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

Good afternoon, everyone. Happy to be welcoming our next presenter out of the Aerospace and Defense Group, which is Kratos. And we have with us here from the company, CEO, Eric DeMarco; CFO, Deanna Lund. Eric, Deanna, thanks so much for being with us.

Good afternoon. Thank you for having us.

Great to see you. Eric, I have a bunch of questions to get into here, but maybe just to set the stage, if you just want to give a 90-second overview of who Kratos is, where you sit in the market just to set the stage here.

Kratos is a technology company serving the national security, the defense and certain commercial markets. We're product- and technology-based. The vast majority of our contractual revenue, both on the military and the commercial side of our products. Our strategy is to make the internal investments to be first to market with low-cost disruptive systems that are relevant, that meet requirements or needs of the customers, and we've positioned ourselves very nicely with the recent contract wins over the past few years for sustained organic growth. We just came off a 10% organic growth quarter. We're projecting that for the foreseeable future year-over-year based on the successful execution by the team of the strategy.

Excellent. You referred to yourself there as a technology company. You've made that reference more lately than you used to. Why is that?

Because our primary offerings in our biggest business, for example, Space and Satellite Communications, we, over the last several years, have developed a software-based virtualized command and control and telemetry tracking and control system. And from hardware to software, the legacy command and control systems are primarily hardware-based. We've converted those to software. Now we're moving on to modems. So that's an example of a true technological shift from previous technology to new technology. Another area, in the drone area, we are the leading provider of high-performance jet drone aircraft, both in the target area that represent adversarial threats and on the tactical side. This is a significant step forward in technology. Our tactical jet drones are the first of their type in their class in the world. And the third example I'll give is in the propulsion system and the engine system. We have developed and we're under contract now and designed in on multiple platforms, next-generation turbojet and turbofan engines for powered munitions, cruise missiles, drones and certain hypersonic platforms. Again, a significant technological jump from where things were previously. We funded the majority of these on our own with internally funded R&D. So we own the intellectual property. We didn't include the money, the investments in our G&A rates. So the government can't make claims on it, which is very similar or analogous to a commercial technology model.

Okay. Tactical unmanned has been, sort of, the main area of the business in terms of opportunity for forward growth, although a lot's happening in the other segment and in the space business. But maybe just kind of update us in tactical unmanned specifically, what are the main programs that you're now most focused on that are most likely to become real revenue contributors for you over time? And which ones give you confidence in the near-term outlook versus maybe a little bit longer dated?

So in the tactical drone area, heretofore, the vast majority of our work on our revenue have been under S&T, Science and Technology, or RDT&E, Research, Development and Technology programs. One of the more notable ones was the Skyborg program, which was an artificial intelligence program. It used one of our most high-profile drones, the Valkyrie, to test out and demonstrate augmented autonomy or artificial intelligence, if you will. Another program that we were on is the low-cost attributable demonstrator program for low-cost drones. Again, the Valkyrie was the flagship there, and we did multiple different types of demonstration flights with the Valkyrie. Those were both Air Force programs. Both of those now have folded under a new classified umbrella of drone programs that the Air Force is talking about that we're unable to comment on based on its folded under it. In the other areas, the United States Marine Corps recently acquired some Valkyries. They've recently come out and they've said their initial or primary mission is going to be in the electromagnetic warfare, electronic warfare spectrum. And we are expecting another Marine Corps contract on it before the end of this year for a few tens of millions of dollars. So we see this moving forward with the marines expeditionary warfare initiatives. As you know, our drone aircraft are runway independent. They're launched off of rail. So this is very similar to the marine manned aircraft initiatives in the Harrier type or the F-35C class that are runway independent or jump jet. And we're working with some other customers that we can't get into yet. Similar in the RDT&E test and evaluation area. Now to wrap that up, the most recent budget came out, the '24 request, for example, the Air Force has over $6 billion in that budget for the 5-year period for drones. The Navy recently came out and they envisioned 50% or 60% of the air wing to be jet drones in the future. And the momentum is building for jet drones as force multipliers, keep manned and womaned piloted aircraft out of harm's way. And the funding based on the fight up and the budgetary documents are starting to indicate the money is being put where the Pentagon's intentions are.

