Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2018 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 is being recorded. Joining us today is Mr. Eric DeMarco, President and CEO, and Ms. Deanna Lund, Executive Vice President and Chief Financial Officer. I will now turn the call over to Ms. Lund. Ma'am, you may begin..

Thank you. Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions third quarter 2018 conference call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer.

Before we begin the substance of today's call, I'd like everyone to please take note of the Safe Harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon.

Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today's call. Today's call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G.

Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today's press release, we have provided a reconciliation of these non-GAAP financial measures to the Company's financial results prepared in accordance with GAAP.

With that, I will now turn the call over to Eric DeMarco..

Thank you, Deanna. Deanna stood in today for Marie, our General Cousin, who has who has a very bad cold. Kratos' third quarter reflected the expected continue improvement of our Company's financial maintenance fees, our organic growth trajectory and overall performance and our execution.

In Q3 Kratos' gross margins, operating margins and EBITDA margins all increased. We generated positive cash flow and we expect cash flow in Q4 and for 2019 to continue to increase as we transitioned from the investment mode in our Unmanned Aerial Drone business and as we move towards production.

Deanna will provides the details on Kratos' overall, third quarter financial performance, and our guidance in our prepared remarks.

Kratos' business mix continues to improve favorably as we execute on the plan we communicated to you at the beginning of this year to focus on higher margin programs with better payment terms and liquidity and to deemphasize or not pursue lower margin opportunities.

In Q3, Kratos' is bid pipeline increased again up to $6.7 billion reflecting the significant opportunities that we have and Kratos' is alignment with the recently released national security strategy priorities. In Kratos' Unmanned Systems business, our target drone programs perform substantially as expected in Q3.

On schedule, on budget, and in line with the expected ramps in production, including our large programs with the U.S. Navy, the U.S. Air Force in the U.S. Army, and we are expecting a particularly strong Q4 from our Unmanned Systems business based on current production and execution schedules.

These under contract long-term drone production programs are expected to be key future organic growth drivers for our Company. For Kratos' U.S.

Navy SSAT program, we expect a solid Q4 and we expect significantly increased production quantities beginning in the second half of 2019 and we moved from Low Rate Initial Production 1 or LRIP l, LRIP 2 then LRIP 3 and then ever greater quantities beyond 2020, 2021. As we achieve expected full rate SSAT production.

We are also to continuing to ramp up on our U.S. Army target drone programs with increased execution and quantities expected to begin in 2019. We also expect increasing production with another under contract program beginning in the second half of 2019 as it transitions from LRIP to full rate production over the next few years.

On our US Air Force AFSAT program, we expect steady execution and production throughout 2019 as a result of AFSAT production year 2014 which we recently received sole source and we also received AFSAT production option years 2015 and 2016 also sole source which we expect to execute on in 2020 through 2021.

Internationally, we have now completed negotiations and expect to receive a large new target drone system program award in the next few days with the potential value to Kratos up to approximately $100 million over the expected performance. Initial exercises under this new contract award are expected to begin in mid-2019.

We are also tracking a number of additional new international target drone programs, which we are hopeful of receiving over the next 18 to 24 months. In Q3, we also received increased funding on a next generation unmanned aerial target drone program we are under contract on.

With the global recapitalization of strategic weapons systems and the related requirement to test and evaluate these weapons systems with threat representative targets by the U.S.

and our allies, we believe that Kratos' unmanned target drone systems business is well positioned for sustained future growth with this business expected to move towards approximately $250 million in annual revenue over the next few years. In Kratos' tactical drone business area, each program remains on schedule and on budget.

Kratos' XQ-58A Valkyrie is currently going through ground safety checks and reviews with the initial flight scheduled to occur within a window we have in the next approximate 90 days.

For security related reasons, I cannot at this time provide any additional information on the specific Valkyrie flight timing, but needless to say, Kratos and our customers are extremely excited as we move towards the initial series of flight demonstrations of this long-range, high-performance strike UAS.

Once the Valkyrie successfully executes that series of scheduled demonstration flights, we expect to receive initial unit orders later on in 2019. For Kratos' Mako, we are completing negotiations on the next phase of this program with our customer set.

