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

Mike Crawford - B. Riley & Co. LLC Mark Conrad Jordan - Noble Financial Capital Markets Tyler E. Hojo - Sidoti & Company, LLC John F. Nelson - State of Wisconsin Investment Board.

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Fourth Quarter 2014 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, today's 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. Ma'am you may begin..

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions fourth 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 shutdown 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 for the quarter ended December 28, 2014 included adjusted EBITDA and the associated margin rates, adjusted EPS from continuing operations, excluding restructuring and acquisition-related items and other; amortization of purchased intangibles; stock compensation expense; costs related to pending contract change orders and contract modification adjustment; non-cash impairment charges and cost on completed contracts 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 non-cash items that would 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 fourth 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.

one, a tactical UAS field opportunity; and the second, an Aerial Target Drone System opportunity. We are making significant investments in our Unmanned Systems business. We are seeing the results of these investments and we believe that we are positioning this business for sustained growth in this area beginning next year.

Related to the protests, all of the protest situations we discussed in our third quarter call have been successfully resolved in our favor, except one. The successful resolution of these was not unexpected as only 13% of all protests decided on the merits or actually decided in favor of the protester according to the GAO's most recent report.

Unfortunately, the still unresolved protest where Kratos was originally awarded a new approximate $50 million contract in Q3 of 2014, is now back in a re-procurement situation by the customer.

Accordingly, we have excluded this opportunity from our first half 2015 financial plan, with positive resolution expected hopefully in the second half of this year. Also recently, the 3DELRR contract, a large multi-billion dollar radar system upgrade program, was awarded to Raytheon, which award was subsequently protested by the non-winning bidders.

The Air Force has now announced that they will be reconsidering the bids and potential award of 3DELRR, which the Air Force is currently expecting to take approximately four months. 3DELRR is a major program Kratos expects to support in the future.

However, we have excluded this opportunity from our 2015 forecast due to the ongoing protest and program delay situation.

We have also excluded from our 2015 financial forecasts, a large, new Directed Energy opportunity we are pursuing and that we expect to win, and we will wait until the contract awards are finalized and any potential protest cleared before we incorporate these back into our forecast.

Moving on to our initial 2015 guidance; based on the factors we have discussed today, including the previously mentioned AFSAT, Patriot and HATS program award delays and related delivery schedules, our revised profitability and growth strategy for PSS, where PSS will be generating lower revenue going forward than previously expected as we focus on higher margin programs, the delay in the international Unmanned System opportunity I mentioned and the continuing protest situations, at this time, we are currently forecasting full year fiscal 2015 revenue and adjusted EBITDA to be approximately similar or slightly lower than 2014 with fiscal 2015 free cash flow exceeding 2014's.

For the first quarter of 2015, due to the temporary break in AFSAT and HATS program deliveries, the Patriot program deliveries which are scheduled to begin in Q2 and the planned future reduction in PSS revenue as a result of our change in strategy, we expect Kratos' Q1 to be the lowest of fiscal 2015 with revenue and EBITDA of approximately $180 million to $190 million and EBITDA of $10 million to $12 million.

We expect revenue and EBITDA to begin increasing sequentially in the second quarter as we begin deliveries and execution on AFSAT, Patriot, HATS and large also under contract Satellite Communications programs we were awarded in Q4 and as we realize the full effect of the cost-cutting actions we made in Q1.

We expect revenue and EBITDA to increase in Q3 driven by increased deliveries and execution on each of these under contract programs I just mentioned. And we currently expect Q4 revenue and EBITDA to approximate Q3's, bringing full year of 2015 revenue and adjusted EBITDA approximately at or slightly below 2014.

Important 2015 programs are expected to include AFSAT, Patriot, HATS, SEWIP, Barak, P-8, Aegis BMD, Trident II, EA-18G, certain Satellite Communication programs and certain Unmanned Drone System programs substantially all of which are currently under contract.

Lastly, Kratos' board of directors is continuing our previously announced business and strategic alternatives review which based on progress made to date, we expect to have initial results to report to you no later than the end of the second quarter of this year.

Also related to our strategic alternatives review and Kratos' insider trading window policy, at this time, Kratos' insiders are prohibited from buying or trading in Kratos' stock. With that, I'll turn it over to Deanna..

Thank you, Eric. Good afternoon. Our fourth quarter revenues of $221.5 million came in below our expected range due to delays in contract awards and shipments of Unmanned Targets to an international customer that are now expected to commence in Q2, which Eric mentioned earlier.