Okay. A lot of the signals have been positive in terms of that funding number you just alluded to. Just direct clear statements from members of Congress, members of the Pentagon that make decisions on what they want in fleet. But as you alluded to, you've had these programs that have had name changes and timing changes and now have been consolidated under this different umbrella. Why has that happened? I mean if they want this product, if the product gives them the capability and the value that they are looking for, that they've said they want and need, I guess, why are they not just buying it? And why are there these continuous revisions to the program definitions?

Right. I don't know, but my opinion is that what we are doing with unmanned jet drone aircraft, this is brand new. This is not an F-35 replacing an F-15 or F-16. This is not a jet drone replacing a propeller reaper drone that's designed to kill terrorists. These are drones that are designed to survive an anti-access area denied environments. They're stealth, they have significant unfueled ranges up to 3,000 miles that's been disclosed, all internal weapons. This is a brand-new platform for a brand-new paradigm. It's not replacing something. And so I believe the government customer is working to understand how to best employ these, how to best missionize them, what types of operations to use them in because it's the first time. And then you bring in things like commlinks, communication links, satellite communication links, inertial navigation systems, augmented autonomy, artificial intelligence. There's a lot that goes into these. And my personal opinion is the Pentagon, the branches are working their way through the way to field this brand new paradigm of weapon system.

That makes sense. I mean our world sometimes thinks in shorter time horizons maybe than that world. And so if it's brand new, and there's a lot of optionality in terms of what the aircraft can do, it sounds like they're just, sort of, taking time to define exactly what they want before they buy it and field it.

Yes. And I'm glad you phrased it that way because in legacy or historical military or Pentagon time lines, they are moving at light speed with tactical drones. This is a light speed. The Valkyrie first flew in 2019, and here we are in 2023. And I just mentioned some of the budgetary numbers that are out there in multiple billions of dollars relative to drones. So yes, it's definitely slow from Wall Street standpoint. It's obviously slow from my standpoint, I have ants in my pants, but it's, I think, actually very quick for Pentagon time.

Okay. And Valkyrie has been the most high profile for you. There's a lot of discussion from the Air Force and others about desire to have Loyal Wingman. They're talking about having Loyal Wingman on pretty much every major manned aircraft platform at some point in the future. Should we think about your tactical unmanned efforts at this point as largely having folded into Valkyrie? Or are there still other completely different capabilities within tactical unmanned, other aircraft types that would be part of the $6 billion or that are still big opportunities for you?

Yes. There are others. So something that we can talk about here is our AirWolf for our tactical fire jet drone. And so if you Google that, you will say that's also runway-independent. It's launched off a pneumatic launcher, so they can be launched rapidly in salvos. It's a smaller jet drone, but it's -- think of the Valkyrie -- [indiscernible] of Valkyrie to a long-range strike aircraft. The tactical fire jet is a fighter. It can pull an incredible amount of Gs. It's visibility, both visibly in other ways, is incredibly low. Its range is less, but it's very potent and very lethal and it's designed also for a one-way trip that it doesn't have to come back. And we are under contract with that with certain entities, and that would be an ideal type of a platform for, say, what's going on in Europe or what might happen over in the Pacific. Okay. So that's one example. There are some others, but that's probably the one that the public investor will be hearing or reading the most about in the coming months.

Okay. Let's maybe pivot to some of the drivers in KGS. Maybe I'll ask you just to describe what you see as the biggest opportunities in your space business because it sounds like there's been a few that have kind of rapidly evolved recently.

