Deborah S. Butera - Chief Compliance Officer, Senior Vice President, General Counsel and Secretary Eric M. DeMarco - Chief Executive Officer, President and Director Deanna Hom Lund - Chief Financial Officer and Executive Vice President.

Michael Crawford - B. Riley Caris, Research Division Mark C. Jordan - Noble Financial Group, Inc., Research Division John Nelson Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division Sheila Kahyaoglu - Jefferies LLC, Research Division.

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Second Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary. Please proceed..

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Second Quarter Conference Call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer.

Before we begin the substance of today's call, I'd like to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos corporate website at www.kratosdefense.com.

It is also available on the SEC's website. Additionally, I'd like to remind our listeners that this conference call is open to the media, and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the company's website later today.

During this call, we will discuss some factors and matters that are likely to influence our business going forward.

Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance, and the potential impact of sequestration, federal government shutdowns and the constraints on the federal budget constitute forward-looking statements.

These forward-looking statements are subject to risks and uncertainties, including those found in the risk factors section of our annual report on Form 10-K and our quarterly reports on Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements.

We encourage all of our listeners to review our SEC filings, including our annual report on Form 10-K and any of our other SEC filings for a more complete description of these risks.

All forward-looking statements are qualified in their entirety by this cautionary statement and we undertake no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date hereof.

This conference call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G.

Certain of the information discussed, including adjusted EBITDA and the associated margin rates, pro forma EPS from continuing operations excluding restructuring and acquisition-related items and other; unused office space and other; amortization of purchased intangibles; stock compensation expense; contract design retrofit costs and other; loss on extinguishment of debt; using a cash tax rate; and using a statutory tax rate of 40% are considered non-GAAP financial measures.

Kratos believes this information is useful to investors, because it provides a basis for measuring the company's available capital resources, the actual and forecasted operating performance of the company's business and the company's cash flow, excluding extraordinary items and noncash items that would all normally be included in the most directly comparable measures calculated and presented in accordance with Generally Accepted Accounting Principles.

The company's management uses these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating the company's actual and forecasted operating performance, capital resources and cash flow.

Non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information presented in compliance with GAAP and non-GAAP financial measures as reported by the company may not be comparable to similarly titled amounts reported by other companies.

As appropriate, the most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the company's website. In today's call, Mr.

DeMarco will discuss our financial and operational results for the second quarter of 2014. He will then turn the call over to Ms. Lund to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business and then we will open the call up to your questions.

With that said, it is my pleasure to turn the call over to Mr. DeMarco..

Thank you, Deborah, and good afternoon. In Q2, we continue to make progress on our strategic focus areas and in transitioning the company to more product-centric business, where Kratos technology and intellectual property provides us a differentiator in an extremely competitive environment.

Since we last updated you, there have been a number of positive developments with several major Kratos supported programs. These include, Boeing being awarded production of 21 EA-18Gs for the U.S. Navy and 12 for the Royal Australian Air Force. Sikorsky winning the presidential helicopter award for 21 aircraft.

Qatar announcing that they will be acquiring 10 Patriot batteries. Rate beyond resuming production of GMD warheads. Northrop received an award for 25 E2D advanced Hawkeyes.

Lockheed received an award for completion of two additional space-based infrared satellite missile warning satellites and Northrop being awarded production for additional APR-39 electronic warfare systems.

Additionally, the Navy successfully launched 2 Trident II D5 submarine launched ballistic missiles on a test, a Kratos ballistic missile target successfully supported a confidential mission and the Iron Dome system is performing extraordinarily well in Israel.

The President Obama last week signing and approving a $225 million emergency supplemental Iron Dome funding bill. In Q2, Kratos won a large production contract with a DoD customer with initial delivery scheduled to begin in the second half of this year, which was subsequently protested by a competitor.

This has prevented us from beginning work until the protest has resolved. There have also been a number of programs where Kratos products, solutions or IP are already designed in or have been selected, where we are accepting contract awards in Q2 that have been delayed until later this year, early '15.

These include in the satellite communications, software, target drone and BMD areas.

Also, a very large international missile system program where Kratos electronics and systems are designed into the missiles with the potential program valued to Kratos of tens of millions of dollars has had the systems acceptance flight tests delayed until the second half of this year.

We're also informed last week that our team Kratos was on, was not successful on a multi-year classified opportunity we're hopeful of winning. In Q2, our PSS business grew sequentially 30% from the first quarter.