Shipments have hardened mobile tactical facilities in our Modular Systems business which are now expected to occur in Q2.

In addition, shortfalls in our Public Safety business resulting from the large national account delay in the deployment of new systems and to a lesser degree due to the change in focus to higher margins and forgoing lower – larger lower margin opportunities.

In the fourth quarter, we have begun to report two separate segments within our KGS businesses; one which includes the historical KGS businesses of our Electronic Products, Satellite Communications, Missile Defense Rocket Support and Modular Systems businesses; and a new separate segment representing our Unmanned Systems business.

We have begun to separately report our Unmanned Systems business as a separate segment due to the expected growth potential in the next several years for this business driven in part by the expected 2016 commencement of low rate initial production of our SSAT program, moving to full rate production thereafter, the expected acceleration of low rate initial production into 2016 on another Unmanned System program we're under contract on, and expect it to continue to progress with our UCAS initiative and other opportunities we are pursuing.

On a sequential basis, revenues increased for our KGS segment from $151.4 million to $159.3 million for Q4 over Q3.

The fourth quarter sequential increase of $7.9 million or 5.2% in our KGS segment was offset partially by a sequential quarter decrease of $1.8 million in our US segment from $22.9 million to $21.1 million, and a sequential decrease of $1.7 million in our PSS segment from $42.8 million to $41.1 million.

The US segment decrease was primarily due to the completion of AFSAT production Lot 10 deliveries in Q4, which Eric mentioned earlier, and we are now under contract for production Lots 11-13 which we will begin deliveries on Lot 11 later on in 2015.

As mentioned earlier, PSS revenue was down in Q4 in part as we began the transition to focusing on the higher profit margin opportunities.

As a large amount of PSS quarterly revenues are smaller programs that are booked and executed in a given quarter, which can present challenges in forecasting revenues, especially when larger contract awards, which typically provide more visibility due to the associated backlog, are delayed.

On a year-over-year basis, Kratos' revenues decreased 6% or $14.2 million from $235.7 million in the fourth quarter of 2013, with a year-over-year decrease in our PSS business of $14.5 million from $55.6 million to $41.1 million, primarily due to the delay of system deployments by a large national account mentioned earlier, as well as delays in other expected larger awards, a year-over-year decrease in our Unmanned Systems segment of $7.6 million from $28.7 million to $21.1 million, partially offset by an increase in our KGS segment of $7.9 million from $151.4 million to $159.3 million.

The year-over-year comparison for our KGS segment includes the following. Our Legacy Services business continued to decline due to competitive pricing pressures and commoditization, which decreased $5.7 million (sic) [$5.9 million] (24:16) from $19.4 million to $13.5 million.

The Legacy Services business revenues are approximately up slightly sequentially $100,000 from $13.4 million from the third quarter.

Revenues were also impacted by the expected reduction in two sizable Satellite Communications projects as the scope of work completed its natural contract lifecycle, transitioning from production to sustainment, resulting in net aggregate reduced revenues of $2.5 million.

The changes in our Unmanned Systems business was impacted by the reduction of shipments of certain of our Aerial Target products which has been impacted by the delays of certain expected awards of Unmanned Drone Systems for domestic and international customers and the completion of deliveries of the AFSAT production Lot 10 in Q4, which we mentioned earlier.

These year-over-year declines were offset partially by increases of work performed in our training business of $5.8 million, driven primarily by increased work in our Air Crew Trainer business, increased shipments in our specialized Modular Systems business of $4.4 million, driven by growth in our surface combatant, radar and missile system and hardened facility areas, and increased specialized work performed on government weapons ranges of $2.2 million.

As Eric had mentioned, we have made significant personnel reductions in the first quarter, which we should start seeing the full impact in the second quarter. In addition, we should also start seeing the impact of the cost negotiations with key suppliers that we have made in our PSS business.

Our adjusted EBITDA of $23 million for the fourth quarter is from continuing operations and excludes the following charges which have been reflected as adjustments since we either believe the items are non-operational and/or non-recurring in nature.

Acquisition and restructuring related items and other of $5 million, which includes employee termination and excess capacity costs of $700,000 in our US business as we continue to right-size the business; a $1 million net non-recurring credit related to the settlement of a litigation matter; $1.9 million of non-cash charges and cost primarily related to a write-down of the carrying value of inventory assets and certain receivables; and $3.4 million of costs related to pending customer change orders related to scope increases and additional work performed in our PSS business.

