Deborah Butera – Senior Vice President, General Counsel, Corporate Compliance Officer and Secretary Eric DeMarco – President and Chief Executive Officer Deanna Lund – Executive Vice President and Chief Financial Officer.
Kevin Ciabattoni – KeyBanc Capital Markets Mark Jordan – Noble Financial John Nelson – State of Wisconsin Investment Board Josh Nichols – B. Riley & Co Eric Selle – SunTrust Robinson Humphrey.
Good day, ladies and gentlemen, and welcome to the Kratos Defense and Security Solutions Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. [Operator Instructions].
As a reminder, this conference call may be recorded. I would now like to introduce your host for today’s conference, Ms. Deborah Butera, Senior Vice President, General Counsel, Corporate Compliance Officer and Secretary. Ma’am, you may begin..
Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense and 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 would 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 businesses going forward.
Any matters discussed today that are not historical facts – particularly comments regarding our future plans, objectives, contract opportunities and expected future performance; the potential impact of sequestration, federal government shutdowns and the constraints on the federal budget; the timing and expected impact of the pending divestiture of our US and UK electronic products businesses, and the Company’s planned use of the proceeds from that divestiture, including the Company’s repurchase of a portion of its outstanding senior notes – constitute forward-looking statements.
These forward-looking statements are subject to risks and uncertainties, including those found in the Risk Factor 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 June 28, 2015, including adjusted EBITDA and the associated margin rates; adjusted EPS from continuing operations, excluding restructuring and transaction-related items and other; amortization of purchased intangibles, stock compensation expense, and contract design retrofit costs and additional contract costs using a cash tax rate, 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 second quarter of 2015. 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. Kratos’ second-quarter revenue and adjusted EBITDA came in within our previously forecasted guidance range, with both being sequentially higher than Q1, including adjusted EBITDA increasing nearly 60%.
And we continue to forecast the second half of 2015 revenue and EBITDA to both be sequentially higher than the first six months of the year.
In Q2, Kratos’ mix of business trended more towards higher-value differentiated products, including unmanned systems, satellite communications, microwave electronics, and specialized training systems, with second-quarter satellite communication products and related cyber business gross margins of approximately 50% being represented of this favorable mix.
We expect this favorable mix trend to continue into the second half of the year, with higher revenue and profitability in each of these areas, and lower than previously expected revenue in our modular systems business, with a certain large government agency program now pushing out into next year.
In Q2, PSS’s revenues continue to trend lower, though at a higher margin rate, with PSS year-to-date booked gross margin on the majority of new programs being approximately 30% or higher, and with our most recent week’s bookings being at just under 34% gross margin.
In the second quarter of 2015, PSS’s executed gross margins on programs were sequentially higher than Q1, with the month of June’s executed gross margins being the highest so far in 2015.
We expect PSS’s gross margins and EBITDA rates to continue to increase in the second half of 2015, as older lower margin programs are completed, and new higher margin programs we have been booking continue to come online, with PSS 2015 revenues expected to be lower than we originally forecast, as we are aggressively focusing on these higher margin programs.
Accordingly, and a result of the business mix changes, we continue to expect second half 2015 revenue and adjusted EBITDA to both be sequentially higher than the first half, with forecasted FY15 adjusted EBITDA remaining within our previous guidance of $50 million to $55 million, and revenues forecasted at $670 million to $690 million, driven as a result of the favorable business mix trend.
This forecast is for our continuing operations and excludes the businesses we are divesting, and we are forecasting the FY15 adjusted EBITDA of $50 million to $55 million after making tens of millions of discretionary internally-funded investments, including approximately $17 million to $20 million of expected internal research and development, primarily focused on our unmanned systems and satellite communications business areas, which I will discuss momentarily.
In Q2, we continue to experience significant contract protest activity. With Kratos obtaining a favorable result on one protest, losing another, and a third situation, with the Kratos team initially winning a new contract award, which was subsequently protested by the losing team, still being undecided at this time.
The significantly increased number of protests is an industrywide problem, which shows no signs of abatement for the foreseeable future. And we are trying to incorporate this situation into our forecasting the best we can.
In the second quarter, we continue to make progress on our UCAS or our UTAP 22 unmanned combat aerial system initiative, with our US government sponsor, with our demonstration flights remaining on track for later this year, with all three aircraft now off the production line, with systems and sensors being integrated.
