Good day, ladies and gentlemen. And welcome to the Kratos Defense & Security Solutions Fourth 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, today’s conference may be recorded. I would now like to turn the call over to Marie Mendoza, Senior VP and General Counsel. Ma'am, please begin..

Thank you. Good afternoon, everyone. And thank you for joining us for the Kratos Defense & Security Solutions fourth quarter 2018 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 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..

Great. Thank you, Marie. For Q4 in 2018 the organic growth trajectory of Kratos continued and we generated our company's best operating and financial performance in many years substantially exceeding EBITDA, gross margin, operating income and EPS objectives, including positive GAAP EPS in the fourth quarter.

As we begin the new year, we are forecasting continued organic growth, including organic revenue growth of approximately 12.5% and adjusted EBITDA organic growth of approximately 15% for 2019 over 2018 and this excludes all of the following. It excludes the impact of the FTT acquisition we announced today.

It excludes the impact of any potential tactical UAS production revenue we could generate. And it excludes the impact of the potential upside from certain very large hypersonic system and ballistic missile target opportunities we are pursuing, which are expected to be awarded this year.

Supporting our future organic growth expectations, Kratos Q4 book-to-bill ratio came in at 1.3:1 and last six month book-to-bill ratio was 1.4:1, with every Kratos business unit generating between 1.1 to 1.4 book-to-bill ratio for fiscal 2018.

Overall, our bookings increased 254 million or approximately 55% for 2018 over 2017 and bookings for classified work were up significantly year-over-year.

Additionally, even with the substantial 2018 bookings, our bid pipeline continues to increase its valid at $6.8 billion at the end of 2018 and this reflects our alignment with the DoD 's national security strategy and its funding priorities.

At December 30, 2018, our Unmanned Systems division generating organic growth of 75% over the previous 24 months and we are forecasting our Target Drone business to grow to approximately $250 million in annual revenue over the next few years or 90% organic growth over the 2018 revenues.

And our Tactical Drone business, we now have six customer funded Tactical Drone programs with several additional programs expected to be under contract by the end of this year.

The moment in Kratos’ Tactical Drone business continues to build and based on very recent customer meetings we are more confident than ever that is not a question of if, but rather when this business will be an explosive growth generator for company.

We also believe that when is rapidly approaching and we expect our Tactical Drone business to ultimately be substantially larger than our Target Drone business as we achieve production. We continue to see 2019 as the year of bookings for our Tactical business with significant growth and financial contribution expected to begin in 2020.

We also see 2019 as the year that Kratos is established as the world leader in the high performance unmanned aerial drone system product class that we’re in, which we see as a multi-billion dollar opportunity for our company.

From a perspective program update standpoint in late December 2018 the Air Force publicly announced that Kratos will execute 58 Valkyrie, it’s scheduled to fly in calendar of Q1 2019, which means in the next 30 days.

One of the successful series of Valkyrie flight occurs, which will be one of the most significant milestones in Kratos’ history, we expect to receive initial unit orders for Valkyrie. Based on recent customer meetings and discussions which have been extremely favorable, we expect this to occur in 2019.

Program F is scheduled for additional customer funded demonstration flights in Q2 of this year and we expect initial unit orders later on in 2019 or early next year.

The DARPA funded Gremlins program with our prime partner Dynetics has planned initial demonstration flight scheduled for Q2 of this year and once of the Gremlins’ demonstrations are successfully complete, we expect initial orders later in 2019 or in 2020.

On our confidential Thanatos program, which we were informed by our customer that we were successful in late last year, work on the new and expanded secure production facility is beginning and we have executed the lease on the new facility I previously mentioned on last call. We expect Thanatos’ to be a meaningful contributor beginning in 2020.

We recently announced Kratos’ Ethon ISR UAS [ph], which is flying today. It is now under a funded development contract with the government agency for several millions of dollars, with this program expected to be a meaningful contributor to Kratos in 2020. Project Spartan continues to gain traction.

We currently expect to be under initial contract in Q3 of 2019, with this program expected to be a meaningful financial contributor to Kratos beginning in 2020. We have a new project we can now discuss with you.

It's called Apollo, which we expect to be under contract by Q3, Q4 of this year and which is expected to be financially meaningful to Kratos in 2020.

Kratos' DIU Mako UAS Program was delayed from a previously expected Q4 2018 funding date, to now expected Q2 2019 funding date, with this delay being indicated in a public announcement by the customer in December.