We expect to be under contract by the end of the year with the approximate value of this phase ultimately totaling in excess of $20 million to Kratos over approximately 18 month period. This Mako contract phase has been delayed several months due to the gap and change in leadership at the DIU, but Mr.

Michael Brown is now in place as the new DIU Head and we expect to be rolling again shortly. As a result of this delay, once under contract, we expect our Mako program to begin ramping in Q3, Q4 2019 continuing into the following year.

We are also currently in negotiations with a separate customer from Mako and we are hoping to be under contract in late 2019 as related to the fiscal 2020 DoD budget. The Kratos' Dynetics Gremlin program remains on schedule for mid-2019 demonstration, and one successfully demonstrated, we expect the initial orders later on in 2019.

As we reported on our last earnings call, Program F has successfully completed its initial under contract demonstration flight series and additional contract to demonstration flights for enhanced capabilities are now planned for the first half of 2019.

Once all planned demonstration flights are successfully completed, we expect that initial Project F unit order late in 2019 or early in the following year.

We can now also report to you that we expect Project Spartan, which has an extremely high performance drone we have been working on which is flying today to be under contract in Q2, Q3 of 2019 for initial demonstration flights.

We have also now begun initial discussions with the customer on what we internally and initially will call it Project A and Project Z with each of these UAS is also now flying today. Project A and Project Z are two new tactical system related opportunities.

We have been working on for some time now and we are expected to continue to make progress on each of these going forward with hopes for an initial contract award late in 2019 or early in the following year, also was related to the 2020 budget.

Just last week we held a facility ribbon cutting for our new high performance drone manufacturing site in Oklahoma City. Chairman of the Armed Services Committee, Senator Inhofe was in attendance as was Congressman Steve Russell, the Governor of Oklahoma, the Mayor of Oklahoma City, and many other Oklahoma representatives.

I need to specifically mention Oklahoma Governor, Mary Fallin, who has been just an outstanding supporter of Kratos and an advocate for her state.

And what we have done and will be doing in an Oklahoma would not have occurred without Governor Fallin's leadership, her vision, her encouragement and the support of our entire staff, and we truly thank her for this. We are tracking for the first Kratos UAS to come off the Oklahoma line in early 2019.

Additionally and very importantly, we are close to executing a lease on another large new drone manufacturing facility, which will require a custom build out over the next several months for security related reasons, related to a new tactical program we have recently been successful on program Thanatos, which is expected to have a material financial impact to Kratos beginning in 2020.

Due to the restricted nature of this new Kratos program, we are unable to provide any further details at this time.

There are recently been a number of recent publications, which discussed the future of unmanned combat aerial drones, drone swarms, manned, unmanned teaming, including a Barron's article this past weekend, all of which I encourage you to review as I believe these will help frame up the size of the high performance tactical drone opportunity we're pursuing, which is extremely large exciting, and it is happening.

As I have just summarized, we expect the next approximately 15 months to be very important for Kratos' tactical drone business with several important milestone scheduled with initial orders expected late in 2019 or 2020 and meaningful revenue, profit and cash flow from this business currently forecasts to begin in 2020.

We are convinced that Kratos has the right drones at the right time, at the right, affordable cost to be the leader in the new and forecasted high growth tactical drone market, and we can literally see the momentum building for high performance, affordable, tactical unmanned aerial drone systems over the past several months.

Kratos satellite communication business had a solid third quarter and that's expected to have an even stronger Q4 with the space and satellite area of the DoD budget, seeing some of the largest increases due to the current threat environment.

As you know, the nature of Kratos' satellite business, programs, executions and schedules and the government fiscal year funding flows result and cradles is calendar Q3 and Q4 financial performance for this business to be stronger than our calendar Q1 and Q2 and we are seeing this trend again in 2018.

With as I mentioned Q4, looking to be particularly strong, and we currently expect to see this trend continue in the future. Major space programs Kratos supports include WGS, AEHF, SBIRS, MOUS and GPS.

Kratos' training systems business continued solid performance in Q3, which is expected to continue in Q4 and into next year as a result of major program wins we have received including MCAT, AVET & NATS, KC-46 and RSM FMS.

