with EarthLink. We're working with a lot of these guys. And I just can't get into the details. And we are now demonstrating this product with them. We're under contract with them. And our plan is to start rolling it out with them in mass next year. In addition to that, what's going on with -- and this ties into that with LEOS and MEOS. This is part of the reason why this opportunity is occurring. With the ASC acquisition, we are one of the few companies now that have the technology, the tracking technology as LEO satellites fly by, I think, every 4 seconds. The ubiquitous and seamless handoff between the satellites by the antenna tracking technology, we have that. That is enabling us to bid on another set of new opportunities in the market that we were never able to address before. We just weren't able to. And then finally, we are now seeing a trend with the customer, which is the operator. So I think like the U.S. Air Force or Intelsat or SES, where they are disaggregating the space by from the ground equipment line. And I believe there are a number of good business reasons why they're doing that. We're -- heretofore, they would buy the ground equipment -- the majority of the ground equipment from the same guy that they would buy the space system. That is giving Kratos an opportunity now to bid on very large ground system opportunities. I think right now, we're pursuing 5, over $100 million each. Several of which, if not all, are going to be awarded this year, some of which I think we're going to win, where heretofore, a big opportunity for us was $30 million or $40 million. So there is a lot going on in the immediate and near term for us. This is one of the reasons we're so comfortable in a 10% year-over-year organic growth rate for the next several years. We've won a lot of programs. We're going to win a lot more. And then Seth, finally, on top of that, what's going on with 5G, which is more of a midterm or long-term opportunity for us, which is going to sustain this growth rate and 5G in the space area, with the auction just happening and the funds being available now for the incumbents to be able to relocate out of certain 5G spectrum, certain customers. This is going to drive new satellites, new ground equipment. It's a very robust target-rich environment for our space business right now.

Excellent. That's helpful. I guess there are a couple I wanted to get to in our -- for maybe a few minutes here. Maybe there are 2. One is on the last call, it seemed like, you thought there was potential for -- it seems like the organic growth guidance at a company level this year seems like it's about low double digits. And it seems like you feel like there's potential for that to accelerate further in 2022. And so, I guess, what are the -- what do you see as the key drivers there? What gives you confidence in being able to sort of do better than that sort of double-digit for this year?

Right. So the target drone programs like SSAT that were under that are transitioning from LRIP to full rate production. The space business programs we've won, for example, OPIR, Overhead Persistent Infrared, we've won a portion of that, which is going to be a significant growth driver for us in '21 and '22. Ground Based Strategic Deterrent, Northrop announced, we're on their team. Our development phase contract is somewhere around $180 million over the next several years. That's going to be ramping '21 to '22 to '23 for us. Our rocket launch business, I can't talk too much about this, but there is a significant step function in growth for Kratos from '21 to '22 in our rocket launch business, assuming COVID doesn't rear its ugly head again and shut down the weapons ranges. Seth, we've won a lot of contracts and a lot of big programs in the last year. I think our book-to-bill was 1.4:1 or 1.2:1 or something like that. And we've been a lot more in the pipeline that I expect us to win because of our intellectual property positioning. So right now, at that level, the game field looks very, very fortunate for us. And as I mentioned at the beginning of the discussion, with what appears to be coming out of the Biden administration and the appointee so far as far as new technology and quantities and affordability and an alternative to the incumbents in our areas, of course, it's very healthy for us right now from a growth -- organic growth trajectory standpoint.

Excellent. Okay. With that, we are up against time at 5:10 here. But Deanna and Eric, I want to thank you both for being with us and for sharing your time and your insights. And we look forward to being in touch.

Thank you very much.

Thank you.