As expected, new business starts occurred and projects were awarded including security deployments in the mass transportation, municipality, oil and gas, energy, education, healthcare and financial services market verticals.

With PSSs current backlog and record level bid pipeline we are expecting a strong second half of the year and in particular, the fourth quarter. And we are forecasting increasing EBITDA margins for this business in Q4 continuing into 2015, primarily through aggressive management of our vendor and supplier base.

We continue to make significant IR&D and other investments in the unmanned system, electronic warfare and satellite communication areas, primarily due to a number of large, new industry programs with the objective of significant and increased designed in positions for Kratos' products.

The number of new platform and program opportunities for Kratos has increased substantially over the past few months including in the EW, radar and missile systems areas, and then aircraft platform. All where we have the chance to be designed in, which we are pursuing.

As a result, our current expectation is that these elevated internal investments will continue through the third quarter of this year. In the Unmanned Systems area. During the second quarter, we achieved all expected contract milestones across each of our programs.

We had a number of successful flights with our high-performance aircraft, and we experienced no major flight anomalies. We continue to make progress on the largest current program opportunity in the company.

In aerial drone program, we are currently under contract on with the DoD customer, and we have a number of additional contractual milestone flights schedule later this year and into 2015.

Kratos' UCAS initiative also continues on track with our 3 UCAS or UTAP, Unmanned Tactical Aerial Platform aircraft currently in production, and flight test with our government-sponsored scheduled for Q3 next year. This month, we will be negotiating with the U.S.

DoD customer an approximate $70 million unmanned drone system order, which we expect to have under contract by the end of this fiscal year September 30.

We are also completing negotiations with an international customer for an initial order of approximately $30 million for unmanned drone systems, which we are hopeful we will have under contract by the end of this quarter, but this could slip into Q4 early '15.

We're also in discussions with this customer for a second TUAS order of similar size, which is expected to be awarded next year. Also, as I have mentioned previously, a certain U.S.

government agency has selected a Kratos high-performance UAS for a new government program with performance expected over the next few years, and we are still on track for Kratos UCAS or UTAP aircraft to be an important element of a certain U.S. government-sponsored war game at the end of this calendar year. And in the unmanned ground vehicle area.

We are working with the U.S. Army related to an initiative to retrofit a certain portion of its tactical vehicle fleet with robotic or unmanned systems, and we are working with the customer on unmanned robotic seaborne platforms.

We are making significant internal investment in the unmanned aerial ground and seaborne areas, and our entire unmanned strategy in both IR&D and CapEx, which are expected to continue for the balance of this year and throughout 2015.

If we are successful in the unmanned area, we believe that the program opportunities we have could truly transform our company a few years from now. Approximately 1 year ago, Vice Admiral Gerald Beaman joined Kratos as President of our UCAS division, and he and his team including Vice Admiral Mike Malone has made outstanding progress.

At the beginning of this month August, we combined our UCAS and our advanced drone, ground system, sea system, robotics and target systems businesses into a new unmanned systems division where Jerry will be President and responsible for all of Kratos' unmanned business.

We made the decision to combine our unmanned businesses to address important customer, resource, technical and strategic considerations or requirements, and I ask all of you to join me in congratulating Jerry in his new position as President of Kratos' Unmanned Vehicle division. Industry wise. The U.S.

federal government, the government contracting in DoD environment remains challenging. Including delays with program starts and contract awards that I mentioned earlier.

Aggressive competition, routing protest being made by companies losing competitive procurements, customer funding issues, and the threat of another continuing resolution later this year.

However, we continue to forecast the second half of 2014 to be stronger than the first half with the fourth quarter being particularly strong based on our current backlog and expected timing of future awards, program execution, schedule product shipments in higher-margin product and software sales.

Important second half 2014 programs for Kratos are expected to include SEWIP, Patriot, EA-18G, Trident, APR-39, P-8, E2D, two large mass transit authority security system deployments, a large confidential production program for a certain U.S. government agency, and a specialized software implementation with a certain U.S. government agency.

We are optimistic about our company's future prospects with Kratos products or IP designed in on a significant number of strategic national security programs, many of which are expected to go into production in the next few years.

And we are particularly excited about our electronic products division opportunities in the EW, EA, radar, missile system and aircraft areas. The company is highly diversified with approximately 35% to 40% of our business being either commercial or international customer sourced, and our critical infrastructure security business is growing strongly.