On our under-contract SSAT unmanned aerial drone program, we also continue to make progress. We recently had another successful development program test flight, and we remain on schedule to begin low rate initial production late next year.
We also remain on schedule to begin low rate initial production next year on a separate new under-contract confidential UAS program that I mentioned for the first time earlier this year. Each of these under-contract unmanned aerial system programs are expected to be key future growth drivers for our Company.
On our AVSAT unmanned aerial drone system program, we expect to begin deliveries of the first of approximately 25 aircraft under production lot 11 in Q3 of this year. And we are under contract for lots 12 and 13. AVSAT is expected to be a key growth driver for Kratos in the second half of 2015 and into 2016.
We are also under contract with the government agency supporting unmanned systems swarming technology, and we recently demonstrated our technology with a swarm of a flight of nine unmanned aerial vehicles. We have additional tests and demonstrations with our products and technology scheduled also for the second half of this year.
We are currently in discussions with a certain US government agency for a derivative of our high-performance 167 aircraft, where if we are successful, this customer could acquire up to 10 systems annually going forward.
We were recently informed by a potential new international customer that they would like a BAFO, or a Best and Final Offer, on a large unmanned aerial drone system opportunity, where we have submitted a competitive proposal with initial value of approximately $20 million.
And we are in discussions with another potential new international customer, which has recently indicated they would like to negotiate a multimillion dollar sole-source solicitation with Kratos for a high-performance unmanned aerial drone system later on this year.
As we mentioned on our last call, we are in pursuit of and in the capture process on two tactical unmanned aerial system opportunities, either one of which if we are successful, could become one of the largest and most important programs in our Company.
One of these program opportunities is currently expected to be awarded late this year, and the other in the first half of 2016.
In the unmanned ground system and seaborne areas, we also continue to make important progress in Q2 on our strategic objective of being an industry-leading unmanned system provider, including in the command-and-control and onboard robotic automation, and unmanned vehicle mounted attenuator areas.
We have recently entered into an agreement with one of the nation’s leading final stage truck manufacturers to develop the industry’s first unmanned autonomous truck-mounted attenuator truck, with a focus on mitigating or eliminating injuries and fatalities in the workplace.
Additionally, we are now in discussions with a large state transportation agency regarding an unmanned truck-mounted attenuator robotic vehicle pilot program.
We are also in discussions with the US federal government agency regarding the conversion of heavy armored combat vehicles to automation or robotic vehicles with Kratos unmanned systems technology.
These are just some of the highlights of the progress we are making in the unmanned systems and robotic ground vehicle area, and why, as we mentioned in our last call, we have increased our business development, capture and IR&D discretionary spend for the pursuit of these important new program opportunities.
Importantly, in the unmanned area and throughout Kratos, our strategy is to own critical intellectual property or design rights, which is also directly related to the significant discretionary investments we are making and the valuation of the business.
In summary, we are making solid and demonstratable progress in our prime strategic unmanned systems area. We have two new large under-contract UAS programs entering production in late 2016, and we are in pursuit of several other large opportunities, all of which are expected to be key growth drivers for our Company.
In Kratos’ satellite communications and related cyber business area, we are beginning the initial rollout of two of our new products, SpectralNet and SigX Protect, with initial feedback being positive. Part of our strategy with these new products is to familiarize our customers with this new technology.
So for both new deployments and when the two to three-year ground infrastructure refresh buys occur, we are positioned for our products deployment. With the balance of year, we will be executing on this customer new product and technology familiarization plan.
In the satellite ground command control and signal monitoring area, we are very excited about the progress we are making related to positioning Kratos’ command-and-control RF interference network operating and related cyber products and solutions for the growing small and nano satellite market, including both national security and commercial-related, with literally thousands of nano satellites expected to be launched over the next several years to address RF and optical communications, ISR, imagery and underserved geographies.
Accordingly, today we announced Kratos’ quantumGND, a full-function, low-cost, low-risk ground system designed specifically for small satellites. Also in our satellite cyber and training business, we just last week received a $50 million sole-source single-award contract, which we have not yet formally announced.
And in the satellite communications area, we were recently awarded a new unmanned aerial system-related award, which due to its nature, we will not be able to formally announce.