We have submitted or are in the process of submitting change orders for two sizable PSS projects, both of which have very recently been completed. We believe we will be successful in obtaining customer change orders to reimburse as per additional work we have performed at our customers' request based upon our historical experience.

However, for accounting purposes, we have recorded all the costs we have incurred on these two projects without reflecting any of the anticipated change orders we have submitted or are in the process of submitting, until actual receipt of this sign change orders.

As expected, our adjusted EBITDA was impacted by the continued increased IR&D investments during the fourth quarter, which were at $6 million or 2.7% of revenues.

On a GAAP basis, net loss for the fourth quarter was $2.2 million, which included $5.5 million of expense related to the amortization of intangible assets, a $3.8 million credit related to non-cash stock compensation expense, as well as a $1.4 million income tax provision. Moving to the balance sheet and liquidity.

Our cash balance was $34.7 million at December 28, plus $5.4 million in restricted cash. Cash flow from operations for the fourth quarter was a generation of $25.9 million resulting primarily from a reduction in DSOs from 107 days at the end of the third quarter to 102 days at the end of the fourth quarter.

As expected, the net working capital requirements in the third quarter primarily related to production of certain combatant hardened facilities were converted to cash as these sizeable milestone billings were collected in the fourth quarter.

As we have discussed previously, our DSOs can fluctuate due to milestones and shipments on our production type contracts and will likely continue to impact our DSOs and cash flows from operations in the future.

Our contract mix for the fourth quarter was 85% of revenues on fixed price contracts, 11% on cost-plus contracts and 4% in time-and-material contracts. Revenues generated from contracts with the Federal Government were approximately 62% including revenues generated from contracts with the DoD and non-DoD Federal Government agencies.

We also generated 5% of our revenues from state and local governments, 19% from commercial customers, and 14% from foreign customers with an aggregate non-DoD revenue comprising 38% of our total revenues. Backlog at quarter end was $1.1 billion with $662 million funded. Backlog at the end of Q3 was $1 billion.

Now, on to the financial guidance that we are providing at this time; as Eric stated, we are expecting FY 2015 revenues and EBITDA to be approximately at or slightly below FY 2014 levels, with stronger free cash flow reflecting a full year's impact of annual cash interest savings of over $18 million as a result of the refinancing.

EBITDA is expected to continue to be impacted by internally funded investments by the company, with IR&D and other investments now expected to continue at higher than normal levels as a percentage of revenues throughout the year as the company continues to pursue large new opportunities in the UAS, Electronic Warfare, Radar, Signal Processing and Satellite Communications areas.

As Eric mentioned earlier, we are continuing to make investments from IR&D and CapEx perspective in certain of our Electronic Products, Satellite Communications and Unmanned Systems businesses.

Our total estimated CapEx for 2015 is $15 million to $19 million, with the most significant investment being in our Unmanned business as we will be manufacturing an increased number of aircraft for expected customer presentation requirements and includes production of UCAS aircraft. I will now turn the call back over to Eric..

Great. Thank you, Deanna. Operator, we'll now open it up for questions..

Thank you. Our first question comes from Mike Crawford with B. Riley & Co. Your line is open..

Thank you. Thanks for giving all the color on the Unmanned Systems and breaking it out of Government Solutions.

Can you talk a little bit about what margin you might expect from that business as you enter full rate production on things like SSAT and Lot 10, 11, 12 – or – I'm sorry, Lot 11, 12, 13 of AFSAT as well as UCAS and whether that margin change is depending much on actual mix?.

Okay. First piece, on the new program on SSAT, under contract right now, we have two production options. They're both LRIP options.

On those LRIP options, the margin we expect to be similar to maybe slightly above what KGS is, and then after we get to LRIP and we get into full rate production and we're down a learning curve, we would expect them to increase from there.

What was the second part, Mike?.

So, that's interesting on SSAT.

And then what about if you are successful in your demonstration on Unmanned Combat System?.

We would hopefully expect those to be somewhat higher than that on those..

And just, let say, we're down the path at some point in the future without getting into a specific year, but let's say that business is running somewhere closer to, say, $200 million in revenue, is that something that could be high teen margin business or would it be less than that you think?.

It can be mid-teens to high teens at that revenue rate..

