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

Okay. Hello and good morning, everybody. This is Noah Poponak here from Goldman aerospace and defense equity research. We'll be starting our next presentation here from Kratos. And with us on the line from the company is CEO Eric DeMarco; and CFO Deanna Lund. So Eric and Deanna, I can't see you, but it's nice to hear from you. And thanks so much for joining us today.

Good morning.

Good morning.

Eric, maybe to just jump right in, in listening to the last earnings call, I've been rereading the transcript, it kind of jumped out at me that you seem to be referring to at least one but it seemed like multiple new program opportunities or just the new things that are coming your way outside of what we've already been discussing on a path here. And I wondered if you could just elaborate on are these things you expected and are just part of the longer-term maturation of your products and the programs you thought they would go into and the volumes you've talked about potentially getting to longer term? Or are these just kind of, to a degree, coming out -- not coming out of nowhere, but are these truly new and incremental to where you thought the business would go?

They are part of the strategic vision that we have had from the beginning. However, the opportunity set appears to be accelerating and moving to the left, not to the right. And for example, the Navy coming out and saying over the next few years, they envision 40% of their wings to have unmanned drones, including potential missile-carrying drones. The Air Force reiterating that they're looking for initial operating capability for the Skyborg family of drones no later than 2023. The Air Force coming out on Gremlins and saying we have an additional concept of operations for Gremlins now which includes rearming the Gremlins in-flight inside the mother aircraft carrier ship. And there are 3 additional new opportunities that have come out that appear to be gaining traction. And those are MQ-Next, OBSS and ISR-Next, all of which appear to require attributable low-cost jet drones like the one Kratos has.

Okay. So this is sort of -- these new programs you're referring to go, some of which you were saying you even can't really talk about yet, these are within the natural evolution of what you expected for the business. But they're concrete milestones and customer confidence in the product, and maybe are happening a little faster than you had thought at this point?

Absolutely, they are. And the Air Force announcing the day that we earned on the first Skyborg flight with our Mako drones. The Air Force announcing our drones have been communicating and coordinating with aerial tankers in a protective defensive role flying with them. These are data points that we were aware of, and I'm very pleased that the customer is now coming out and making public just some of these. There are several others, to give the investing community the comfort traction has occurred and opportunities are accelerating.

Now last year with the pandemic and COVID protocols closing [ranges], you had some delays, and I think some things took longer than you expected. And we've heard some other companies referencing just the change in administration causing some disruption in the flow of order activity. What are you seeing in that general bucket of just kind of cadence of action? I mean year-to-date, has anything moved slower than you thought?

Since around February of this year, nothing has moved slower than we thought. Things are -- opportunities, exercises, demonstrations on the weapons ranges are where we thought they would be. And in some cases, they're occurring at a faster operational tempo than we had initially thought. And so we appear, knock on wood, to be through the COVID-19 impacts and DoD restrictions, travel restrictions, distancing restrictions and range restrictions. We seem to be clear of those right now. On the administration side, we have seen no negative impact at all. And as I tried to articulate last week with some of the appointees, like Michael Brown who is replacing Ellen Lord, and obviously Secretary of Defense Austin, the Deputy Secretary of Defense, and then very publicly coming out and saying -- Kathleen Hicks coming out and saying, I'm paraphrasing here, we need to eliminate, reduce, retire the legacy systems to free up procurement dollars and sustainment dollars for new technology systems to address the peer threat, including drones. That is just great from our perspective.

Yes, okay. That's really interesting. I mean I'm just curious how much that has surprised you. I mean there was a general concern that this administration might reduce the defense budget. There was some concern with some of the prior Pentagon leadership being pretty supportive of your efforts, and then if there was going to be a transition. And it sounds like so far this administration, they're not growing the total defense budget rapidly, but they've maintained it at a level maybe a little higher than the industry expected. And then the notion of faster to market, modernizing the military, lower-cost systems, things that have long been discussed but are kind of hard to change and cutting through all the bureaucracy, I suppose, are maybe actually happening. Is that what we're seeing? And how much is that surprising?