The delay in the DIU Mako funding was one of the primary reasons why our Q4 revenues came in below forecast, with this program now expected to be financially meaningful to Kratos beginning in 2020. Also importantly, we now have a third customer for Kratos' Mako.

With this initiative named Athena [ph] and we are looking for contract award from this customer in the second half of 2019. We also continue to work Project A and Project Z, and are looking for initial development contract awards in 2020.

Just a few weeks ago, the first high performance Kratos drone came off our Oklahoma facilities manufacturing line, with production quantities expected to increase throughout 2019 and a significant step up in production expected in 2020, related primarily to Kratos' tactical programs.

For 2019, we expect primary growth drivers in our Unmanned Systems business will be from our target drone business, including under contract programs with the U.S. Air Force, U.S. Navy, U.S. Army and other agencies, and also from a very large multi-year international award we received in late 2018.

In 2019, we expect to continue ramping on the Air Force AFSAT program, full rate production year 2014, with full rate production years ‘15 and ‘16, which represents production and deliveries for fiscal years 2020, 2021 and 2021, 2022 expected to be formally authorized in 2019. This program is sole sourced to Kratos.

In 2019, we expect continued execution on Kratos' five-year $93 million contract for Target Drones with the U.S. army that we received last year. Our most recent information from the customer indicates this program will begin ramping in late 2019 and into 2020, and also into 2021. This program is sole sourced to Kratos.

We are also in production with a confidential customer. With execution expected to continue increasing in the second half of this year and into 2020, as we head into future full rate production. This program is also full sole sourced to Kratos. In July of 2018, the U.S.

Navy announced the expected sole source award to Kratos of FSAT program low rate initial production year three or LRIP3 for up to 60 BQM-177 target drones. This award was originally expected in late 2018.

We are currently negotiating LRIP3 with the customer, which now has an expected Q2 2019 award date with forecast LRIP3 quantities now at approximately 50 drones. We have reflected this new anticipated schedule and revised quantity in our 2019 guidance.

Our SSAT customer has also recently indicated the award of a multi-year sole sourced full rate production contract to Kratos at increased quantities and this is expected to be pulled to the left and accelerated with an expected award date either late this year or early in 2020. If this happens, this will favorably impact Kratos in 2021 and 2022.

And directly related to the SSAT program and our financial forecast, just yesterday, now they are publicly announced that Kratos' BQM-177A has achieved initial operating capability or IOC, which is an extremely important milestone and further solidifies our expectation for SSAT to ultimately be $1 billion plus program to Kratos.

As I mentioned, in late 2018 we announced a large new sole source multi-year international target drone contract award with the potential value up to approximately $100 million, which we expect to begin contributing to us in 2019. However, on this and other Kratos international Target Drone programs, the temporary U.S.

federal government shutdown caused delays in certain export license related approvals, which are required for Kratos to ship drones out of the United States, which situation was also recently reported as having an impact on the industry by the Wall Street Journal. This delay in export licenses is also impacting Kratos' Satellite business.

Accordingly, in our 2019 financial guidance we have taken a cautious approach and we have moved to late ‘19 certain international program related execution or deliveries we had previously expected for the first quarter and the first half of 2019, as the government works through its backlog of export license approvals.

Kratos' Satellite Communications, Cyber and Training division, our company's largest and most profitable had a very solid 2018 and a particularly strong second half of the year including Q4, which trajectory is historically typical for this business and which we are forecasting for 2019.

This business also had very strong 2018 bookings, including bookings in the second half of the year of nearly $250 million or 1.5:1 book-to-bill ratio.

Additionally, our Satellite business has had a number of positive developments since we last reported to you, including that we now expect to be successfully designed in or selected for a number of new space opportunities many of which are classified, which when the related Kratos products and solutions reach production and delivery beginning approximately 18 months from now, we expect a significant new growth curve to begin for this business.

National security related spending in the space and satellite area are seeing some of the largest DoD funding increases. These are driven primarily by the perceived Russian and Chinese threat to our country's space assets, which is providing Kratos a number of large new opportunities.

Also there are thousands of new LEO, GEO and MEO satellites planned for over the next several years, with that recently being reported that an estimated 3,300 new satellites are expected to be launched through 2027, representing a potential market opportunity of $284 billion.

Of this market opportunity, we believe that approximately 70% of the space systems lifecycle costs are associated with the ground solutions and ground solutions is what Kratos is a clear industry leader as represented by our ground equipment services and solutions, which support approximately 85% of U.S.

space missions and which are used by approximately 75% of all global satellite operators.