Kratos' Microwave Electronics business similar to prior years is expected to have a particularly strong Q4 as we execute complete and deliver on multiple under contract programs. Programs Kratos microwave electronics business supports include F-15, F-16 Griffin, BARAK, Arrow, Iron Dome, and Magic Wand.

Kratos' rocket support and ballistic missile target's business also had a solid Q3 as we execute on a number of missile defense related programs.

Since we last spoke with you, Kratos' ballistic missile targets have had a number of successful missile defense related missions including intercepts, certain of which have been highly publicized, including video of Kratos' BMD targets systems in action. I encourage you to take a look at these videos.

We are currently tracking multiple new missile defense related opportunities, which if we are successful receiving or expected to be important contributors to Kratos' growth and financial performance beginning in Q3, Q4 of 2019.

In our Rocket Support business, we are also pursuing certain hypersonic opportunities, which are hopeful of being successful on and receiving new contract awards in Q2, Q3, of next year.

Similar to Kratos' unmanned aerial drone system business and our BMD targets and hypersonic business, Kratos' competitive differentiators include our intellectual property or proprietary system positioning or proven ability to rapidly develop, demonstrate, and field technologically advanced systems all at an affordable cost.

Kratos' C5ISR Modular Systems business had a particularly strong Q3. Also driven by the global recapitalization of strategic weapons systems. In 2019, is currently shaping up to be another solid year based on our current bid proposal, an opportunity pipeline.

Major programs Kratos' C5ISR businesses supports includes Patriot, Fad, CBRNE, SBIRS, [indiscernible] and CPP.

As we mentioned on last quarter's call in Q3, we exited our modular system divisions, non C5ISR business closed a facility and reduce staff in order to increase profit margins and cash flow, which will result in reduced revenues in Q3 and Q4, 2018, but at higher margin rates. In Kratos' traditional government services business.

We recently received an approximate $60 million five-year radar system contract award which we expect to begin ramping in Q2, Q3 of 2019. This recent contract award is expected to help stabilize this business, which as you know, has been declining over the past several quarters.

Related to the Kratos plan to deemphasize or not accept lower margin contracts or contracts with unacceptable payment terms. There are two specific recent instances where Kratos could have executed these contracts months ago, but certain terms would not acceptable and as a result we were not willing to move forward.

One of these is now under contract and the other we have just reached agreement on and expect to be under contract by the end of this year. Having ultimately reached terms on both of these were acceptable to our company.

The delays and contract award on these two large programs will impact Kratos' Q4 revenue slightly and our Q1, 2019 due to the related delay in execution, but we are forecasting to be caught back up and on the original plan for these programs by Q2, Q3 next year. The global threat environment, including peer and near peer threats is increasing.

And as a result, the recapitalization of strategic weapons systems by the U.S. and our allies to deal with these threats, as I've mentioned before, is underway.

Kratos' core businesses include Unmanned Aerial Drone Systems, Satellite Communications, Training Systems, C5ISR Systems and Microwave Electronics, and they are well positioned for this environment and addressing these threats.

Additionally, Kratos is recognized as the affordable alternative system provider in our core business areas and affordability does and will continue to matter and be a competitive differentiator for Kratos and our customers routinely communicate this to us.

Kratos is on a solid and we believe sustainable organic revenue profit and cash flow growth trajectory as a result of the investments we have previously made, which are now substantially complete.

The long-term under contract programs we have successfully received over the past several years as a result of these investments and that we expect to continue to receive going forward. We want to thank our employees, customers, and all of our stakeholders and being instrumental in building Kratos to the Company than it is today.

Deanna?.

Thank you, Eric. Kratos' third quarter 2018 revenues of $159.4 million, up 1.5% from third quarter 2017 revenue of $157.1 million were at the upper end of the range of our estimate of $150 to $160 million. And our adjusted EBITDA of $16.7 million or 10.5% adjusted EBITDA margin exceeded our forecast of $12 million to $14 million.

Additionally, Kratos' adjusted EPS of $0.08 per share also exceeded our forecast of $0.02 to $0.04 for the quarter. Our third quarter year-over-year consolidated organic revenue growth was driven by growth of 9.2% in our KGS segment, primarily reflecting demand in our satellites training systems businesses.