Accordingly, we will continue to remain focused internally with the intention of aggressively managing our cost structure and PSSs supply chain in particular over the second half of the year, and focusing on continuing to reduce our accounts receivable DSOs in generating cash.

Deanna?.

Thank you, Eric. Good afternoon.

Our second quarter revenues of $229.3 million came in at the midpoint of our expected range with strong organic growth and our specialized modular systems business unit and in our PSS segment, which generated a combined sequential growth of $23.3 million from the first quarter, offset partially by reductions in certain of our services business.

Sequentially, revenues increased from 14.6% or from $200.1 million in the first quarter to $229.3 million in the second quarter.

On a year-over-year basis, revenues decreased 2.5% from $235.2 million in the second quarter of 2013, a growth in our specialized modular systems and PSS businesses of $20.9 million, offset by continued contraction of our legacy Government Services business, which declined $5.1 million from $21.9 million in the second quarter of '13 to $16.8 million in the second quarter of 2014.

Revenues were also impacted by the expected reduction in 2 sizable satellite communications projects as the scope of work completed as natural contract lifecycle, transitioning from production to sustainment resulting in net aggregate with reduced revenues of $4.4 million, and the reduction of shipments of certain of our electronic warfare and aerial part of products.

The growth in our PSS segment includes the delivery of sophisticated security related communications equipment aggregate $15 million, which we expect will be subsequently integrated into our customer command and control network.

In Q2, PSS EBITDA margins were lower-than-expected due in part to the mix of revenues, which was more product-focused during the quarter, which typically generates lower margins compared to systems integration, which typically generate higher margins.

In addition, EBITDA margins during the quarter were impacted by certain new program starts, which have lower initial margins and due to cost growth on 2 other deployments. However, as Eric previously mentioned, we have initiated an aggressive internal vendor and supplier cost reduction plan, which is expected to have a meaningful impact by Q4.

The growth in our specialized modular systems business was primarily driven by growth of approximately $11.8 million in our service combatant and missile system, radar system and hardened facility product lines.

Operationally, we continue to remain focused on cost reductions and efficiencies and in the second quarter, we reduced our headcount by an additional 98 personnel or 2.7% of our total workforce, down to a total headcount at quarter-end of 3,598. This compares to a headcount of 3,815 at the end of 2013.

We've reduced headcount each quarter for the last 4 quarters by 2% to 3%, as we right size the business to address the current industry environment and customer requirements. This cost rationalization will be a continuous process, which will also help to enhance operating efficiencies while improving our operating margins.

As a result, in the second quarter, we have recorded charges related to excess capacity, costs in part by the delays in procurements and awards, severance and contract design retrofit costs. For instance, included in the second quarter is a charge of $700,000 related to the cost of personnel reduction actions and excess capacity charges.

A charge of $500,000, primarily related to legacy related contract costs for certain of our new aerial target platforms, and a certain legacy modular systems contract.

Our adjusted EBITDA of $19.5 million for the second quarter is from continuing operations and excludes the charges highlighted, as well as a loss of $39.1 million on the extinguishment of debt related to the refinancing of our 10% senior notes that we completed in May.

As expected, our adjusted EBITDA was impacted by an accelerated level of R&D investments during the second quarter, which were $5.9 million or 2.6% of revenues. As a reminder, our normal R&D spend as a percentage of revenues has been historically at 1.7% to 2% of revenues.

On a GAAP basis, net loss for the second quarter was $49.9 million, which included the loss on extinguishment of debt of $39.1 million, a loss from discontinued operations of $100,000, $5.7 million of expense related to amortization of intangible assets, $2.9 million of noncash stock compensation expense, as well as a $1.6 million income tax expense.

We continue to believe that it's also meaningful to provide our earnings per share excluding the amortization expenses, stock compensation expenses and reflecting our cash pay income tax and excluding nonrecurring items.

On a pro forma basis, adjusted EPS from continuing operations excluding the amortization, stock compensation expense, restructuring-related items, excluding the contract design retrofit costs and the loss on extinguishment of debt, utilizing the estimated average quarterly cash pay income tax provision of approximately $600,000 with adjusted EPS of $0.02 per share for the quarter.

Moving to the balance sheet and liquidity. Our cash balance was $26.9 million at June 29, plus $5.1 million in restricted cash.