Right. The space business is -- the industry right now is incredible. The technology advances in both launch systems to put up cost effectively, LEO, MEO, and GEOs, the cost points have come down incredibly. The technology -- Moore's Law -- smaller, faster, quicker, more power, less space, is showing itself in spades in low earth orbit satellites and mid-earth orbit satellites. And then on the military side, there's the threat against our space assets. So the disaggregation, we're putting up lots and lots of space assets. So you can't target one exquisite and take out a significant amount of capability. It's the macro backdrop that is driving our ground equipment. Space assets are no good unless they can communicate with the ground. Someone say, well, they have optical links between each other. Sure. But at some point, they're going to come down to the ground. That's where Kratos is. I put out some statistic at the earnings call a few weeks ago that at the end of last year, there were like 6,000 satellites in orbit. By the end of the decade, they're supposed to be 100,000. Let's say that's up 30%. There are 70,000 up there. The bottom line is the number of space vehicles going up is incredible. That means the demand for the ground equipment is going to be equally incredible, and we're the industry leader in the ground equipment. Then you add on top of that that we are first to market with virtualized, software-based command and control, TT&C and modem, first to market, which has enabled us to win 3 large programs, 2 of which that we can talk about. One of them was with Intelsat, the largest commercial operator in the world. We're on the ground. If you want to see an interesting video, go to Intelsat's website and pull up the video they've put up on Kratos' software-defined ground equipment. So we're the backbone for their LEOs, MEOs, and GEOs. On the military side, so you can see there's market acceptance on both with this new product. We have a partner called BlueHalo. There's a program called SCAR. It's related to the space control network. I can't get into too much about it. You can Google it and see what it's about. Our initial piece is about $160 million for software-defined ground command and control and communication systems. So there's the backdrop for the industry, and there are 2 of the large programs that we've won that very recently that are a key part of the growth for the business.

Okay. You've referenced hypersonics as a potential growth area as well. It's obviously a huge priority within the DoD. There's been acceleration of timelines there, which to your point earlier, is uncommon. Tell us about what Kratos does in hypersonics and what the opportunities are there for you.

So in the hypersonic area, there are only 2 or 3 companies in the United States -- Kratos being one of them -- that has the capability with our own rocket systems and vehicles to put something in the right place at the right time at the right speed, including hypersonic speeds. We have been doing hypersonic-related launches for many, many years. So our programs are high fire, high cause, fast. They weren't in vogue until recently with what Russia and China have come out with, but we've been involved in them. Now we know what our adversary is doing. So we have recently won 2 major programs with our partner, Dynetics. And we're involved in the hardware and the vehicle side. One of them is called Mayhem. I can't get into what that is. You can Google it and see what's said about that publicly out there. And the other one is called MACH-TB. And both of these are right in the sweet spot of the hypersonic initiatives by the Department of Defense and the funding that is coming. I mentioned on the earnings call a week or so ago that our launch manifest launches we're going to do under contract over the next 24 months is at an all-time high. I expect that to continue to grow because the only way the U.S. is going to exceed our adversaries with hypersonic weapon systems is test and evaluation, and testing has to increase, and the funding is there for testing, and that is an area that Kratos is one of the gold standards in.

Okay. You referenced Dynetics. You have a few different things going on with Dynetics, and there's sort of all moving around a little bit. Does the changes at -- or do the changes at Leidos impact that at all? Or it's just kind of full steam ahead?

Right. So as you're alluding to, a couple of years ago, Dynetics was acquired by Leidos. And we have an outstanding relationship with Leidos. We have had an outstanding relationship with Roger Krone, who recently retired. We have an outstanding relationship, I do with Tom Bell, the new CEO, who came in from Rolls-Royce because, as you know, Kratos is on the B-52 re-engine program, one of our biggest programs with Rolls-Royce. So I know Tom very well. Based on what I know -- I have not spoken to him since he took over. But based on what I know, I don't -- I've not heard of any changes in the strategic thesis of Leidos from moving from a services company more toward a product and technology company like Kratos, which big step they took via the acquisition of Dynetics.

Okay. It seems like most of the companies in that arena are talking about more product versus service. Does that create more longer-term competition in the product markets or not really for you?