In the second quarter, the Naval Surface Warfare Center announced a solicitation and intent toward Kratos’ on a sole-source basis 55 Oriole rocket motors and 20 Oriole thrust vector control systems, where Kratos had previously made a significant discretionary investment and owns the intellectual property, with these systems to serve BMD and other missions at the Pacific Missile Range facility, NASA Wallops flight facility, and other test ranges.
These new contract awards and opportunities, including ARAV Oriole BMD, AVSAT, and several other new programs, including in the directed energy and electromagnetic railgun areas, are expected to be very important contributors to the second half of 2015 for Kratos, generating expected sequential revenue growth for Q3 over Q2, and an even increased sequential ramp for Q4 revenue above Q3.
With the speed of technology change today, the long timelines of major defense acquisition programs – which can take 15 to 20 years in development, and many more years of procurement and service – these are no longer tenable.
The changing global innovation environments specifically related to national security, and including that of our adversaries, is driving the Department of Defense to leverage outside commercial and industry-backed innovation to sustain its technological advantage while operating in a restricted budgetary environment.
In response, the DOD is leading several initiatives, including a Defense Innovation unit based in Silicon Valley, which was established to identify emerging technologies and encourage stronger partnerships with innovative high-tech companies with leading-edge technologies.
We believe that Kratos is very well-positioned for this changing DOD high-technology rapid deployment to fielded affordable-cost environment, which is driving our differentiated products and discretionary investment strategy, and are working in partnership with our customers to address their needs and requirements. Deanna..
Thank you, Eric. Good afternoon. As a reminder, all financial data has been recast to reflect the US and UK electronic products business as discontinued operations for all periods presented.
Our second-quarter revenues from continuing operations of $160.5 million came in our expected range with sequential growth from our first-quarter revenues of $156.9 million or approximately 2.3%.
Revenues generated from the discontinued operations were $22.3 million or combined aggregate revenues of $182.8 million for the quarter, including both continuing and discontinued operations.
On a year-over-year basis, revenues decreased from $204.2 million in the second quarter of 2014 to $160.5 million for 2015, with the largest decreases in the PSS segment of $28.2 million resulting from the one-time $13 million equipment order we disclosed last year, coupled with sustained change and strategic focus in PSS to emphasize higher-margin smaller projects, which is impacting overall sales volume.
Decreases in our KGS segment of $15.6 million was a result of reduced shipment of hardened mobile, tactical facilities for a certain US government agency customer in our modular systems business.
As we had mentioned on our last conference call, we made significant personnel and cost reductions in our PSS business in the first quarter, and we have started to see the initial impact of the reduced cost structure in line with our recent change in strategic focus on reduced volume, higher margin work.
We are going to continue to right size the PSS business cost structure in order to achieve our profit margin expectations. As Eric had mentioned earlier, the new security system deployment work we have been booking in the PSS businesses this year has been at substantially higher margin rates and smaller in size than in previous years.
We are also completing work on the remaining PSS backlog of certain of the previous larger, lower-margin, longer-term projects, which can impact our overall operating margins until those projects are complete. As expected, our adjusted EBITDA in Q2 increased sequentially nearly 60% from Q1.
The sequential increase was due to the favorable product mix of revenues and increased revenues in the KGS and unmanned systems segments.
Our adjusted EBITDA $12.1 million for the second quarter is from continuing operations and excludes the following charges, which have been reflected as adjustments, consistent with our prior presentations, since we either believe the items are non-operational and/or non-recurring in nature.
Transaction and restructuring-related items of $6.4 million, which includes the following – $1.8 million of acquisition and transaction-related costs and expenses, primarily related to the pending sale of the EP assets.
Excess capacity costs of $3.1 million in our modular systems and unmanned systems businesses, which reflects the unabsorbed manufacturing overhead costs due to reduced sales volumes, resulting from the delays in anticipated contract awards.
$800,000 of investments we are making in conjunction with our government sponsor to develop a non-recurring IP investment we discussed last quarter that we are making for our unmanned combat aerial system platform; and $700,000 of a reserve recorded on a customer receivable, due to liquidation proceedings in our international commercial satellite communications business.