Okay, great. And then you mentioned the Lockheed and Northrop protest of Raytheon's 3DELRR win.

So, you're a Raytheon partner, are you partnered with the others as well?.

I'll answer that question, generally, Mike, because of the NDAs we're under. On most of the large procurements, our strategy, as we've talked about before, is we, our strategic partners with – strong partners with all of the OEMs, except BAE. We do not have a very strong position with BAE.

So our strategy is to have content or to be in a position – be positioned to have content with each team. And more often than not, the content position with one can be higher than the other. And that's typically our strategy.

So, if Raytheon is involved in a large program where Northrop is involved in a large program, we – or Boeing, we typically expect to participate in that because we have participated on their past programs and we have strategic relationships with them..

Okay. Thank you. Just one final question; on your strategic process, you seem confident in being able to discuss some progress in the second quarter on that.

Is that, do you think, limited to non-core businesses, such as maybe training, Modular Systems, PSS, or could it also include something more – that you would define as more core?.

Because of where we're at in this process right now, Mike, I really cannot say any more than I said in the prepared remarks..

Okay. Thank you very much..

Okay..

Thank you. Our next question comes from Mark Jordan with Noble Financial Group. Your line is open..

Hello? Hello?.

Hi, Mark..

Hello? Can you hear me?.

Somewhat. It's very staticky, sir..

I'm sorry. Could you talk a little bit about the UCAS market with regards to what other players in the marketplace may or may not be doing? I mean, this is a major opportunity. Some people have tremendous vested interest in things like Predator (36:18) platforms.

What are they doing to potentially compete with you, or are they being quiet at this point in time?.

I'll tell you what I know. What I know is that four of the biggest players; Boeing, Northrop, Lockheed and GA, are all focused on the UCLASS opportunity, which is going to be coming out in RFP very, very soon now. And so, on the UCLASS opportunity, that's where they have been focused.

There have been some RFIs that have come out primarily from DARPA, including very recently, on some other types of next-generation Unmanned Combat aircraft that we are pursuing, and I understand that certain of they are pursuing.

So, we obviously expect this to ultimately be very, very competitive, which is why it was so critical for us to maintain our intellectual property position on our aircraft for the niche area that we are going for.

And the niche area that we are going for, and when I say a niche, that sounds small, but for us, it's very, very big as we're a small company. Our understanding right now was we are the primary player there today, Mark..

Okay.

Of the $7.4 billion pipeline, what of that will – has been submitted or will be submitted within by mid-year of 2015 and how much of that do you expect to be awarded by the end of the current year?.

Right. Roughly, Mark, approximately $1.6 billion of that has already been submitted. It has been submitted already. I would imagine probably another $1.5 billion or so will be submitted between now and the end of the year, and then the balance of it waterfalls in 2016 and into 2017..

Do you have any guesstimate as to what amount of that $3.1 billion that you will have submitted to the government by the end of the year will actually be adjudicated?.

Mark, when I don't know something, I'll tell you. I don't know that off the top of my head. I do not know..

Okay. The Rail Gun, I thought I saw or read somewhere that there's now talk that that initiative may actually be deployed on a DDG-1000.

And the evolution of that from a – not a laboratory but from its development phase to actually being put to street (39:30) is that a positive event for you from a revenue standpoint as you've supported that program?.

Yes. What is happening there is very positive for us. We are involved in the Electromagnetic Rail Gun in several different areas under several different programs. So this is – this over time, as this continues to move forward, will become a significant program for us at various divisions throughout the company..

All right. Final question from me, the services revenues declined 6% sequentially, down at $91 million in the fourth quarter.

Given your comments, should we assume that that services line for the full year will be closer to kind of annualizing that fourth quarter run rate than what you had for the full year?.

Yes. So, Mark, this is Deanna. The way we actually dissect it is looking at – so what we report from on our earnings release with services is not necessarily our traditional services revenue because services that are wrapped with products are also included in that number.

So, what we look at more carefully is the actual traditional Legacy Services revenue which is at about a $13.5 million run rate per quarter. So, it's running just under $60 million currently. That's down from last year's annual run rate of about $85 million.

We did see sequentially from Q3 to Q4 that that $13.5 million was about the same as it was in the third quarter. So, we don't expect that to continue to decline at the rate that it has on a year-over-year basis, especially just given what we've seen in the most recent two quarters..

Okay. Thank you. One last question; you did note that the strategic review is ongoing.