Related to this forecast market growth, recent publicly announced developments on the ground, which are clearly aligned with Kratos' satellite and space business, include the introduction of cloud based technology architectures from companies including Amazon, which will be offering ground stations as a service under the name of AWS Ground Station.

Additionally, Google parent Alphabet Inc. has an initiative called balloon, which is offering cell tower connectivity using balloons that fly in the edge of space. And there are a number of HAPS or high altitude pseudo satellite drone initiatives under way.

Each of these represents new opportunities for Kratos' industry leading ground based Satellite Space business. Also as you know, Kratos owns and operates what we believe is the largest commercial network of space focused radio frequency sensors, which is used to identify, locate and mitigate interference or other unwanted issues with space signals.

Kratos' ground network consists of several 100 sensors at approximately 20 locations around the globe and is one of our company's fastest growing and most valuable businesses and assets.

Kratos' Vector Monitoring business is expected to continue to organically grow for the foreseeable future driven primarily by the thousands of additional satellites expected to be launched in the next few years and our government customer demand.

Kratos' Training Systems business also had a very solid 2018 and we are forecasting an even stronger 2019 driven by the major long-term programs we have successfully received, including KC-46, Marine Common Aircrew Trainer, CH-53, AVET & NATS, and RSM.

Kratos' Training Systems business is one of the largest bid proposal pipelines in our company, which include several large multi-year programs we are pursuing, which is directly related to the significant funding increases and the DoD budget for weapon systems, upgrades and operational readiness.

Kratos' Rocket Support Services or RSS business continues to be an industry leader in the rapid development demonstration and fielding of high performance technology leading ballistic missile target and hypersonic systems areas which are also seeing significantly increase DoD funding and growth.

Emphasizing this growth opportunity, since we last reported to you, the President has announced a new missile defense policy aimed to address the proliferation by peer, near peer and rogue advisory advances in ballistic and hypersonic missile systems. Representative of the mission critical U.S.

national security priorities that Kratos’ RSS business supports the U.S. Navy recently publicly stated that the next-generation air missile defense radar or AMDR system had successfully performed in 14 ballistic missile tests, with additional test planned.

While I cannot get into specifics for security reasons, Kratos’ RSS BMD Targets Systems are important element of this test regiment and we recently announced that Kratos’ RSS target system successfully exercise the AMDR system.

2019 is currently forecast be very strong for RSS, with Q3 and Q4 expected to be particularly strong based on current expected mission and execution requirements and new contract awards.

Additionally our Ballistic Missile Target and Hypersonic Systems business is currently pursuing a number of new large program opportunities, which if we are successful in 2019 award schedules hold could provide significant upside to our 2019 financial forecast and position this business for further substantial growth in 2020.

Our C5ISR Modular Systems business had a strong second half of 2018, including the fourth quarter and we are executing on a number of unmanned aerial system, missile, defense, radar and other C5ISR and CBRNE system opportunities.

This business has firmed up over the past several quarters primarily the result of the recapitalization of strategic weapon systems by the U.S. and our allies, and the related procurement of missile, missile-defense, radar, unmanned drone and other systems with Kratos supports.

Based on our C5ISR businesses current backlog and the opportunity pipeline in 2019 we’re anticipating moderate organic growth with quarterly performance – quarterly financial performance expected to be driven primarily by our respective customers’ production and execution and delivery schedules.

Major representative programs our C5ISR business supports includes Patriot, Fad, LCS, CPP, SHORAT [ph] and certain unmanned aerial system programs. Our Microwave Electronics business performed as expected in 2018, with the second half of the year being the strongest and with this business full year book-to-bill ratio being approximately 1.1:1.

We are forecasting moderate organic growth for this business in 2019, including an anticipated strong second half of 2019 based on delivery and execution schedules from our current near record backlog. Q1 is being forecasted as by far the lowest for this business with the business ramping from there.

Representative programs are Microwave business support include F-15, F-16, Iron Dome, Sling of David, Barak, Spider, Arrow and Griffin. For Kratos’ Traditional Government Services business the good news is that in the second half of 2018 we were awarded two new large contract supporting a directed energy laser program and radar program.

However, each of these new programs is currently ramping far slower than we anticipated, this delay in ramp is also a primary driver to cause Q4 revenues to come in below our forecast. We are working with respective customers to address the delays and we expect these to be back on track by the second 2019.

In the full year and Q1 2019 financial guidance Deanna will be going through with you in addition to the business considerations that I previously mentioned we are including no initial tactical UAS production in our 2019 forecast and we are not including certain very large new program opportunities we are pursuing including in the missile defense and hypersonic areas as the outcome of these are very binary and if we are successful these could meaningfully positively impact our 2019 forecast.