Also included in our reconciliation to compute adjusted EBITDA are foreign transaction losses of $600,000 and $1.2 million of additional contract costs related to contract retrofits on an international aerial target program in our unmanned systems business.
On a GAAP basis, net loss for the second quarter was $15 million, which included $3.6 million of expense related to amortization of intangible assets, non-cash stock compensation expense of $1.9 million, a $2.3 million income tax provision, and income from discontinued operations of $900,000.
Moving to the balance sheet and liquidity, our cash balance was $22.2 million at June 28 plus $700,000 in restricted cash. Cash flow from continuing operations for the second quarter was a use of $12.3 million, which reflects a semiannual interest payment made on the senior notes of approximately $22 million.
Including the cash flow from discontinued operations, combined cash flow from operations was a use of $8.3 million. DSOs decreased 4 days from 120 days at the end of the first quarter to 116 days.
As expected, the net working capital requirements in the second quarter primarily related to the build of inventory and product, as we are producing units that are not expected to be shipped, and ultimately build until the second half of the year, once shipments have occurred and contractual billing milestones have been achieved and completed.
As we have discussed previously, our DSOs can fluctuate due to milestones and shipments on our production type contracts, which will likely continue to impact our DSOs and cash flows from operations in the future.
As we discussed earlier, as the revenue is not recorded and billing milestones on a number of our contracts are not achieved until units are shipped and delivered, our revenues EBITDA and operating cash flow will be impacted in the near-term.
Our contract mix for the second quarter was 79% of revenues generated from firm fixed price contracts, 17% on cost plus fixed fee contracts, and 4% on time and material contracts. Revenues generated from contracts with the federal government were approximately 62%, which included revenues with the DOD and non-DOD federal government agencies.
We also generated 6% from state and local governments, 22% from commercial customers, and 10% from foreign customers, with our aggregate non-DOD revenues comprising 38% of our total revenues. Backlog at quarter-end was $954 million with $555 million funded and $399 million unfunded. Backlog at the end of the first quarter was $980 million.
Both of these balances reflect the disposition – the pending disposition of the EP assets. Kratos’ book-to-bill ratio was 0.8-to-1 for the second quarter and for the last 12 months was 1-to-1.
The guidance Eric provided earlier reflect the continuing investments, including IR&D, bid and proposal, non-recurring engineering, and capital expenditures in certain of our microwave products, satellite communications, and unmanned systems businesses.
Our total estimated CapEx for 2015 is forecasted at $13 million to $15 million, with the most significant investment being in our unmanned business, as we are manufacturing an increased number of aircraft for expected customer presentation requirements, and includes production of Kratos’ owned UCAS aircraft.
Our expected adjusted EBITDA for the second half includes the adjustment for expected excess capacity and unabsorbed manufacturing overhead, and the one-time investment we are making in conjunction with our government customer sponsor in development efforts to preserve our intellectual property rights for a UCAS initiative.
The sale of the US and UK assets of our electronic products business is expected to close in the next few weeks, at which time we will initiate a repurchase of $175 million of our senior notes.
Assuming a successful repurchase process, which we expect to be formally announced shortly, Kratos’ debt will be significantly reduced at approximately $450 million, with zero amounts outstanding on our $110 million bank line of credit, and approximately $40 million of cash on our balance sheet.
Post the asset sale of the EP assets and a successful bond repurchase, we believe that we will be well-positioned to continue to execute our strategy of building a differentiated product and technology business, with major future growth opportunities in the unmanned systems, satellite communications, and related cyber security areas..
Great. Thank you, Deanna. Moderator, we will turn it over to you for questions..
Thank you, sir. [Operator Instructions]. Our first question is from Kevin Ciabattoni of KeyBanc Capital Markets. Your question please..
Hi good afternoon Eric and Deanna..
Hi.
Hi.
Thank you for taking my questions. So it sounds like the strategy in PSS – in terms of smaller deployments, higher margins – is going as planned.
I mean, any specific examples you can cite there in terms of how you’re going after that business differently? And Eric, maybe, I don’t know if there’s any kind of target gross margin – you gave some color as to kind of where it’s heading.
Is there kind of a long-term target you have in mind for that business?.
Absolutely. The long-term target sustained across the business we’re looking is 26% to 28% executed. We’ve been booking, as I said, in the 30% range. And so, if we can execute it 90% of that or so, we should be able to achieve the 26% to 28%.