Do you have a sense that of a timeframe at which it will – things will happen or it will be completed and I think will happen?.

Yes, sir. You may not have heard it, Mark, in our prepared remarks. We believe that before the end of the second quarter, we will be able to report on progress made..

Okay. Thank you very much..

Yes, sir..

Thank you. Our next question comes from Eric Sal with SunTrust (42:06). Your line is open..

Hey. Good afternoon. I see that you guys have changed the manner in which you're estimating guidance.

Should we see the current guidance as more conservative and achievable as we've seen in the past?.

We definitely, Eric (42:24), have – we have changed it because of what's been happening with the environment and what we envision is going to continue to happen with the environment. Our absolute plan is that this is a more conservative approach for us, yes..

Okay. Good.

And then given the lower Q1 guidance in EBITDA, should we – and slightly or close to slightly down over 2014, should we expect year-over-year growth in the back half?.

Oh, yes, sir. Yes, absolutely. A good portion of that, as I mentioned in the remarks, is under contract, and that's when the deliveries begin and start to ramp up..

And they can't be protested?.

We've won them..

Okay..

They cannot be protested..

Okay.

And that's offset by we're going to keep R&D higher?.

As Deanna mentioned, we're going to keep R&D higher, and we're going to keep some other investment areas higher, particularly in the Unmanned area..

And then what are the key drivers/press releases that could cause you to meet or beat it? And kind of laden in your answer assumptions on the budget, the size of the cost savings and then the potential for some of these protests to come back..

Right. So, I think the biggest question mark out there is October 1 of this year, Federal fiscal 2016 begins. And as we all know, there's a very large disconnect between the Pentagon and the President's request and what the Budget Control Act says and what sequestration, the law, says.

And so, we'll just have to see where all that plays out and what that does or does not mean come October 1. That is probably the largest question mark that is out there..

Would that impact 2015 or 2016?.

It depends. So, it's obviously in our fiscal 2015, and let's say for – I don't expect this, but let's say, for example, that there's not an agreement and the government shuts down again, but there's not an agreement and there's an extended continuing resolution. That should not impact us materially in 2015.

But if it were to go into Q1, it would impact us in 2016, which is very similar to what happened to us in 2014..

Okay. And, Deanna, you guys said that despite flat to slightly down revenue and EBITDA, that free cash flow is going to be up in 2014 (sic) [2015] (44:56). Two questions on that.

One, is that all due to the interest savings? And then secondly, what number are you guys using for 2014 free cash flow?.

So, our 2014 free cash flow is actually a use of $7.7 million. So, the comments that we made that we expect free cash flow to be greater in 2015, it is driven somewhat by the interest savings, as well as expectations from a working capital perspective..

And that 101 AR days, can we assume that you guys stick to that for the year, I mean just as you see it right now?.

So, we're actually at 102 days, and what I had mentioned in my prepared remarks is that because we are so product-centric now and delivery-based and shipment-based, those DSOs can vary from quarter-to-quarter as we saw during 2014, and that was something that we remark that we expect that type of variability in the future.

It is down from 107 days in the third quarter to 102 days in the fourth quarter, but there could continue to be variability just because of the way our shipments and milestone contractual billing terms are negotiated with our customers..

Because of the timing, you just don't know when exactly they come?.

Correct. Correct. Yes..

And then I know you can't say a ton about asset sales, but absent an asset sale, could you guys still pursue buying back bonds?.

Very candidly, we have not put any thought into that path at all right now..

You're focused on the asset sale?.

We are focused on executing the strategic alternatives review that our board has set for us..

And then finally, your change in strategy on PSS, does that change attractiveness to suitors?.

In my opinion, it definitely should because the margin and the liquidity presentation of the business has already begun to improve. However, hypothetically, there are some people that like lots of revenue growth and then they'll figure it out later, there are other people that like high margin revenue growth.

So, it would be hypothetically in the eye of the beholder. But this is the right – in our opinion, the right way to run the business, and that's what we're going to do..

And then I'm sorry I lied but just one more.

Do you guys disclose what that business did in profit, and then how big are these, the cost savings you guys are putting through?.

Yes. So we do disclose that, Eric (47:42). So, it's in our press release So, if you look at page two of our financial tables, the Public Safety business for 2014 full year generated revenue of $196.4 million in revenue and adjusted EBITDA of $7.1 million..