Cash flow from operations for the second quarter was a use of $12 million, resulting primarily from the $29.2 million sequential increase in revenues from the first quarter, which resulted in an increase to the company's receivable balance of $18.3 million despite our day sales outstanding or DSOs decreasing 7 days from 113 at the end of the first quarter to 106 days at the end of the second quarter.

Our DSOs are impacted by the timing of achievement and/or completion of certain contractual billing milestone. As our revenue mix is more products focused now, our DSOs fluctuate due to the timing of shipments and satisfaction of billing and contractual milestones.

We believe that certain of these more sizable milestone events will be achieved later in 2014 and some into 2015 resulting in a reduction of DSOs and generation of cash flows from working capital.

Our contract mix for the second quarter was 83% of revenues generated from firm fixed-price contracts, 13% on costs plus contracts and 4% on time and material.

Revenues generated from contracts with the federal government were approximately 54%, including revenues generated from contracts with the DoD of 44%, and revenues generated from contracts with non-DOD federal government agencies of 10%.

We also generated 6% of our revenues from state and local governments, 28% from commercial customers and 12% from foreign customers. With our aggregate non-DOD revenues comprising 46% of our total revenues. Backlog at quarter end was $1,000,000,046 with $557 million funded. Backlog at the end of the first quarter was $1,000,000,071.

Now moving on to our financial guidance. The company today affirmed its guidance within its previously communicated range of full year fiscal 2014 financial guidance of revenues of $920 million to $960 million, adjusted EBITDA of $93 million to $100 million, and adjusted free cash flow of $25 million to $40 million.

Revenues and adjusted EBITDA are expected to increase and ramp throughout 2014 due primarily to the timing of expected deliveries and shipments in the second half of the year with an expected favorable mix of higher margin product shipments and software sales expected and EBITDA is also expected to be impacted by internally funded investments by the company with IR&D now expected to continue at higher than normal levels as a percentage of revenues for the third quarter.

As the company pursues large new opportunities in the UAS, electronic warfare, radar signal processing and satellite communications areas. We expect PSS to continue to grow organically year-over-year compared to 2013 performance.

However, we do not currently expect sequential quarter growth in the Q2 levels due to the sizable delivery of the communications equipment during the quarter. As we have not had a conference call since the refinancing was completed, we thought we'd take the opportunity now to go over more of the details at this time.

From an interest expense perspective for 2014, the approximate savings resulting from the refinance is approximately $8.5 million after taking into consideration the $1.5 million monthly savings of interests resulting from the 3% reduction in rate for 6.5 month since the refi closed at May 15, less the increase in interest on the borrowing we made of $41 million on our line of credit to fund a portion of the refi.

Our attention is to pay down the borrowings on the revolver with cash generated from operations.

However, as we had to pay double interest for the 1 month period from May 15 when we closed the new bond deal, and we were paying interest on the new bonds and the old bonds through June 13, when be closed the process to redeem the old bonds, we pay double interest of $5 million.

Therefore for 2014, the net cash interest savings is approximately $4.5 million computed as $8.5 million net P&L interest savings plus $1 million of the amortization deferred financing costs, but less $5 million of the duplicate interest grew that 1 month.

On an annual basis, beginning in 2015, Kratos' yearly cash interest payments due as a result of the refinancing has been reduced by approximately $18.75 million as compared to our previous 10% notes.

As Eric mentioned earlier, we are continuing to make investments from an IR&D and CapEx perspective and certain of our electronic product, satellite communications and Unmanned Systems businesses. Specifically, we are making additional investments in our Unmanned Systems business where we are pursuing 2 business models.

The first model in which we are selling our unmanned aircraft, and the second model in which we are building aircraft to be used for presentation purposes to customers, whereby we are paid with the presentation and, if and when the customer shoot down our targets.

Our total estimated CapEx for 2014 has increased from our initial estimate of $13 million to $16 million, to $18 million to $19 million with the most significant increase being in our Unmanned business, as we will be manufacturing an increased number of aircraft for expected customer presentation requirements.

Our estimated free cash flow guidance is comprised of the $93 million to $100 million of estimated adjusted EBITDA, less cash interest of $58 million, which includes the duplicate 1 month interest payment of $5 million, less capital expenditures of $18 million to $19 million, less estimated cash taxes of $2.5 million to $3 million and assuming a reduction of DSOs of approximately 4 to 8 days or $10 million to $20 million cash generation.

As a reminder, we reduce DSOs by 7 days from 113 to 106 days in the second quarter. We expect that as we achieve certain contractual milestones, that we will be able to continue reducing our DSOs in the second half of 2014.