And on the first part of your question, Kevin, we are passing up and not pursuing and not bidding on a number of very large opportunities, where there is significant competition from large well-known system integrators that are turning into low-priced technically acceptable shootouts..
Okay.
What, I mean, just in terms of background, I mean, if you look back a year or two in that business, kind of what were the gross margins of the business you – the existing business you have versus the kind of 30% to 32% you mentioned in the last couple weeks, months?.
Yes. So, 18% to 22%..
Okay..
And what drove our decision to do this is, over the past three or four years, is defense budgets were coming down. And we were looking – we always have high margins in our defense business, so we were looking for growth, and this was a great area to grow. Well, defense budgets, they are firming up. We are seeing that in certain areas.
Some of our division presidents have actively been telling us that, and which has been the impetus to switch the strategy..
Okay. I’ll let that kind of transition into my next question on defense budget, I guess. Looking at kind of where the budget stands today for 2016, it seems like we may get a continuing resolution for at least a few months at this point.
Have you guys factored that into your guidance in terms of maybe bookings pressure or, I guess, specifically maybe any issues that might come up with these new unmanned contracts that you’re – either won or are working on?.
Yes. We – as you just indicated, we right now are fully expecting that there’s going to be a continuing resolution authorization. Very similar to last year from October 1, that will hopefully be resolved between Thanksgiving and Christmas. That is what we are expecting.
We do not believe that – the continuing resolution, we do not believe that it will impact the demonstration flights that are scheduled for Q4. We don’t believe it’s going to impact those two large international opportunities.
It is possible that that one large domestic tactical opportunity we are pursuing, that is currently scheduled/planned to be awarded in Q4, it’s possible that could be pushed out into the New Year because of the CRA..
Okay, perfect. And then last one from me and I’ll jump back in queue. Any kind of color you can give us on free cash flow expectations for the year? And maybe the case – obviously, I know 2Q and 4Q tend to be lower just with the interest payments.
But anything in terms of additional detail you can provide?.
Sure, Kevin. This is Deanna. For the second half, especially with the activities of the pending close of the transaction, taking – putting that aside, our expectation is for free cash flow for the second half to be breakeven to positive $5 billion..
Great. Thanks, guys..
Fixed [ph].
Our next question is from Mark Jordan of Noble Financial. Your question please..
A couple of numbers that reflects some of the heightened investments you’re doing this year. I want to see if I’ve got all of the numbers down. And if you could add more depth to them, I would appreciate it.
I think you said you are spending $17 million to $20 million of internal R&D, and that CapEx would be $13 million to $15 million, heavily skewed towards aircraft that you will be demoing for trying to attract new business.
Is there additional investments beyond that that you are making?.
There are, Mark. So they would actually be in our G&A line. So that would be the bid and proposal type cost that Eric was talking about, as far as infrastructure costs as well. So that – those costs are embedded in SG&A and we have not called those out separately..
Okay.
Relative to that one opportunity that is relatively near-term, could you tell us exactly where that program is, which is the one that the large UAV contract that could be awarded in the – implied in the October November timeframe – is the RFP out on The Street? How long will that cycle be? And specifically when do you think that is going to be potentially awarded?.
Yes. The RFI came out several months ago. We have responded to that. There have been significant communications back and forth since then. Mark, the RFP is expected out in the next two weeks. The response time is supposed to be something like a couple of months, and then the award period is supposed to happen immediately after that..
That is a rather rapid cycle, is it not, for this type of business?.
Absolutely. It absolutely is. It is – what I told you it’s stated, it’s out there, and it is very rapid. It’s a very rapid path from this customer..
Okay. Last question from me, and it centers as a series around your flights you will be demoing this – in the fourth quarter, relative to what I believe is a potential Navy customer. As you know, the U-class is out there, it’s been a program that’s delayed, rumored to be incredibly costly.
Is it true that you are dealing with the same program office as the U-class? And is it your understanding that that office is looking for a – wants a combat vehicle that can survive in a contested space? And can – is the U-class reasonably priced to – if it’s designed to survive in combat?.