Revenues in our Unmanned System segment reflected the current year expected production schedule which was down 20% from the prior year due to the timing of the production ramp which occurred in the third quarter of 2017, and which included the initiation of low rate initial production of our SSAT aerial target and an international target program.

As Eric mentioned earlier, we expect the production ramp in the fourth quarter to increase in our Unmanned System segments and our full-year 2018 Unmanned Systems revenues to be substantially greater than the prior year.

In the third quarter, KGS generated revenues of $126.1 million, adjusted EBITDA $14.1 million and operating income of $11 million, all which were up from the prior year comparable revenues of $115.5 million, adjusted EBITDA of $6.4 million and operating income of $1.4 million.

Reflecting the growth primarily in the satellite communications and training systems businesses as well as margin improvement in our modular systems business.

From an accounting standpoint, Kratos which required to adopt a new revenue recognition practice beginning January 1 of this year, which can affect the timing of revenue recognition for certain contracts. The impact of this new accounting standard was approximately $5.3 million on Kratos' third quarter 2018 revenues.

Operating income of $10.1 million in the third quarter of 2018 increased year-over-year from $100,000 in the third quarter of 2017 and increased sequentially from $2.6 million in the second quarter of 2018.

These improvements were driven by a more favorable mix of revenues which positively impacted gross margins with margins increasing to 27.7% in the third quarter of 2018 from 23.7% in the third quarter of 2017 and include the deemphasise of lower margin opportunities that Eric mentioned previously.

The increase in gross margins which accompanied with a reduction of SG&A expenses reflecting the impact of cost reduction actions we have taken. On a year-over-year basis, our Q3 2018 adjusted EBITDA increased 47.8% or $5.4 million from $11.3 million in the third quarter of 2017, up to $16.7 million in the third quarter of 2018.

Our adjusted EBITDA for the third quarter is from continuing operations and excludes non-cash stock compensation cost of $1.7 million and severance related cost of $100,000.

On a GAAP basis, net income for the third quarter was $1.7 million, which includes income from discontinued operations of $300,000 and includes a tax provision of $3.4 million primarily reflecting tax expense for foreign jurisdictions and for states where which we cannot utilize our NOLs.

As mentioned on our previous call, we currently expect to recognize an approximate net breakeven position on the sale of PSS after current estimates of working capital adjustment, changes in retained net assets or other adjustment.

Any future changes to the working capital adjustments or the retained net asset and the completion of those related projects will be collected in those future periods. Moving onto the balance sheet and liquidity. Our cash balance was $187.2 million plus $300,000 in restricted cash at September 30.

At quarter-end, we had zero amounts outstanding on our bank line of credit and $5.3 million of letters of credit outstanding. Debt outstanding was $294 million at quarter end and net debt was $106.5 million. Our LTM or last 12 months adjusted EBITDA was $58.4 million with a net leverage ratio of 1.82 to 1.

Cash flow generated from continuing operations for the third quarter was $14 million which includes the use of approximately $1.4 million of internal non-capital expense related development costs, related to the LCASD program.

Capital expenditures were $6.9 million including approximately $3.7 million related to the Unmanned Systems division, primarily reflecting the two LCASD Kratos owned aircraft and related equipment that we are building. And we expect this capital effort to be substantially complete in the fourth quarter of this year.

Our free cash flow from operations for the quarter was $7.1 million reflecting the $14 million of cash flow generated from operations, less capital expenditures of $6.9 million. After reflecting the final payment of $2.9 million for acquired satellite communications technology, free cash flow was approximately $3.2 million.

On accounts receivable, DSOs decreased from 137 days at the end of the second quarter to 129 days at the end of the third quarter as certain of the milestone payments we were expecting were collected during the quarter.

Our DSOs include long-term delivery projects where we invoiced amounts at the completion of certain milestones and/or the final delivery of the product. And we are forecasting a number of billing milestones to be achieved and paid upon completion of contractual milestones in the fourth quarter of the year.