Additionally, as a result of the change in control of the House of Representatives and the resulting immediate partial U.S.

Federal Government shutdown and our initial 2019 financial forecast, we are providing a cautious outlook and we are assuming a federal fiscal budget 2020 continuing resolution will begin on October 1st of this year and it will last throughout the rest of the year to 12/31/19.

This assumption means planned customer production increases on certain Kratos’ under contract target drone programs will not be realized in calendar ‘19, but we are forecasting them for calendar 2020 once the federal fiscal 2020 budget is assumed authorized.

Deanna?.

Thank you, Eric. Good afternoon. Kratos fourth quarter of 2018 revenues of $164.4 million, which were up sequentially from third quarter 2018 revenues of $159.4 million, came in below our expectations of $182 million to $192 million.

Our revenue coming in below our expectations was primarily related to five programs four of which Kratos has now successfully received which were awarded either later in the fourth quarter that we forecast or which have not ramped as quickly as we forecast and our DIU program which Eric mentioned earlier with the new contract award now expected in Q2 of ‘19 to do the recent changes in DIU organizational leadership.

The good news is that four of these are now under contract with Kratos we're working closely with our customers to ramp them up including the hiring of highly cleared personnel on two new UAS programs and we are forecasting that each of these contracts will be back on the planned run rate by the middle of 2019, which is reflected in our 2019 guidance.

Compared to the fourth quarter of ‘17 revenues decreased slightly by $1.9 million or $166.3 million primarily due to the continued reduction in our legacy government services revenues as well as the timing of production and shipment ramps in the fourth quarter of ‘17 compared ‘18 primarily on our FSAT program in the Unmanned Systems division.

Our debt to EBITDA came in at $18 million above our expectation of $13 million to $17 million primarily driven by a favorable mix of revenues and the positive benefit of cost reduction actions we have taken throughout 2018, as well as our initiative of enhancing operating margins by foregoing low margin opportunities or more aggressively negotiating more favorable margins with the potential results of reduced revenues.

Additionally, Kratos’ adjusted EPS of $0.09 per share also exceeded our forecast of $0.03 per share to $0.07 per share for the quarter.

In the fourth quarter, KGS generated revenues of $128.2 million, adjusted EBITDA of $15.1 million or 11.8% of revenue and operating income of $11.6 million, all which were up from the prior year comparable revenues of $124 million, adjusted EBITDA of $12 million and operating loss of $15.8 million or operating income of $8.4 million excluding the impairment of goodwill respectively, reflecting the growth primarily in the Satellite Communications and Training Systems business, a favorable mix of revenues, as well as margin improvement in our Modular Systems business.

From an accounting standpoint, Kratos was required to adopt a new revenue recognition practice beginning January 1st of this year of 2018, which can affect the timing of revenue recognition for certain contracts.

The impact of this new accounting standard was approximately $9.4 million and $29.9 million on Kratos’ fourth and full-year – fourth quarter and full year 2018 revenues respectively.

Our Q4 operating income was $10.8 million or 6.6%, up from the fourth quarter of ’17, with an operating loss of $15 million, which included the impairment of goodwill and our DRSS or Legacy Government Services business of $24.2 million. Excluding the impairment of goodwill in 2017, operating income was $9.2 million or 5.5% of revenues.

The increase was driven by a reduction of SG&A expenses reflecting the impact of the cost reduction actions we have take, as well as a reduction of discretionary R&D expenses. Our adjusted EBITDA for the fourth quarter from continuing operations and excludes non-cash stock compensation cost of $2.1 million and severance related cost of $400,000.

On GAAP basis net income for the fourth quarter was $4.7, million which includes a loss from discontinued operations of $500,000 and include a tax provision of $200,000, primarily reflecting tax expense for foreign jurisdictions and for states for which we cannot utilize our NOLs.

Moving on to the balance sheet and liquidity our cash balance was $182.7 million, plus $300,000 restricted cash at December 30th. At quarter end, we had zero amount outstanding on our bank line of credit and $9.7 million of letters of credit outstanding. Debt outstanding was $294.2 million at quarter end and net debt was $111.5 million.

Our LTM adjusted EBITDA was $60.5 million with the net leverage ratio of 1.84:1. On a pro forma basis for the FTT acquisition which was announced earlier today, net leverage is approximately $2 million -- $2.0 million.