Right. Our aircraft in our vision is a much different – much different than the U-class. The U-class is the size of a man; aircraft is roughly the size of an F-14. It has the payload capacity of a significant aircraft and the loiter time of a significant aircraft. Ours are much smaller, much faster, more fighter-like.
They have different attributes that some say are much more positive. And where the price point or the cost point of a U-class, say, is publicly out there somewhere between $50 million and $100 million, our price point is somewhere between $3 million and $5 million..
Okay..
And so it’s a different vision. Higher quantities..
And that is a rail-launched version, so if it were for the Navy as an alternative to U-class, it could be flown off of a different ship rather than an aircraft carrier?.
Absolutely. Our vision is it does not take any deck time on an aircraft carrier. It is very versatile, and it can be launched off a rail, it can be launched off a number of other means, all of which are mobile and/or transportable or fixed..
All right.
And finally, assuming success in the demo flights in the fourth quarter, when do you think the Navy may come to a decision point as to progressing forward with this program or not?.
Right. So we are hopeful that our sponsor – and you said Navy, I will say sponsor – that our – we believe our sponsor will be in a position, along with several other customers that we’ve been briefing routinely along the way and are very interested in this, that we will get some traction.
And I don’t want to get ahead of anybody, that’s – I don’t want to define it. We will get traction early on heading into 2016 if we are successful..
Thank you very much..
Yes, sir..
Our next question is from John Nelson from the State of Wisconsin Investment Board. Your question please..
Eric and Deanna, a question related to the announcement that you made, the press release on the satellite program that you have introduced called the quantumGND..
Yes..
Could you talk a little bit about what the size of the potential market is for that? And what your thoughts as far as the time it will take you to penetrate this market in a significant way?.
Yes, sir. So we are – or we believe that we are the leader in command and control ground infrastructure for the space segment today. We believe that. And that is primarily with geosynchronous orbit satellites and with MiOS.
The small sat for the nano satellites are Leos, so quantumGND is a scaled-down version of our big satellite command and control software. Because these nano satellites, even though electronics are getting smaller and the microprocessing technology is rapidly moving forward, these nano satellites do not have the capability of a big Geo.
That’s why they are much less costly. And so they need, by definition, to be effective in the market, you need a lower cost command and control system, which is what quantumGND is. John, I am frankly stunned at the number of new – potential new small sat operators that there are on the commercial side. They are talking thousands of being launched.
BAE is talking alone putting up 900, I think, in the next few years. It’s incredible. It’s thousands. This market is going to be a multibillion dollar market on both the commercial side and the military side.
On the military side, of course, the big focus here is on redundancy and not having all your eggs, my terms, in one big multibillion-dollar satellite basket that can be jammed or shot down. And on the commercial side, it’s communications, its Internet, its delivering service to underserved or non-served areas right now.
As you know, QUALCOMM is involved, Google is involved, SpaceX is involved, Virgin is involved, and many, many others. This is going to be a multibillion dollar market, and this is going to be a multi-tens of millions, if not hundreds of millions of dollar opportunity for us. Because we are a premier player in this market right now.
We have the products, we have the past performance qualifications, and we have many of the customers already..
And is there – who is your significant competition for this particular side of – the nano side of the market, if any?.
There are a couple of guys out there, John. I don’t want to talk about them here. But there are a couple of guys out there – one of them is a private company, one of them is a public company – that are our competition on the big side and they’re the competition here as well..
Okay. Thanks.
And with regards to a number of programs that you are focused on over the coming years, like unmanned aircraft and railgun, hypersonic, missile radar, satellite-com, and electronic warfare, have there been any significant changes in the last three to 6 months as far as the size of the market opportunities for Kratos? That is, have they changed in a positive or negative way?.
Yes. On every one that you just mentioned, it has changed in a positive way in the past three to six months. And it is happening industrywide because of the shift or the pivot of the DOD from asymmetric warfare or warfare fighting ISIS or fighting terrorists, to nation-state warfare.
We are seeing significant interest in the directed energy area and we are winning a lot of contracts in that area. We cannot disclose them, this is both in the laser and the electromagnetic railgun area. As I was talking with Kevin about, this one unmanned aerial system opportunity came up – has come up in the last nine months.
And it’s on a very rapid path. And there is another one that we are pursuing, but the RFI is not out yet, that is very similar, that’s on another rapid path. And they are both focused on a certain – on certain threats, which is why we have made the decision and we are going to – and it’s the right decision, to make the investment now.