Our contract mix for the quarter was 84% of revenues generated from fixed price contracts, 11% from cost plus fixed fee contracts and 5% generated from time and material contracts. Revenues generated from contracts with the U.S.

federal government during the quarter were approximately 76%, including revenues generated from contracts with the DoD, non-DoD federal government agencies, and FMS or Foreign Military Sales contracts. We generated 8% from commercial customers as 16% from foreign customers.

Backlog at third quarter end was $571.7 million with $528.1 million funded, and $43.6 million unfunded and our book-to-bill ratio was 1.4 to 1.0 for the third quarter and 1.0 to 1.0 for the last 12 months ended September 30.

Today, we are providing fourth quarter revenue guidance of $182 million to $192 million adjusted EBITDA guidance of $13 million to $17 million and adjusted EPS guidance of $0.03 to $0.07 per share.

We are adjusting Kratos' full-year 2018 revenue guidance to $635 million to $645 million and adjusted EBITDA to $56 million to $60 million and adjusted EPS guidance to $0.18 to $0.21 per share.

We expect operating cash flow for the fourth quarter to be in the range of $12 million to $22 million with capital expenditures in the range of $4 million to $8 million and free cash flow from operations of $8 million to $14 million for the fourth quarter.

For full-year 2018, we expect our capital expenditures to be in the range of $22 million to $25 million for FY 2018 with approximately $13 million to $16 million related to our unmanned systems business.

We expect our estimated cash taxes to be approximately $2.5 million to $3.5 million for FY 2018 and expect the impact of tax reform to be fairly insignificant to our estimated cash taxes due to our over $330 million net operating loss position.

We are adjusting our full-year of cash flow from operations guidance to reflect a delay in the expected collection of networking capital proceeds of the PSS business retained by Kratos' which we now expect in the first half of 2019, adjusted to $2.27 million to $37 million and free cash flow of $5 million to $12 million for the year.

Consistent with our past practice, we will be providing Kratos' 2019 financial guidance along with our Q4 and full-year 2018 report.

When we do provide our initial 2019 guidance, we expect revenue, adjusted EBITDA, cash flow and EPS to all be significantly increased over 2018 as Kratos' organic growth trajectory continues and as we expect Kratos' 2019 quarterly trajectory to be similar to 2018 with Q1 being the lowest in similar to what we guided to for Q1 2018 with Q2, Q3 and Q4 of 2019 each increasing and being significantly higher in Q1..

Thank you, Deanna. We'll now turn it back over to the moderator for any questions. Thank you..

Thank you. [Operator Instructions] First question that I have is from Ken Herbert of Canaccord. Your line is open..

Hi. Good afternoon, Eric and Deanna..

Good afternoon..

Yes, I just wanted to first, Eric, you went through a number of new potential programs on the tactical side. Just a high level question, as you look at some of the increased sort of maybe caution around what the ultimate fiscal 2020 defense budget could look like. I know it's a fairly tight range.

But have you seen any sort of incremental risk to timing on Project A, Z, Spartan any other new contracts or maybe the existing portfolio with was sort of the increased concern around how fiscal 2020 can ultimately look in terms of defense spending?.

We are actually seeing an increased interest across the Board because of the affordability of the drones and also can, as you know our drones, they're leading edge, they're not bleeding edge and the fact that they're leading edge, there are proven for the most part they're flying today or what else - what we're doing or derivatives up or what we're flying today.

It significantly reduces risk and schedule in our customer's mind, which also obviously ties into cost and affordability. And so we are seeing things accelerate and we are seeing the expectations for those out years accelerate as our customers want quantities deployed, quantities of weapons deployed..

And I know your overall sort of bid pipeline has grown, but can you provide any sort of additional detail on the new tactical opportunities? Just even at a high level in terms of the potential revenue upside?.

Can have one believes that two, three, four, five years from now there will be high performance unmanned drones accompanying the manned aircraft, which I do when, which is why I encourage people to look at some of the articles I mentioned.

This is happening and it is happening in a big way and the ones I can talk about - I'm talking about the other ones that have the last couple of years, as you know, we've been shutdown on a lot of information it is happening. And we believe this is going to be substantially bigger than our target's business.

And you heard what I said about that today and that is growing very rapidly and it's going to continue to address the global threats and the exercise weapons systems..