Also, as our Modular Systems business had record bookings in Q2, and we are building large complex missile system, surface combatant and hardened facility structures and systems, we expect a number of these milestones will be achieved for this business in the fourth quarter.

But it is expected to cause a near-term use of working capital in the third quarter due to these milestones.

We are increasing our adjusted EPS estimates to $0.20 to $0.35, reflecting earnings from continuing operations, excluding the amortization costs, excluding stock-compensation costs, excluding the loss on extinguishment of debt, excluding contract design retrofit costs and restructuring and acquisition-related items, computed using a cash tax pay rate of that $2.5 million to $3 million for the year.

Our adjusted EPS estimates were positively impacted by the reduced interest expense resulting from the refinance. I would now turn the call back over to Eric for closing remarks..

Great. Thank you, Deanna. We'll turn it over to the operator to take questions at this time..

[Operator Instructions] Our first question will be coming from the line of Mike Crawford from B. Riley & Company..

Regarding the one push out on the test schedule for unmanned system, I think it's targets, when is that now to be scheduled again and this is for a potential $70 million program did you say?.

No. So the $70 million, Mike, is we're in negotiations right now with the U.S. government customer. The customer has indicated to us they want the negotiations complete and the contract led by the end of federal fiscal year, September 30. And we're pretty confident right now we'll have that done. So that's an order with the U.S.

government customer approximately $70 million. The test that I mentioned that was pushed out has to do with a weapon system, a missile system where our electronic products are actually on the tactical missile themselves. The test have been scheduled for the first half of this year.

It is now scheduled, I know the date, I can't give it exactly, it is scheduled for the second half of this year, this program, because we're actually on the tactical missiles is worth north -- is worth north of $50 million to us..

Okay. And then the large target opportunity that could be 50 to 100 units a year..

Yes, on that one, Mike, we've had successful flights in the quarter. We have additional flights scheduled for the second half of the year and into '15. As a reminder, we're under contract. The contract that we're under has -- goes all the way from development through LRIP through initial production orders.

And that's the contract that we're operating under..

Okay.

I know it's a bit early, but given all these moving parts, the record bookings in modular and in the PSS business is offset by the headwinds, is it fair -- how would you characterize the probability of having higher revenue in 2015 versus 2014?.

That is going to depend solely on right now, if there's another continuing resolution on how long it goes..

So if a resolution -- if we get a budget in place say by December 31?.

Then as we sit right now '15's revenues should be higher than 2014's..

Our next question will be coming from the line of Mark Jordan from Noble Financial..

Eric, you've mentioned both the $70 million drone contract that is should be signed by the end of the quarter and an international relationship of $30 million you're building.

What would be the -- when would the production start under those orders and what would be the duration of the delivery schedule?.

Okay. On the first one, Mark, right now, it's forecast that the production would begin at the beginning of '15. And it would go for somewhere between 30 and 36 months. On the $30 million one, that production would begin immediately and it would be complete 12 to 15 months..

And then the follow-on would just literally follow-on after 15 months?.

It's possible the follow-on could be let during the production of the first one..

Okay.

In the last call, you've talked with some potential optimism about the continuous monitoring IDIQ that you had received, could you give us an update of what success or what you see happening in that area?.

Right. Mark, there are 4 task orders out right now under that program. But the $100 million to $200 million each level. We are -- whereof those 4, we are going after all 4. They're in our area. 2 of them are right in the sweet spot. This program if you have been following it, things have been delayed, it's been pushed.

There are 2 reasons I haven't talked about this much, because things have been delayed and pushed, and these are binary events. Within the next 6 months, we hit 1 or 2 of these, it's a binary event for us and it's a step function. So they're out. We'll be bidding on them over the next several months.

They're currently scheduled to be awarded later this year. That may be delayed and it's very possible that once they're awarded, the losing bidders could protest them..

Probably. Likely..

Exactly. I know it's a terrible situation. But that's the current status. Mark, as I mentioned in the prepared remarks. It's very frustrating. We won a large production quick burn program with one of the 4 branches in Q2. It was protested. And now, it's all gummed up. We're under a stop work until it's resolved..

Was that the series of modular systems that you....

No, no, everyone that we announced -- to everyone that we announced was not protested and we're moving forward. The one I'm talking about, we did not announce because right after we got it, it was protested..

Okay..

We never announced it..