So on the surprise, we were very pleasantly surprised that the skinny Biden national security and defense budget submission, that was basically flat, just slightly under the Trump administration's 2022 budget. That was very pleasantly surprising to us. Very, very pleasantly surprising to us is when Secretary of Defense Austin and the Deputy Secretary of Defense came out and put color around it saying what I alluded to before, that they are going to push very hard to retire legacy systems that would not be optimal in a peer or near-peer conflict. And then they went on and talked about drones, artificial intelligence, space and satellite communications, et cetera. So that was very pleasing for us. Now just as recently as yesterday we, including myself, at a meeting at the Pentagon, and we are extremely encouraged that the leadership recognizes the threat. They recognize the technological advances and the speed of technological advance that the threat is making. And now I'm going to paraphrase. They understand and recognize that small and midsize companies like Kratos can be very, very innovative and rapidly innovative in deploying things. And they're looking to us in certain areas, including our core business areas to do that. So there's going to be some tension here, no question, between I'll say the established defense industrial primes, and the I'll say the smaller and more innovative up and coming product and system companies, for obvious reasons. But I think the tide is changing, and it needs to because we can't have an infinite defense budget. I mean it's $750 billion. Is it going to be $1 trillion? I don't know. But affordability is key, and Kratos equals affordability.

Okay. Yes, it's pretty interesting. Now in the past, there have been times where, well I mean through your business, it's long been the case that you're in a lot of the right areas where the budget is going, where the priorities are going, where the threat is going and that you can help on military. But we've also seen actual, hard and fast, real deal orders for your products sometimes take longer than expected or not come through quite how we thought they would. So while these top-down developments are positives and even these new programs are positives, what are we looking for on the order front? I mean for which products under which programs can investors expect to see actual orders through the rest of this year and into next year for Kratos? You can tack upon that.

Yes. So to date, we have received orders for drones -- a number of drones, including Valkyries under the Skyborg program, the LCASD program and the LCAS program. To date we have. We've also received orders for the Mako tactical drone, which the Air Force released information on as recently as last week under a services model where they're Kratos-owned assets and the customers are utilizing them under a services model. We envision between now and the end of the year, under all or some of those programs I just mentioned and potentially to others that I cannot mention, one of which the customer mentioned a few weeks ago, but I'm not -- I'm still -- I cannot talk about it, but that name is out there, the name of that program. I believe between now and the end of this year, we are going to receive additional orders, either sales of the drones or in a services model for the drones, for Valkyries and for Makos. And then I'm going to say going into next year, into early next year, I see actual sale orders for Valkyries accelerating once the 2022 budget is in place after an expected continuing resolution.

Why does a services model make sense?

I believe the services model makes sense for the customer, and of course it makes sense for us and our shareholders, because it enables them to utilize different drones. And as you know, Kratos is the only company that we're aware of that has any jet drones, 4 variants, in this class line today. It enables them to, my words now, plug and play with our open architecture, various different payloads first EOIRs, weapon systems as they are studying and trying to determine what the best application and concept of operations are. And then once they have concluded that is when they will acquire them for their inventory. So I think even though it's not the big bang that I would have hoped for initially, I think it's actually very smart what the customer is doing. And if you recall, the capital assets we've built both in the Valkyrie and in the Mako UTAP-22, and we've also now built some capital asset Gremlins that Kratos owns, that has turned out to be very tactically competitively differentiating for us. Because it enables the customer set to utilize them and determine what they want, what configuration they want them in, before they buy them off of the running production line.

But doesn't it suggest a risk of a slower time to market here, if the customer needs time with the product to figure out what they even want it for? I mean I thought it was more along the lines of the customer had multiple potential applications for your product, knew what those were, needed the product, wanted it quickly, and [ would fill it. ]

I agree with everything you've said, and I know that it's definitely frustrating for us and me personally the rate of moving forward here. But the government has been moving -- our customers, I think have been moving incredibly fast relative to their history. I mean we received Skyborg orders, and we've already flown and demonstrated under the Skyborg program. We received some other orders on programs, one of which I mentioned relative to the aerial refuelers the government announced last week. There are a number of other things going on that aren't public yet. Hopefully, the government -- the customer is going to announce them in the next few weeks or months. That will show that the pace of acceptance by the customer of our products is accelerating. And this is the path that it has turned into, and this is the one that we're going to be supplying to the government. This is just the way it's evolved.

Okay. That makes sense. Maybe just give us a little bit more detailed update on Gremlins. That had some flight time line delays with access to ranges. Where does that stand? And what are the upcoming milestones now?