Okay, great. That's helpful. Just one final one, Deanna, the reduction in the cash flow guide this year about $7 million? Is that all attributable to the working capital proceeds, sort of delay on received there.

Is there anything else going on?.

It's all attributed to that. And we originally expected it in the fourth quarter. It's now moving to the first half of 2019..

Okay, perfect. Thank you very much. I'll pass it back there..

Thank you..

Next question is coming from Mike Crawford of FBR..

B. Riley/FBR thank you. So Eric you mentioned this other new tactical program that will result in new building yet another new production facility and I think you said there will be a material impact in 2020 without going into details of that program.

Can you talk about what sort of investment we might expect in that, given the way that you've retained proprietary data rates to things like the Valkyrie?.

Yes. So first Mike, thanks for this question. So I can clarify, this was a leased facility..

Okay..

And so there will not be a capital outlay for the facility. The internal build-out of it will not be substantial. This is not millions and millions of dollars. That will not be substantial. The fact that we're under contract, a good portion of that will, will be covered.

And I really, I cannot get into anything on the data rights and IP on this I'm sorry..

Okay. That's fine. Then - it's nice to hear that you have in your initial thoughts on 2019 that revenue cash flow EPS I will be up significantly, I think was the effort being used.

But do you expect bookings to grow perhaps more quickly than the other metrics given, Gremlins and potential Valkyrie orders and depending on when Project F comes in and then 2020 would be seen revenue growth acceleration?.

Yes. Because all of those bookings would be incremental if it's a new business area. So yes, absolutely….

And then 2021 would be margin expansion, right? Because right now you - I think at double-digit margins on your asset but why so say on asset which might take you a couple of years, I get up to that level?.

That's correct. We expect to see margin expansion continuing into next year as production levels increase on the targets drones. Then we see them increasing more the following year as we reach full rate production, for example, on SSAT. Then on another program we have.

And then layer on top of that if we're successful in the initial production runs and some of these tactical programs and the leverage we expect to get on the fixed overheads and the fixed manufacturing facilities, our model is even increased margins after that..

Okay, thanks.

And then final question would be the relative margin potential between targets and the tactical drones? Are they at the same or different?.

So the domestic targets and the tactical drones are about the same. Our international target margin opportunities are much, much higher on the international ones. Other than the Mako which has been approved internationally in certain areas, I do not believe there will be any international opportunity for any of our other tactical systems..

Okay, great. Thank you very much..

The next question comes from Michael Ciarmoli of SunTrust. Your line is open..

Hey. Good afternoon, guys or good evening. Thanks for taking the questions. Eric, maybe just on the tactical side. So we now have Program A, Z, F, Spartan, Valkyrie, Mako. I think the other one you said was, correct me if I'm wrong, Thanatos, but I mean we've got so many different variants right now.

I guess the technology is still in the proof-of-concept phase here. Can you maybe articulate or elaborate what the key differences between all these systems? And as you guys are looking at, maybe assigning probabilities of what goes and what doesn't go.

I mean, can you give us any sense of just sort of why you're seeing all these different programs, maybe what the subtle differences are in the platforms?.

Sure. Hi Mike. I think the base premise on why we're being successful is the base technology of the target drone is proven, it's flying today, is low cost and they're already built to be a treatable because target drones are inherently built to be shot down.

And as you know, the performance of our target drones are, they represent like on the aircraft side 4.5 generation threats, so like a F-15 or F-18 Super Hornet or an SU-35 for example. And so they have the flight and the performance envelopes that are equal to or better than manned aircraft and they're low cost. Now specifically to your question.

As I mentioned briefly, these are not bleeding edge, they're leading edge and they're proven which reduces risk.

It reduces schedule because they're affordable, they can be obtained in quantity and that old acronym back in World War II, quantity has a quality all of its own is really coming back home right now where there is an deemphasise on strategic exquisite systems that are very capable, but they're very expensive and they make great big juicy targets.

And distributed lethality is key because as you know, many of the powers to be in the Pentagon, there will be no sanctuary in a peer to peer confrontation. I think all of that is trending in our favor here. All of it, it's trending in our favorite. These are not PowerPoint presentations.