Of your Q3 and Q4 revenues what is in funded backlog right now?.

We have $557 million funded backlog right now, Mark..

And I said, what percent of those projected revenues for the quarter are currently funded?.

It is roughly about half of that is expected to be burned in the rest of the year..

Okay. And then I guess, while you've talked about 2015 in aggregate being better assuming we get off a budget around year-end.

I think it's though clear that at least the early quarters of 2015, given the awards that you've received and the push outs that you've had that would fall from '14 into '15, should mean that you would have a better start to 2015 than you suffered through this year?.

To some degree. So some of the awards, depending awards that Eric was talking about, it depends on the type of revenue recognition we have on each of those programs. Some of them are on units of delivery. So it's, revenue is recorded as the shipments are made and others are on percent complete. So it's both..

Okay. And finally, for me. The Unmanned Vehicle division that you set up.

Does that -- the business that went into that, was that CEI and Microsystems?.

Those were 2 of them. Yes..

Are there other distinct units that we would know that went into?.

There are. A significant portion of our electronic products division supports that division. And a portion of our modular systems division, we built ground control structures and flight and transport UAV transport structures and they support it as well. Those are in separate divisions..

Our next question will be coming from the line of John Nelson from State of Wisconsin Investment Board..

Eric, can you tell us anything more about the internal UCAS program as far as progress and potential without divulging anything that's classified?.

We are working with a U.S. government agency that is our sponsor. We are -- we have begun production on 3 aircraft. One is a ground test aircraft and 2 will be flight aircrafts. These are derivatives of one of our high-performance unmanned aerial drone systems. So these are not new drawing board aircraft. These are aircraft that exists. They fly.

There's a logistics tail that's in place. There's an inventory that's in place. There's a spare parts inventory that's in place. So it's not an on the -- off the join board type of a thing. We expect to have those 3, the first plane the ground test aircraft is supposed to come off the line first.

The 2 combat aircraft are supposed to come off the line next by the end of the year or early next year. Then we are going to be integrating specialized systems including some weapon systems into them and we are currently working with our sponsor relative to the range, time for Q3 of next year for the flights.

We are looking -- we compare this to our target drone business. If we could ultimately, annually, sell 50 of these a year at $2 million or $3 million each, that would be fantastic..

Okay. Very good.

Is it possible or I should say is it possible that your -- as you run through this program and reach several of your -- if you reach your internal milestones, that the sponsor comes in and picks up more or all of the funding of the program? Is that anything in the -- is there anything in the plan for that or is that not possible?.

That's a very important question you've asked, John. We're funding it because and so we own the IP and we own the data rights to the aircraft. It is possible that the sponsor may pick up certain additional elements, but it will not be all. So long that we need to ensure that we own the data rights to the aircraft..

Okay. Good. Second question is related.

Can you tell us anything more about the sea-based program and its potential?.

Yes. The sea-based program is related to command and control systems and I call them little robots that are -- were sea-based, small sea-based boats, I think fast attack boats are being converted to unmanned systems. The larger opportunity, John, is the conversion that's being initiated by the army and I also believe by the Marines.

I believe it's up to 1/3 of their tactical, the Army's tactical wheeled fleet where they'll be converted from manned to either robotic or unmanned or dual source where you would put a kit or I reckon this type to a terminator. You put a terminator in the driver seat and the terminator drives it.

That we are under contract, we have a contract, we are under contract. We are working with an agency on this. This if it goes into production, and we are involved in that, this could be tens of millions of dollars to us..

Okay. And last question is related to the PSS division had lower margins and estimated, earlier estimated due to the mix with the more hardware.

Going forward, should we expect that to bounce up and down depending on the mix, or is there any kind of a shift that's occurring where hardware is going to be a bigger component of the overall contracted sale?.

It's in the near-term, John, and when I say the near-term, I'm going to say the next 2, 3 or 4 quarters. It will probably remain somewhat bumpy, because the system integration work is much higher margin when we actually system integrate the security products that we deploy.

Now I believe approximately 13% or 14% of the business today is a recurring revenue stream where once we have deployed the security systems, we get a multi-year contract to maintain it or run it. That part of the business is obviously, much higher margin.

That part of the business we had targeted a couple years ago to get up to 20%, which would have significantly lifted the entire businesses margins. However, over the last few years, I think 2 years ago, this business did like 1 85, last year, it did like 2 10 and this year we're looking at like 2 25 or 2 30.