The cash consideration portion of $33 million, which is subject to working capital related adjustments, consists of approximately $19 million paid at close with the balance payable over three years.

Cash flow generated from continuing operations for the fourth quarter was $2.7 million, which includes the use of approximately $400,000 of internal non-capital expense related development costs related to the LCASD program.

Capital expenditures were $4.7 million, including approximately $2.3 million related to the Unmanned Systems division, primarily reflecting the two LCASD Kratos owned aircraft and related equipment that we are building and we currently expect this capital effort to be complete in the first quarter of 2019.

Our free cash flow from operations for the quarter was use of $2 million, reflecting the $2.7 million of cash generated from operations, less capital expenditures of $4.7 million.

Milestone collections primarily two large training systems and two international target drone programs that were expected in the fourth quarter of ‘18 are now expected in the first and second quarters of ‘19 based on our most recent operating plans.

The shift in the achievement of these milestone deliverables resulted in an increase of our DSOs from 129 days at the end of the third quarter to 131 days at the end of the fourth quarter. Our DSOs include long-term delivery projects where we invoice amounts at the completion of certain milestones and/or final delivery of products.

Our contract mix for the quarter was 86% of revenues from firm fixed price contracts, 10% on cost plus contracts and 4% on time and material contracts. Revenues generated from contracts with the U.S.

Federal Government during the quarter were approximately 72%, including revenues generated with the DoD, non-DoD Federal Government agencies and FMS contracts, which were approximately 9% in the quarter. We generated 7% from commercial customers and 21% from foreign customers.

Today we are providing first quarter revenue guidance of $147 million to $157 million, adjusted EBITDA guidance of $9 million to $11 million and adjusted EPS guidance of $0 per share to $0.02 per share and full year revenue guidance of $720 million to $760 million and adjusted EBITDA of $71 million to $77 million.

As Eric mentioned earlier, full year and first quarter of 2019 financial guidance reflects the estimated impact of the recent partial government shutdown that has delayed certain domestic and foreign military sales contract awards and export license approvals required for international sales.

The company is providing full year 2019 cash flow from operations guidance of $40 million to $50 million, capital expenditures of $28 million to $30 million and free cash flow guidance of $10 million to $20 million, plus the expected final cash receipt of the retained working capital of the company's divested PSS business of approximately $4 million to $6 million.

We expect CapEx to be at elevated levels for 2019 as we make the necessary investments for manufacturing and test equipment for our new Oklahoma and new secure facility that Eric mentioned earlier of approximately $6 million to $8 million and approximately $4 million to $6 million related to aerial target drones the company plans to build in preparation of fulfilling expected customer requirements.

We expect our estimated cash taxes to be approximately $2.5 million to $3.5 million for FY19 and expect the impact of Tax Reform to be fairly insignificant to our estimated cash taxes due to our over $300 million of net operating loss position. Our guidance also reflects the anticipated impact at the FTT acquisition that we announced earlier today.

Eric?.

Thank you, Deanna. As Deanna mentioned, today we announced Kratos' acquisition of Florida Turbine Technologies are FTT. This is the first acquisition Kratos has made since 2012.

FTT is a technology and products company, strategically positioned for the small to medium sized affordable turbofan and turbojet market, including for high performance unmanned aerial drones, missiles and weapons systems. The affordable leading edge in technology that FTT brings to Kratos and to our Unmanned Systems business is truly incredible.

With recently developed FTT engine systems offering thrust and SFC performance improvements that have previously been unobtainable in the low cost jet engine area. As you know, the number one cost and most Kratos drone and weapon systems building materials is the engine and affordability is a key differentiator for Kratos' platforms and systems.

Accordingly, we are looking for FTT to further Kratos' vertical integration of our drone and weapons systems, increase Kratos' technology and our performance lead in the systems and also reduce system costs.

Additionally, the projected market for advanced turbojet and turbofan engines in this class alone is easily in the many thousands over the next five years, given the projected number of extended range and low cost cruise missile systems and next-generation unmanned weapons systems to be acquired.

And Kratos and FTT, we intend to be the leader in this extremely large and growing market space. FTT today is currently under contract on or pursuing 12 specific programs at this time.

Finally, beyond traditional turbo jet and turbo fan engines, FTT is also working to develop advanced affordable engines for hypersonic systems in their special programs area or Skunk Works that we believe will demonstrate a new class of affordable hypersonic propulsion system.

Importantly, FTTs next-generation engine technology and programs were previously funded by FTT, meaning intellectual property ownership for Kratos. These FTT engine programs and initiatives are now substantially U.S. government agency and customer funded, meaning no significant internally funded Kratos investment should be required.