They're flying and they're just minor tweaks to things you make to turn a target drone. And now I'm coming to that part of your question into an unmanned aerial tactical drone or to turn a target drone into something else..

So what's the difference between Program A and Z? I mean, is it - are we talking size? Is it range? Is it payload capability? I'm just trying to understand why customers are asking for different variants, when you've already got another variant flying?.

So certain of our target drones can carry 600 pound payload and they can carry it for three or four hours depending on the mission profile. And certain other ones carry a substantially less payload, could still be a very lethal payload, but they're much smaller, which means maybe they would be much harder to identify and pick up.

And certain other target drones that we make the 167 for example, represent fighters. So it's peak performances at 40,000, 50,000, 60,000 feet where the navy target drone, it represents cruise missiles, the most sophisticated cruise missiles in the world and its peak performance zone is 10 feet..

Got it. That's helpful. Thank you very much guys..

Yes sir..

The next question is coming from Sheila Kahyaoglu of Jefferies. Your line is open..

Thank you. It's actually Greg Konrad on for Sheila. Just to follow-up on the last question, you mentioned a number of international opportunities in unmanned and I know there's been an effort to streamline the sales process.

Is there any way to maybe size the international opportunity, I'm assuming some of these systems are probably not exportable?.

Right, and so Greg, you're talking on the tactical side only or both target and tactical?.

Both target and tactical..

Okay. So, on the target side, the variance that we still have to be modified and they have to be ITAR approved and it has to be country specific. In the free world, the largest target drone users in the world are the U.S. Navy, the U.S. Air Force and the U.S. Army. And as you know, those are all of our customers.

Then after that, for example, there's the UK Ministry of Defense and as you know, a little while ago, we announced that we are working through QinetiQ, our partner. We are now supplying target drones to the UK Ministry of Defense. There is another very large one.

The one that I referred to in my prepared remarks were imminently, I believe we're going to be able to announce up to a $100 million contract. The potential of this and once we announced this, you'll understand the dynamics of this user.

There are a couple other - I hate to say a handful of other midsized target users internationally that we are pursuing. In addition to the ones that we have that I believe we're going to be successful on in the next 24 months because these customers are buying US weapons systems.

And they're not planning on shooting down little drones that ISIS is flying around.

They're planning on having to engage a peer or near peer threats with their weapons systems, their missile systems, their radar systems, and they want to exercise those systems against the most threat representative target drones in the world, and Kratos is by far the leader there, by far. It's not close. No one is close.

On the tactical side, as I mentioned, we've been approved in a number of countries just over a handful or it may go-to-market or Mako. Okay, I know and I know you know this. That the rules are changing.

The cruise missile rule, the law is changing and there are things going on with one of the treaties relative to the intermediate and medium range missiles. Irrespective of that, I do not see right now a large, if a large add-all market internationally for our tactical drones other than makeup. I do not believe that we will be allowed to go there..

Thank you. That's really helpful. And then on KGS, you had really strong margins in the quarter.

I mean, was there any type of gain or one-time item or how should we think about the trajectory of a profit for that business?.

So in the nature of that business is, we have the satellite business and we have the C5ISR business to combat system business. And as you also know, we do software, we do cyber product, cyber warfare products and then we have the services business. So we have a different margin mix of the different businesses in there. Okay.

The mix in there in Q three was very favorable. Q4 is looking really favorable, right? Really favorable right now based on what the customers are demanding and that may very well continue into next year. So it's a mix issue. And as you know, our services business has shrunk and come down substantially and that's when the lowest margins are.

And we did win this radar contract, but not by design, but the mix, mix has been becoming more and more favorable as the services business contracts..

And then just one bigger picture question, I mean it's been awhile, but I mean obviously leverage is down to 1.8, I mean you've built up a nice cash stockpile on the balance sheet. You've talked about a lot of investments starting to come down.

I mean how should we think about capital deployment going forward and I guess bigger picture, I mean what are you going to do with the cash?.

Our number one opportunity or use for that cash as we fully expect over the next 12 months to 15 months to continue to win production contracts in our drone area. And some of these - some of these are looking really, really big ones as we continue to do the demonstration flights and demonstrate the systems.