So the deployment part is growing and the maintenance and the annuity stream hasn't been able to catch up to it, you understand what I'm saying? So over the longer term....

It's a catch up..

That's -- I would love to say we're going to continue to grow the business like we did last year at 13% or 15% then we wouldn't catch up. But I have to be realistic, unless you get bigger it's harder to continue to grow at 13% on 2 30 or 2 50.

So as that slows down and as we catch up on these big deployments, hopefully that maintenance stream will stuck in our target is to get it, up to 20% over time. That will lift the margins of the entire business..

[Operator Instructions] Our next question will be coming from the line of Michael Ciarmoli from KeyBanc..

Eric, could you just elaborate a little bit, the unmanned opportunities you mentioned obviously, you're spending the R&D money to own the intellectual property. What other, I mean, are there any other defense contractors from your perspective that have similar capabilities.

I mean, I almost look at unmanned right now maybe more on the commercial side as, it's almost becoming commoditized products. Everyone's got some sort of unmanned capability.

Can you maybe elaborate in terms of what is so proprietary about the systems you're developing and why has the customer selected you guys?.

Sure. It starts back with the company we acquired several years ago now, which was CEI. And back at that time, the big high-performance aerial, unmanned aerial drone or target drone player was Northrop Grumman.

And CEI made the decision and we knew them, because as you recall, Herley built the electronics and the avionics in the ground control stations that fly their planes, which is one of the reasons we acquired them. They made the decision to go to a composite aircraft versus an aluminum or steel aircraft.

And to invest their own money, so not take the government money, when the government solicitation came out. And they won.

They won that procurement with the -- they won a procurement with the Air Force, they won a procurement with the Navy, we've now -- we're in negotiations with the Army and in the current financial environment, especially over the past several years, companies would have to make a significant investment to get into this area.

In the current environment, Michael, the government is moving more towards, they want to own the IP. The reason the government wants to own the IP is because if the government pays for the development either directly or now they're even trying -- they're looking at through the G&A rates.

So if you incur IR&D and you put it in your G&A rates, and that G&A is paid by the government, they come knocking. If the government owns the IP, they take the design and then they'll bid it for production. And they'll put it out to bid. So why do I believe we're sitting where we are today. It's a number of factors. After 9/11, the U.S.

national security position went almost primarily from strategic warfare to asymmetric warfare and terrorist warfare. Somewhere over 90% of all the aerial drones in our inventory today are propeller planes. They're tactical. They're small.

Many of most of them, probably 80% or 90% of that, 90% are handheld and they were designed to -- for asymmetric warfare, fighting terrorists, boots on the ground, et cetera. And there was easy money there, and I'm not saying that is detrimental in anyway and that's for a lot of companies, they focus because there was easy money there.

We focused on high-performance aircraft that can fly in contested environments. And now there's a pivot going on. And there's a shift and we're seeing it in world events or some people are doing it reluctantly, but it's happening.

Where we're going from asymmetric warfare to nation-state warfare where the country's is getting ready to take on, a peer or near peer adversary. And that will be a denied environment or a contested environment, and this is why there's the UCLAS program that Boeing and Northrop and Lockheed and General Atomics are bidding on.

A very sophisticated unmanned aircraft to fly in fully contested airspace. So it's been a con versions of items that is why we believe we're positioned where we are today, and taking these existing target drones, which as I mentioned before, they actually fly. They're in inventory. There's logistics tail. There's spare parts.

All that cost is already incurred. It dramatically reduces the cost of turning in into a tactical vehicle..

Okay, that's fair. That's helpful. About 2 other quick ones. I believe somewhat asked on the continuous monitoring contracts. How about the other big one you've got last year. I think, it was -- maybe you got another one this year, the SeaPort-e contract.

Can you maybe give as an update as to what's happening there?.

Yes. We were -- we're not allowed to announce everything. But that is a very important contract for us and we're doing weapon systems work, directed energy systems work, rail gun work underneath that vehicle..

Can you give us a magnitude of what that would....

Several -- okay, so historically we have done hundreds of millions of dollars of work under that vehicle. We do several tens of millions of dollars of work under that vehicle annually and that number we expect to increase. It is increasing at a certain area that we're in.

Because we are, as you know, from the announcement, we're under every element we won, every element of that vehicle..

So it sounds like you are taking some share there on the contract on a go-forward basis?.

Yes. I -- taking some share. We are winning work in new areas..