Yes. So from our perspective, Gremlins is about 1 year behind where we would have anticipated it to be as we sit here today, primarily related to as you just said, Noah, of the COVID-19 impact on ranges, et cetera. There are the final flights in the series with DARPA are coming up now in the next couple of few months, including hopefully a successful capture in-flight with our partner, our prime partner, Dynetics. And after that, we are hopeful as the services have sent that this will -- Gremlins will transition, transfer from the research agency to the services. The customer set has now said they anticipate Gremlins transitioning to multiple services in addition to the Air Force, which is great. And we know a lot about that, what's going on there, which is one of the reasons we're so confident. We just can't say anything until the other services say something. And as I mentioned at the beginning of our chat here, the Air Force 3 weeks ago came out and they said, "We envision another concept of operations for the Gremlins once it transitions, which includes rearming in the air." And then I think probably one of the most important data points that has come out in the past 3 weeks on something obviously we're aware of, and I'm going to paraphrase here. But there's an article out there where the Air Force did an interview and talked about very recent war games out in the Pacific in the South China sea. In the interview, they specifically said one of the reasons why this war game was successful for the United States was the utilization of the Kratos Valkyries and the Kratos Gremlins in the mission set. Which I don't see a better -- I can't see a better data point for the investing community to see that this is happening for Gremlins, this is happening for Valkyrie. They're being included in war games. The customer is publicly announcing what's going on. You tie that into the other data point too and I have been chatting about here. And I hope people can see it's no longer a question of if, it's when. And the when is coming.

Okay. Yes, that's really interesting. And so how would you, at this point, rank the most opportunistic products in tactical unmanned after Valkyrie and Gremlins? That rank order seems to move around with as the opportunity -- as the program opportunities and the customer priorities move around a little bit. How would you rank that at this point?

Yes. So as you mentioned, Valkyrie is clearly #1, and we expect some big things in Valkyrie between now and the end of the year, Q1. Gremlin has -- excuse me, Mako UTAP-22 has moved up rapidly in the past 3 months. And just by the publicly available data points, including the one a little while ago, that the Makos have been mounted on F-15 hard points in a loyal wingman configuration. So I think Mako is going to be an important contributor next year. Gremlins is going to be. The only reason I don't say -- I'm not pounding the table on the time line. Once we successfully, with Dynetics, demonstrate that capture carry in the next couple of 3 months, then I'm going to be very, very bullish on Gremlins once it transitions. After that, the next big one is Thanatos. Thanatos is in development, as you know. And as we talked about on the call, it's becoming more and more important financially for us this year and next year. And if the schedule holds, and it appears it's going to, first flight for this system will be in '23, early '23. And it appears that the total addressable market for that system is at least equal Valkyrie's for that mission set for Thanatos. And so that's how we see it right now. Air Wolf is coming. We have had a number of successful flights, no anomalies, since the beginning of the year. However, these -- I'm going to use the word the sporty flights are coming up in the second half of the year. Once we successfully demonstrate those, then I'll be more confident on that. But there are some challenges -- challenging demonstration flights coming up for Air Wolf.

Okay. Got it. And in the target drone business, are there new program opportunities there or new places to gain share? Or should we think of that as a steady -- relatively steady growth business.

I would look at it as relatively steady growth, okay? It's definitely for Kratos, it's going to continue to grow as we transition from low-rate initial production on a number of programs, for example SSAT with the Navy, and that goes into full-rate production. We have won a number of relatively large international opportunities, including a pretty big one, we're under -- we signed the contract. We're waiting for State Department approval. There is a new target drone opportunity coming called NGAT, Next Generation Aerial Target, that we feel we are very uniquely qualified for because we're the company that has the target drone flying today. And there is another opportunity, but for competitive reasons, I'm not going to get into here right now. But it's coming. It's going to come out between now and the end of the year. We're going to be bidding it. I'm not sure yet if we're going to be bidding it in the prime role, just based on the nature of it. But it appears it could be a significant opportunity for additional target drone for this unique customer.

Okay. Great. Maybe update us on the turbine opportunity that you've been speaking to, when can we expect to see more progress on that front?

Yes. So as you know, the turbine area we're looking for, these are turbojets and turbofans for cruise missiles, powered munitions and jet drones, including the jet drones in Kratos' class. We have 4 engines under development; 3 of them are running as we speak. One of them, which is related to a classified program and a classified vehicle, is -- we're going to be shipping those out for integration into the vehicle in the next few months. And then flight testing will begin on this vehicle. If that goes well and according to plan, it is very possible that one could go into initial limited production early next year. And I'm very hopeful for this because this program is an important program, and the program has legs. And so technologically, if our system does what it's supposed to do, we are looking at this very similar to our first Mako drone flights in 2015 when we flew with the Harrier. Once we did that in 2016, because we had established credibility, we successfully won every tactical drone solicitation in 2016. I'm looking for the same thing with our engine business. If we're successful on this one I'm talking about here, I believe that's going to give us credibility -- even more credibility with the customer. Then maybe things start to accelerate for us in '22 and '23. And so with that, I'm hopeful for meaningful production revenue here in 2023.