We want to be sure we have the adequate working capital on hand to both psychologically addressed with our customers and financially addressed the programs. Let's assume that we went five, six, seven of these over the next 15 months. We don't want to be getting up to do anything. We want to have the liquidity on hand to execute these as we are..

Thank you..

Next question is coming from Seth Seifman of JP Morgan. Your line is open..

Thanks very much and good afternoon Deanna and Eric..

Hi, Seth..

Okay. So I wanted to start off just asking a question about the model and it looks like, based on the guidance, the EBITDA dollars that we'll see in the fourth quarter will be kind of flattish to maybe slightly down from Q3 even though revenue is going to be significantly higher. And you just mentioned the favorable mix in KGS.

So how do we think about that progression and why there wouldn't be more dropped through on the higher revenue in the fourth quarter?.

We are doing everything that we can. We talked about this a couple three quarters ago. That we want to meet or preferably exceed our expectations. And we are focused on that. And so if everything turns out on the high end of everything, maybe we'll do better than that..

Okay. And then just, I guess, you mentioned that the things were going according to plan on the target side, so we definitely appreciate that.

And we've had a lot of questions about the new tactical opportunities, but feel like in the near-term, the important thing is kind of to execute on the target drones, the programs of record and you've got a new facility starting up shortly to do that.

And maybe talk about a little more color on your level of confidence that that's going to bring about the kind of EBITDA that you're looking for and on the industrialization side that everything's all ready for these new levels of production that you're looking for..

This is on the target side?.

Yes..

If you refer back to what we've said that our Sacramento facility right around the end of 2019 will be full up on the target side. The Oklahoma facility is underway, the equipment has been ordered, it's en route.

We expect to initially start producing drones, they're few one, and we expect a significant increase or ramp in the drones coming out of that facility in Q3, Q4. So it is fully up and capable by the beginning of 2020 at which time the Sacramento facility would be at or near capacity.

So we are time phasing and sequencing this facility in and it is a modular or scalable facility. And to Mike's question, a little - Mr. Ciarmoli's question a few minutes ago, a number of the tactical systems with a substantial amount of that aircraft is very similar to the target system.

And so our Oklahoma facility is intended to be at least initially the primary provider of most of our tactical drones. Now, as I mentioned today, there are certain tactical drones that cannot be built at that facility for security reasons.

They are going to be built at another facility, one of which we're going to be executing that at least in the next couple three weeks and have that one ready middle of next year..

Great. Okay. Thanks very much..

Thank you..

[Operator Instructions] The next question is coming from Joe Gomes of NOBLE Capital. Your line is open..

Good afternoon. Thanks for taking my question. Most of them been answered here, but in listening to some of the calls here or number of companies in this space, there has been some discussion about the employee situation without getting an acceptable number of employees and now it's a somewhat of a challenge.

And I was just wondering how you guys are - if that's impacting you at all and if so, how are you dealing with it?.

That is actually a very intuitive and a great question. We have been and we remain very, very focused on the human capital side and the human resources side. And in particular, where the programs are restricted or they're classified and getting the appropriate people for those programs. We are not running into any significant challenges yet.

We're fortunate in where some of our locations are and some of the dynamics that have happened in those locations that have freed up people from other companies that haven't been successful on things and these people are qualified to work on some of these programs.

This was one of the reasons that we selected Oklahoma because we did a significant study on the human resource pool there and the type of person and can they get cleared, can these people get cleared, et cetera. And that's one of the primary reasons we went there.

And on the other facility, obviously I can't say where it is, but if I could, you'd understand. Yes, that's a good spot for this because those are the types of people that have this expertise and that they can get cleared.

So we're trying to be as thoughtful and methodical about it as possible, but I don't want to leave the impression on you that this is easy. It's a challenge and we've got to stay focused on it and we've got to stay ahead of it..

Okay, great. Thank you..

Thank you..

Ladies and gentlemen, this concludes the Q&A session. I would like to turn the call back over to Mr. Eric DeMarco for closing remarks..

Great. Thank you all for joining us today. We look forward to our next regularly scheduled time to get together. And we'll be, as Deanna mentioned, when we report Q4 and when we give our initial 2019 guidance at the beginning of next year. Thank you..

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