And then, do you have any – like how many people are you guys letting go? Is there any way to calculate what the cost savings would be going forward?.

As Eric had mentioned, he said that we have made over 100 head count reductions since the beginning of the year with a significant piece of those reductions related to the Public Safety business..

And is there any cash severance that will hit free cash flow, and then I guess that's in your free cash flow guidance. So....

Yes..

...it would be in that..

Yes..

All right. Hey, thanks a lot..

Sure..

Our next question comes from Tyler Hojo with Sidoti & Company. Your line is now open..

Yes. Hi, good evening. Just to kind of stick with Public Safety for a second. Get the strategy, get that it's going to be a headwind in terms of the top line in 2015.

I was just hoping that maybe you could quantify kind of how big of a headwind we're talking about as it relates to kind of the flat to slightly lower revenue guidance for the whole company..

I would look at it, Tyler, as a similar quarter to what we just clicked off in Q4..

Okay..

In that ballpark, maybe a little less because we initiated the plan of focusing on higher margin work there, so, maybe that, to a little less, is how I look at the run rate..

Okay. That's good.

And in light of kind of current run rate, could one assume that there are going to be additional cost savings actions taken in 2015?.

Absolutely..

Okay. Okay, got it. And then just in regards to the conversation around IR&D, it's going to be a headwind. I think it was like $6-point-something-million in Q4.

First, what was it for full year 2014, and how big of a headwind are we talking about for 2015?.

Yes. So, Tyler, for 2014, it was $23 million. It's been that the last three quarters have been about $6 million per quarter. That compares to 2013 at $21.5 million..

Okay.

And what are we talking about for 2015?.

We haven't given specific guidance on that, but I would say it would be in about that same ZIP Code..

Around the $23 million mark?.

Yes..

Yes..

Okay. So, just to dig into that a little bit more, we're talking about increasing spending on UCAS.

What's going down to kind of offset that?.

There is some reductions in some of our – in our Satellite business and a little bit in our Electronic Warfare business..

Okay. Fair enough..

Okay..

And then just on free cash flow....

Tyler, let me make another comment on it..

Sure..

In addition, importantly, because I see how you're trying to analyze this. In the Unmanned Systems business, in addition to the IR&D and the way you're framing that up as a headwind, there is also a significant amount of other costs that are not in IR&D that are related to this business, I think we're....

Okay..

For example, we have a number of executives, including on the consulting side, that are working with customers at very, very high levels.

Okay?.

Okay..

And in the overhead area, whenever we do test flights that we pay for, we have to rent the weapons range. We have to pay for the team to go out – our team to go out there and do it. Those costs always typically fall in cost of sales or overhead..

Okay..

In that line.

Like, for example, the demonstration flights that we're going to do in the fourth quarter of this year, okay?.

Yes..

That piece is not being sponsored. So, that piece, we will be paying for that to happen..

Okay, understood. And those expenses are fairly significant..

Yes, sir..

All right..

They're in the millions..

Okay. Very helpful. I appreciate that color, Eric..

Yes, sir..

And then just on free cash flow, I get improving and obviously really nice performance here in Q4, but improving on a full year basis on a negative number, I mean, can you give us a little bit more? I think in the first half of last year, you guys were talking about $25 million to, I think, $40 million in free cash flow.

Are we in that ZIP Code here for 2015, or any comments there, Eric, please?.

Tyler, this is Deanna..

Okay..

I would say our expectation is that it will be positive, and that's really what I'm limited to saying that since we did not provide that specific guidance in our prepared remarks..

Okay. But we are going to be free cash flow positive this year..

Correct..

Okay, got it. And last question from me. There's been a lot of talk from you guys just in regards to the impact from protests in 2014, and I guess it's nice to see them resolved.

But could you maybe just talk high level, like what was the sales impact in 2014? And in context with the impact in 2014, why wouldn't we be better in kind of the base business ex-Public Safety in 2015?.

Right. So, the impact for 2015 that we're going to get in 2015 that we did not get in 2014, think in the $15 million range..

Okay..

Okay? The one that is still unresolved, I believe, I think it's a four-year contract or a five-year contract. So, that's $10 million a year that – excuse me, $10 million a year to $12.5 million a year that we're still not getting because it's been protested.

Okay?.

Okay..

We've taken out this Directed Energy opportunity. I think that's another $40 million opportunity over a few years that we've excluded..

Okay..