Okay. Continue transitioning into the other side of the house, you talked about your space and satcom business having this kind of 10% organic revenue growth base case, and then there being kind of some binary opportunities to potentially be higher than that. Can you walk us through the top key elements that build up to that base case? And then where do we stand on these binary opportunities?

Yes. So on the base case programs, overhead persistent infrared where we've won, we're on that. And that program is ramping for us, and that's going to become more meaningful second half of this year, 2022, 2023. HBTSS, we're on HBTSS. That is going to obviously ramp with what's going on in the hypersonic and ballistic tracking space sensor networks. That's going to be an important contributor '22, '23. TITAN, we are on TITAN, and TITAN is going to become more important for us next year in 2022 and 2023. And then there are literally just under 2 handfuls of classified programs we have won on the ground. This is all on the ground, of course, all of which are ramping. And that's the primary reason we're making the significant capital investment this year in SCIF, in secure manufacturing and production facilities, for our space business because of these TITAN -- these classified programs we've won. All of that makes up the base case where we're very comfortable with 10% year-over-year organic growth. And we won the programs. We can see it. The only thing that I could see causing any of the hiccups in there are continuing resolutions that delay increased year-over-year funding until the budget is in place. Now on the binary stuff, there are a handful of opportunities, 40 million, 50 million, up to 100 million each that we are bidding on that include our new open space software-defined modem and signal processing technology and/or the antenna technology we acquired with the ASC Signal acquisition next year, where we can now deliver an entire system. These are both commercial and security, national security related. I'd say defense, but some are other type of security agency related. And these are binary. If we win, it's a $40 million, $50 million, $60 million build of the system over a 3-year period, and then a space situational awareness or space domain awareness [ tail ] after that. If we are successful on some of those, and we're going to know in the next -- on the first and probably in the next couple 3 months here, that would have a little step function of growth along the way to that 10% base.

Interesting. Okay. And then within the C5ISR piece of KGS, you have sort of that part of the market seems to be growing a little faster than the budget. And then I guess you're layering GBSD on top of that. And then it sounds like maybe there's some other opportunities beyond that. So do I have that correct? Maybe kind of shape the GBSD profile for Kratos? And then what are some of these other opportunities in that part of the business?

Okay. So on GBSD, obviously we're a sub to our prime partner, Northrop Grumman, who has turned out to be just an incredible partner to us, Northrop. And Lockheed is also an incredible Kratos partner. On GBSD, I think we announced that the first phase of the program that we're on, similar to Northrop, is the development for the ground equipment to move, trans -- to move, mobiley, the missiles and the warheads. And that's I think we announced it was just under $200 million, something like that for the development phase. The production phase is not announced yet. I will not get ahead of Northrop. However, and in our industry development phases are typically 4, 5 or 6 -- excuse me, production. The production phases are typically 4, 5 or 6x as large as the development piece. As I mentioned, our development piece is about just under $200 million. So GBSD is a key part of our growth. It is ramping. And it's going to ramp rapidly as we support Northrop. We are absolutely committed to hit Northrop's commitments to the government, and we're going to do that. If we do that, it's going to be a very rapid grower. Elsewhere in C5ISR especially the fifth C, the combat systems, there are a number of programs we have won with prime. We've won. The prime has not announced that we're on the team yet. One of these, the initial piece for us is over $100 million. There's a second one, the initial piece for us is over $80 million. Those are the phase 1s. Think of the missile defense area in the radar area. Missile defense and radars is where this is all happening, including relative to hypersonic systems. And we are a critical subsystem provider to the big primes, Lockheed, Northrop, those guys on these systems. And hopefully, the primes are going to mention that we're involved with them. So then we can say yes we're in fact on this, and this is what it means to us.

Okay. Got it. And remind me the training piece that's declining, how big is that? And I guess what's the quarterly cadence of that as you move through 2021?

Deanna, I'll let you deal with this one.

Yes, I'll take that one, Eric. So last year in 2020, it contributed about 35 million. And with the bridge contract that we have that will be winding up the end of this month, it's about 14 million this year. So it's about a reduction of 21 million in 2021. So the last contribution will be in this quarter.

So 2Q will have a full contribution or a partial?

It will have a partial contribution.

Okay. And then 3Q, 4Q, we'll see the full year-over-year...

That's correct. Correct.

And then first half 2022, we'll see that versus first half 2021?

Correct, yes. So the first half of '22, it will be down about 14 million, 15 million.

Okay. Got it. So Eric and Deanna, you've mentioned -- if I have understood it correctly, I believe you have said that you expect the organic revenue growth rate, so the year-over-year percentage change, in 2022 to accelerate versus 2021. Therefore, the rate of growth is going to be a higher rate of growth in '22 versus '21. Is that correct?

Correct.