Okay. Okay. And then just the last one for me. Missile defense, you mentioned Iron Dome it's obviously, front and center on the news, the ground base mid-course program had a successful test. I mean do you see increasing foreign military sales helping out your business and helping to accelerate top line growth.

I mean, how do you view the opportunity for FMS sales?.

I believe based on the current environment, and saying that the 2 big production programs on the drone side we're working on going to LRIP either late next year or into '16, and we're not going to production after that, that our FMS and our International business is definitely going to increase.

And it's going to increase in missile systems and the electronics that go on the missile systems. It's going to increase in the radars. The electronics that go on the radars. The ground equipment, the command-and-control ground equipment and the radar ground equipment. We just received an extremely large Patriot order.

And Patriot is, if you look at the Patriot OEM, they're looking at a significant international opportunities. We think that that's going to continue to grow for us, and it will probably continue to be a bigger piece over the next couple of years..

Our next question comes from the line of Sheila Kahyaoglu from Jefferies..

I just wanted to follow-up. I know the quarter was modestly disappointing from a top line perspective, but it declined only 2% year-over-year. Are you seeing some of your businesses starting to trough.

Could you maybe comment a little bit about that?.

Well frankly for me, it maybe disappointing for you, Sheila, but for me we hit -- I think we're square in the middle of our range. So it was on track from my perspective.

I -- we saw our business -- other than our traditional Government Services business, which is in the low price technically acceptable round and which has been contracted, which has been contracted in the last few years. I believe you can't say everything, but the business trough in Q1, it troughed in Q1 because in 2013 we had no defense budget.

We had 2, 3 months continuing resolutions and the government shut blah blah blah. We got the defense budget signed at the beginning of this year. Our -- very importantly, our LTM book-to-bill ratio was back to 1.0 to 1. That's outstanding considering you go back a few of those quarters and the LTM period was going on.

We not just in the numbers, but we can feel the business, it's solidifying and it's gaining traction, borrowing something very unforeseen. The second half will definitely be much stronger than the first half.

I went through a number of OEM contract awards that all are awarded in the second quarter, every one of those Kratos builds product that supports them. So there was a big award let of what 10 major programs in Q2. So it's a -- right now, it continues to feel better than it did in Q1 and much better than it did in '13..

Right. So sales just start growing in Q3 per your guidance.

And I guess, I know may be too early to start think about 2015 top line, but if we think about just the contract delays that you had in this quarter, and assume that they don't happen in '14, and the 2 potential unmanned orders that you have that are $70 million and $30 million, we could see potentially government solutions grow 5% to 10% next year is that an accurate way to think about it?.

I'm not going to knock those two. It's too soon and there's an election coming up in November, and I'm -- 1 quarter at a time..

Okay. And then just on, again on GS in terms of profitability it's been swinging around.

Is there anything we should be thinking about for the second half?.

For the second half that in the fourth right now, based on the programs that we're on, I think that the internal investments, the R&D and some of the other internal investments are going to come down, which is going to directly increase EBITDA. That's something I -- we see happening.

We've been making a significant investment to get on, you know all these programs, you know them all. We've been making a significant investment to get on all of these. And if things work out, these are going to be really, really good for us 2, 3 years from now..

Understood. And then I guess just one clean up, I might have missed it.

The corporate expense, that was mainly the refinancing uptick and the restructuring, or am I not getting that correctly?.

Which line item are you referring to, Sheila?.

Just the corporate income line, within this on the segment line, on the segment base, the $3.6 million..

Yes, so those are costs that are not allocable as far as corporate overhead costs. So this corporate office here and some of those costs that are not allocable to from a division perspective..

But should we see that tick down back to the $1.5 million to $2 million run rate or is it $3-plus million?.

There are some increases in our SG&A from a corporate perspective that will unfortunately continue.

So compliance costs in general so it's an IT security perspective cyber, protecting the company from cyber attacks as you can imagine with the kind of work we do, the kind of systems and platforms and that we are on, we are a big target, if you will, from a cyber attack perspective.

So we have increased our cyber security efforts, and that we don't see those costs going down unfortunately. And the overall compliance costs have increased as a result of just the regulatory environment that we're living in..

And at this time, I'm not showing any further questions. I would now like to turn the call back over to Eric DeMarco for any closing remarks..

Great. Thank you very much, all, for joining us. And our current plan is to -- the next communication will be related to our third quarter release. Thank you, all..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a good day..