No. I'm smiling because you're right, the services companies are all trying now to get into products and technology. They're doing it because the services business is all commoditized. It's all a commodity. It's low price technically acceptable. The contract docks, the RFPs and solicitations may say this is best value. They're not. It's low price technically acceptable. So the service guys and gals are trying to move into the product business. It's not easy. We started that initiation in 2010 or '11. Here we are in '23. So it's taken a decade for us to get to where we are. So I'm not...

That's your heritage as well.

Yes. That is, that's Deanna and my heritage as well from the TITAN Corporation. Exactly. So I'm not concerned competitively at all with any of the service companies transitioning.

Sure. And maybe kind of last big piece in KGS is your ISR business. It's another high priority growth area within the budget. Tell us what you do there and what the growth potential is there.

Right. So our C5ISR business, it's going to be probably one of the strongest growers in Kratos for the next several years, primarily because of the [ FTC ] combat systems. The biggest -- one of the biggest programs we have is our partner, and one of our best strategic partners is Northrop Grumman. We are building a significant amount of the ground transport equipment for the Sentinel GBSD ICBMs and the warheads and other aspects. We have the past performance quals with Minuteman. We are under a several hundred million dollar development contract right now that's ramping. I understand looking at the budgetary documents production now, LRIP is supposed to begin in 2026. We would expect to get our contract in 2026. This will be a multi-several hundred million dollar program that's just starting for Kratos, and this will be one of our biggest growth drivers. Another program I'd like to mention because it was just announced that's going into full rate production as IBCS, the Integrated Battle Command System. Our partner is Northrop and we're building the ground equipment for that. And I believe the initial contract they just got is $5 billion or $6 billion. There are many others that are happening. And the primary reason this is happening is what's been going on over in the Ukraine with Russia, the strategic recapitalization of weapon systems. And we are one of the last of only 2 companies that I believe have the qualifications to build the ground equipment for missile systems, radars, hypersonic systems and command centers.

Northrop has referenced small unmanned as a potential growth area. But it's not exactly clear what they're working on. Part of the challenge you faced in some of these timelines is that they're the larger established prime contractors within the defense world that are also attempting to participate in a lot of the demand here. Does it make sense to have more partnerships with the larger companies where you have the first-mover advantage in the product, you've invested in the product and you can sell it through their apparatus to the DoD on a faster timeline?

The answer to that question is yes. We will do what's right for the business, the company and the shareholders. And if that means that Kratos is the prime, we'll be the prime. If that means that it makes more sense for Kratos to partner with a company like a Northrop or Lockheed Martin, absolutely, we will partner with them for the exact reasons you just said.

Hiring has been a constraint for everyone. I think you've referenced recently that, that's loosening up for you a bit. What are you seeing on that front?

Yes. We have seen some improvement, specifically in the first quarter. We just got some data yesterday through month end March -- month end April, and we're still seeing that trend, but we are making net hires in certain key areas. We have JobRack's open across all the business units. But we are seeing a better trend most recently. And I think that's attributable to some of the job market layoffs in certain industries as well as the economy.

Are they coming from tech? Or is it somewhere else within the national security industry?

So some are coming from tech, but I can give you -- there are 2 specific examples. One of the primes at a helicopter business unit just had a layoff of approximately 800 people. And one of the other defense companies in the drone area just had a layoff, we understand, of nearly 1,000 people in the high-end drone area. And so these are very relatively recently, and this has provided Kratos an incredible opportunity to get some very qualified and experienced guys and gals, not only in the engineering area, but also in the fluid and system dynamics areas.

Okay. If somebody who was working in the helicopter business at a large prime can easily translate that skill set into your company?

Oh, yes, especially on the manufacturing side. If they've been working with composites or unique materials and metals, and they have clearances in the aeronautical engineer or system engineering area, absolutely.

Okay. That's interesting. Okay. Deanna, I want to dive into some more financial questions. But before I do that line, just quickly pause and see if anybody in the group here has a question for team. Yes, back there.