It is impacting our near-term EBITDA. It’s not going to last forever, but these opportunities are here now. And we’ve got to try to win some of these or get on them, because if we do, they will drive the Company over the next several years..
Okay, good.
And then is there any significant effort, either by the military or portions of Congress or the White House, to deal with the problems of the contract challenges that you and your competitors sometimes deal with?.
Yes. McCain and the Leader of the House Armed Services Committee, they’ve been talking about it, about procurement reform and contract reform. But in my opinion – this is just my opinion – nothing will change here until there is a new administration. Nothing. It is not going to change..
And do you think it would change, or it would be likely to change with a new administration of either party? Or does it have to be Democrat or – I’m sure they’re saying – does it have to be Democrat or Republican to –?.
My tummy tells me that it would probably be better with one versus the other..
Okay. All right, thank you..
Okay..
That’s it for me. Thanks, and look forward to the second half with the – especially with the excitement on UCAS..
Thank you very much, sir..
Thank you..
[Operator Instructions]. Our next question is from Josh Nichols of B. Riley. Your question please..
Yes. Thanks for taking my question.
I was wondering, so have you seen any continued M&A interest in any of your other business units, like PSS, that you may have been considering to divest as part of a more strategic initiative? And what would it take for you to revisit this plan?.
Yes, we have continued to see interest in certain things. And – but we made the decision, as we said last time, we are not moving forward. And we are focused on these program opportunities we’ve talked about today..
Great.
And in the unmanned aerial systems, would you ever consider supplying some major primes with any of your primary – with any of your proprietary deposit skins? Or avionics? And separately, do you feel like having IP related to engines would be desirable as well?.
Right. So we do provide primes with – I’m going to use the word composite components right now, for certain programs that are non-competitory with us. So we do that. We do provide primes with certain of our unmanned command-and-control avionics and electronic systems onto platforms and programs that are not competitive to us. We do that.
We have exclusive agreements with engine manufacturers for our airplanes. And that’s the route we’ve taken to lock up our supply on that – or capability on that side..
Great, thank you..
Yes, sir..
Our next question is from Eric Selle of SunTrust Robinson Humphrey. Your question please..
Hey, good afternoon. Two for two, that’s a solid streak. Looking at your guidance, if you look at your second half guidance, you have sales growing by $46 million and EBITDA growing by $13 million over the first half.
Is this sales growth one but not protested, I mean is there any risk to the sales growth from protester CR? Or is that pretty much locked in?.
There is always the risk on the protest side. There is. As I said in my remarks, Eric, we are trying to hedge it. And so what do I mean by that? If we believe we are going to win something and it gets protested, typically it gets resolved – typically, typically – it gets resolved within 100 or 110 days. So we’ve tried to build some cushion in on that.
But it’s very hard to just assume everything you win is going to be protested and what that’s going to mean. So we’ve tried to use our best judgment on that. The protest activity that happened in the second quarter – and there were three – it did impact us a little bit. But we had taken that into consideration.
On the continuing resolution side, as you know, we’ve all been through that for the past several years – we think we know what that has meant. We think we know what that means. And as I mentioned on this one opportunity that we are chasing, we expect a new contract award in Q4 – that could be pushed out because of it.
However, we have not assumed, in our forecast, significant revenue at all for that opportunity in the fourth quarter..
So you can say that you have confidence – this is a new achievable believable guidance, and most of that, you have high confidence in, given your calibration of that for protest and CR.
But as you look at it, $680 million revenue, how much of that growth – how much of that $50 million of growth in that back half is subject? And would you say one-third of it? Or is it – do you have high confidence over the majority of that growth?.
I’m thinking and I’m staring at Deanna as I’m thinking..
I would say there is some pockets where there is – there are some assumptions of some contract award wins that Eric had mentioned, specifically in our modular systems business, which, if those do not occur, then there could be some impact to the revenues. But they are not a significant amount of that second half revenue..
Okay, good. And then if I do the rough math, your contribution margin on an EBITDA growth is about 28%, seems somewhat conservative, given your history. Could you give us some of the major drivers of that EBITDA growth? I mean, it looks like you are basing EBITDA solely on the higher sales on a conservative contribution margin.