Yes.

And would that be in both businesses? I mean unmanned having grown in the 30s percent rate in the first quarter, I guess the guidance kind of -- you kind of have to back into it, but the guidance kind of implies that holds that through the year. Actually, it probably would be faster in the fourth quarter. KGS looks fairly flattish, with training offsetting some other growth areas. So is it just both segments are stepping up with the culmination of all the programs we've gone through here? Or is there something outsized that I'm missing?

Both segments are stepping up, with the biggest drivers being tactical drones GBSD, space and satellite, including OPIR and HBTSS. And there are 2 other -- we were talking about C5ISR, C5, the fifth C programs that we've won, that are going to be contributing significantly next year and in '23.

Okay. Got it. Deanna, digging into the margins a little bit, and I guess we can talk cash flow as well, you all had flagged some investments this year. The margins in the first quarter were pretty good relative to last year or just what the run rate has been. Are those investments really primarily capital and not R&D? Or do they come into the margins later in the year? How should we be thinking about those progressing through the year?

Sure. So from a cash flow perspective, so the investments that we talked about, it is a significant amount of capital of about 55 million to 60 million. The first quarter, which is just about 8 million to 9 million. So the following 3 quarters, the capital expenditures will be much higher from a run rate perspective than the first quarter. There's also about 10 million of nonrecurring engineering related to our rocket business that will hit in the last 3 quarters. But that's primarily from a cash flow perspective, not as much from a P&L perspective. The investments from an R&D perspective, that should be about ratable. Each quarter, we've been running about 4% of revenue from an R&D perspective. And as a reminder, about 80% of our R&D is specifically related to our space and satellite business. The mix was favorable during the first quarter, just there was some fairly mature programs that contributed in the first quarter. So -- and we did see some leverage on our fixed operating costs. So that was favorable. As we go into the next couple of quarters, specifically the second quarter and then our guidance that we said, we are seeing some more development-type programs coming online. So a heavier mix of development-type programs versus mature programs, so that's what's impacting the margin. And then in the latter half of the year, we see some more favorable mix, specifically in our space business where some of the open space products that Eric is talking about that based on our -- the award schedules and execution schedules, we see that some of the margins lifting in the second half versus the first half.

Okay. But if I tag up to all the guidance ranges you've given, 2Q revenue and EBITDA, full year revenue and EBITDA, yes the margin stepped down sequentially in the second quarter, but they're not down year-over-year very much.

Correct.

And the full year is down, but not a lot.

Correct, yes.

Okay. And I mean if I look at sort of 2019, 2020 and 2021 average by segment, how should I think about how those margins -- the current margins compare to where you expect these businesses, each side of the business to be 3, 4 years down the road?

We would expect on -- as we get further out in the road, we would expect as we enter into production, either low-rate initial production. And then further in the full-rate production and out of development, we would expect to see the margins expand as well as they continue to leverage off of the fixed infrastructure costs.

Okay. Are the -- and the additional R&D and additional capital, do those both reverse in 2022? Or do they maybe linger into 2022?

The R&D will probably continue at that pace. But the capital, we expect to get back to more normalized levels probably in the 25 million to 30 million range, where this year it's closer to 60. Because we've got some additional capital related to the Valkyries that we're building as well as -- so that's approximately 25 million this year. And then the space capital that Eric mentioned specifically related to outfit our SCIF or secure facilities as well as continued build-out of our network, space situational awareness network, those are kind of onetime CapEx this year. And that's about 12 million to 15 million. So we would expect to be more at normalized levels after this year.

Okay. And you have a net cash position on the balance sheet. You did an equity deal to take you from a small leveraged position to a net cash position. Is that just how you feel the balance sheet needs to be managed for the time being, given both how you see it and maybe how the customer sees it from a -- just given the potential growth that may be in front of the company? Or is there another reason that you would need to maintain a net cash position on the balance sheet?

The reasons that you stated are clearly in the front of our minds to make sure any customers, if they have any concerns about our ability to be able to ramp up. Especially there are working capital requirements on large builds, especially with some of the bill of materials being, for instance, engines, which are typically 12 to 15 months of a long-lead material that we would need to have upfront capital to procure those upfront. So our position is to continue to keep that net cash position to be able to allay any type of concerns from customers, especially with larger awards and larger procurements.

Got it. Okay, well, with that, we're right up on the hour here. So we've used our allotted time. So I'll wrap up the session here. I'd like to thank you, Eric and Deanna, very much for being with us today. We really appreciate your time.

Sure. Thank you.

Thank you for having us. We appreciate it.

Okay. Have a great day, everyone. Thanks so much.

Thank you.