So, there's an Electronic Warfare one program. I don't think I can mention the name of it. That's been protested. That's probably $3 million a year..

Okay..

So, it's – when you add them up, it has been significant..

And just rough order of magnitude, if you added up everything kind of you're expecting to not get in 2015, would it be kind of similar to what the impact was in 2014?.

Yes..

Okay. Very helpful. I'll hop back in the queue. I appreciate it..

Thank you..

Thank you. Our next question comes from John Nelson with State of Wisconsin. Your line is open..

Hi, Eric and Deanna. It's nice to hear I think a more positive tone coming from you two, than previous, the last few calls. And I mean, it sounds like the pipeline is quite exciting.

And for both of you, I'm curious as to what you think of the – if there's going to be much change in the new Defense Budget on anti-ballistic missile systems given the problems with Russia and Eastern Europe. And then whether or not there's a treaty with Iran that either way there becomes a greater focus again on anti-ballistic missile systems..

Right. John, thank for your initial comment on that. We have routinely said that we thought 2014, 2015 from an industry standpoint and for us would be the trough and that we would see us turning out of it in second half of 2015, 2016. And that is what we're seeing.

And we're seeing it in the orders, which is why our funded backlog has gone up so much and we're seeing it in the pipeline and the opportunities.

So, your sense of a little more confidence as we see us coming out of this in the second half of this year and growing from there as a number of these programs that we've won, ramp up and the other ones that we're going after which a lot of them are sole source and if there are not, it's on us and one other guy, we're going to get them.

So thank you for that. Now, on your comment; absolutely on the BMD, the Ballistic Missile Defense area, we are seeing a significant amount of that of increased activity in the BMD area.

As I mentioned in my prepared remarks, we're going to be able to put out a formal announcement, I believe, on Monday where just a few weeks ago, we had three of our Ballistic Missile Targets fired within seconds of each other in a raid format at the fleet.

We are working on some very interesting things, very recently with the Missile Defense Agency that is specifically related to some of the things that you mentioned. Aegis Onshore (58:09), this is taking the Aegis Missile Defense System from the Aegis platforms and putting them onshore in Eastern Europe – excuse me, Western – in Eastern Europe.

That is moving forward. We are involved in that. We are seeing specific activity related to our Ballistic Missile Defense work relative to the Mid East, significant. So each one of those areas you touched on, yes, sir, Ballistic Missile Defense because of the proliferation of missile systems is a high priority area right now..

Okay. Good. And you've talked often about the UCAS program and this being a significant part of the future of the company.

Can you give us any sense of the size of the UCAS market versus kind of ex-ing out that portion that would be – I mean, UCLASS versus UCAS?.

Right. So, John, let me say something relative to the first part of your question. We are definitely making a big investment in our Unmanned Combat Aerial System initiative.

However, a very big part of our future that is under contract is our SSAT program, and today, for the first time, I was able to mention that we are on another very large program that is confidential, but I was able to mention it today that LRIP on that is being pulled in to 2016 as well, and full rate production will begin after that.

So, our targets work, our Unmanned Aerial Drone Target business is going to be a very, very big part of our future and most of that is under contract and we're heading into production on what will be the largest production program in the company, and the second one will be right up there with it.

On the UCAS, the Unmanned Aerial System market is very, very large and there's a lot going on – it's multi-billion, so a lot – there have been $5 billion number thrown around it, there have been $7 billion number thrown around it. It's very large.

There's a lot going on within those pockets and those budgets right now and that has to do with the move away from asymmetric warfare and flying in uncontested airspace to nation state or near peer-to-peer warfare and flying in fully contested anti-access aerial-denied airspace, and that takes a different type of a vehicle.

And there's been a lot of RFI and RFP activity out there for the next generation types of Unmanned Aerial Systems that can perform their mission in those contested environments. We believe that this is going to – this is and is going to be – this is outside of UCLASS, outside of that.

This is going to be a multi-billion dollar budget-funded area because of the mission requirements. And if we can get a small piece of this, this could be a few hundred million dollar a year business for us..

Okay, great. Thank you. Thanks very much..

Thank you, sir..

Thank you. This concludes our question-and-answer session. I would now like to turn the call back to Eric DeMarco, President and CEO, for closing remarks..

Excellent. Thank you very much for joining us today. We will obviously speak with you when we report our first quarter in May unless there is a need to call a meeting prior to that. Thank you very much..

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