It seems like mix and some of the PSS book margin could make this look conservative..
Yes. So, Eric, you hit it right on the nose. There’s a couple of areas that would factor into that EBITDA growth. So one would be the product mix. The visibility that we have is that the certain shipments and deliveries in the second half will be on the higher margin side.
In addition, on the PSS side with the cost reductions that we’ve made in the first quarter, we expect to see more traction in the second half, as well as the bookings that we have been booking at about 30% on those smaller projects.
We expect to see the improvement, if you will, resulting from those booked – the higher book margins as we get into the second half..
Okay..
Eric, one – on your previous question, one item that popped into my head is, as you know, we are involved in ballistic missile target launches, and launches of missiles and rockets for other matters.
And those can be scheduled, and then for whatever reason they can move out to the right by the customer, because assets weren’t available, assets couldn’t be deployed, weather, other reasons we shouldn’t be talking about – that could happen. And we have no control over it. We put in our forecast what the scheduled plan is..
Okay. That is great color. And then, Deanna, you spoke about the cost savings. Great job on gross margin, I think it was up over 100 basis points sequentially and 200 basis points year-over-year. You are seeing that mix come through, and that’s great to see. SG&A was a little bit higher year-over-year.
I guess my question is, is how much of those employee savings have you realized in the second quarter? And should we see SG&A come down [indiscernible] year?.
Yes. So, SG&A – so on the public safety side, there’s about a sequential and a year-over-year reduction of about $1.5 million. The other driver that’s impacting G&A are – there’s two pieces.
The cost, the public company cost that would’ve typically been borne by the entire Company with all the divisions, with these discontinued operations, that those costs cannot be allocated to the discontinued operations. And there’s not a lot of infrastructure from a public company perspective that we can eliminate. So that’s part of the driver.
The second reason, which is the largest driver, is due to the unabsorbed manufacturing overhead in our modular systems and our unmanned systems business, which has been reflected as G&A in this quarter.
So that was roughly about $3.1 million this quarter that was related to that unapplied or unabsorbed overhead that is skewing, if you will, the sequential SG&A and the year-over-year SG&A..
So just kind of parsing, there wasn’t much employee savings in there. That unabsorbed overhead from modular will probably continue. The PSS hits sounds like a one-timer.
And then as the public cost of the entire Company, once you sell that, will those costs come down? Or do we have to absorb those for the whole year?.
We would have to absorb those for the rest of the year. As we get into 2016, we expect we will be able to see some reduction there as far as like audit and tax fees, like consulting fees.
Directors and officers insurance, because we’re a smaller size company – so insurance, that type of stuff, that – we’ll see some of those reductions in 2016 as we negotiate those agreements with the smaller scale, if you will. And just to correct something I think you said, on the PSS side, there was actually a savings of $1.5 million.
[Multiple Speakers].
Okay.
And that was supposed to be $5 million to $7 million on an annualized basis, is that right?.
About $5 million, yes. So that’s about on track with what we expected. But it was just masked by the unapplied or unabsorbed overhead increases to SG&A in our – in the modular systems and our unmanned systems business..
So we could potentially have $3.5 million of employee savings in the back half –?.
Yes, for PSS, yes. And then as I think in my prepared remarks and Eric’s prepared remarks, we – our adjusted EBITDA guidance does assume that the adjustment, if you will, for any additional unabsorbed overhead costs, we are taking some actions there to try to mitigate that as much as possible.
But we may see some additional costs in both the – we will see that in the unmanned systems area and potentially also in the modular systems business in the second half, but should be at a smaller scale..
The variables – the variable cost element we are reducing or eliminating. There’s the fixed piece that can’t be moved. Its quote/unquote non-cash, but it can’t be touched because it’s fixed..
Understood. Understood. Well, hey, listen, we really do appreciate the new guidance. And solid hit, and look forward to the second half. Appreciate your time..
Thanks, Eric..
Thanks, Eric..
At this time, we have no further questions. I would like to pass it back to Mr. DeMarco for closing comments..
Great. Thank you for joining us today. As we indicated in the prepared remarks, in the next week or so, we are hopeful to be announcing the close of the transaction. And we will be talking with you when we report Q3. Thank you..
Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now disconnect. Good day..