Similar to CEi, which Kratos acquired in 2012 and which has been the core of Kratos' unmanned aerial drone system strategy and the UAS business we have today, we believe that FTT over the next few years will also be a disruptive and market transforming business with incredible growth and value generation expected to be realized for Kratos shareholders.

FTT will now become Kratos Turbine Technologies or KTT, a new Kratos division with Stacey Rock, a senior Kratos executive and technologists for over 12 years, becoming the KTT President. It's important to note that the FTT founders and all of their employees will be staying with the company.

KTT and Kratos' Unmanned Systems division will be organized so that they will work extremely closely together with Stacey and Steve Fendley, our Unmanned Systems Division President, both being honored engineer graduates. The acquisition of FTT furthers Kratos' position as a unique technology assets or company.

We're disrupting the national security market with affordable leading technology systems and products, and we're in a growth trajectory that looks pretty substantial for the next several years. With that, we'll open the line up for questions..

Thank you. [Operator Instructions] Our first question comes from the line of Peter Arment of Baird. Your line is now open..

Hi, Peter..

Eric, just to I guess to focus on your initial comment about the, well, I guess the target business growing to $250 million in revenues.

I guess is there a path you see -- how many years does that take and then you said over the next few years, but is it -- are we seeing this all by missile defense testing on existing programs or you see in new programs, maybe just some color there..

The vast majority is existing programs and we see ourselves getting there in three years or four years at the most..

Okay. And just as a follow-up, just -- if I could just on FTT, you mentioned the 12 programs are on, is there any programs or record that you can disclose or is there any more color on that? Thanks..

Let me say it this way and I'm going to say it this way for competitive reasons. If you take a look at weapons systems, a number of them are going to ER or extended range weapon systems.

So if you look at existing weapon systems, these are air to surface weapon systems, ship borne to service weapon systems and you’ll see the name of the weapon system with the -ER for extended range that is a good representative example of the existing programs that are being modified for the threat..

Got it. I’ll jump back in the queue. Thanks Eric..

Thank you..

And our next question comes from the line of Ken Herbert of Canaccord. Your line is now open..

Hi. Eric and Deanna, good afternoon..

Good afternoon..

Hi. Good afternoon..

I just wanted to first start off just again on the FTT acquisition, it sounds like if they are successful on some of these you could potentially require fairly significant investments to support the production ramp.

Can you would all talk about sort of how the CapEx associated with this business looks and NOI we see that's been a major issue for you over the last few years to capitalize to support the ramp.

What's the outlook for this business assuming they are successful and what could the cash implications be around the investments?.

The -- so the outlook for the business is extremely bright. There is a very large and strong demand from government agencies for alternatives and for next-generation turbojets and turbofans for their weapon systems.

The initial investment that’s included in the business plan in our financial forecast is $3 million to $5 million per year, okay, that goes out for a number of years.

If we are successful on some of these programs that we’re getting designed in on and they go into production, those numbers will increase, but so will the revenue of the business the profit of the business from a cash flow.

I’m not going to get into details on what that looks like two or three years from, now if we get there – let’s take it like we did with our unmanned system division. Let’s get designed in, let’s win the programs then I'll walk you through the investment required for the growth..

Okay. That’s great.

But it sounds like on sort of a relative to your tactical business it's likely a much lower investment profile it sounds like?.

Far lot – far -- it is nothing like we have done for the past several years on the Valkyrie and what we did previously on the Mako, no sir..

Okay. Great. And if I could I just wanted to follow-up obviously on press this week on the Boeing announcement of their loyal wing manned market entrants into international markets.

Can you comment Eric on I know obviously you would always expecting you had competition in the market but sort of how you view that relative to your portfolio and is it something you expect near or midterm to be a potential sort of threat to your United States business, and obviously, that particular aircraft seems to be targeted internationally.

But how would you characterize a frame up of that?.

Well, as you alluded to, Ken, we always new competition would come, because the market opportunity for jet drones that can perform in anti-access area denied airspace it’s in the billions, it’s coming we are following the unmanned systems strategic roadmap that was initially put out in 2010 and the last nine years have much pretty much tracked to that roadmap.

Very candidly this competitor and it coming from Australia, with a significant Australian investment. We don’t think it could have worked out better for our company but let me tell you why.

First of all our price point, as the price point on our Valkyrie depending on quantities is to $2 million to $3 million and we have basically proven that out as we built three aircraft, right? Our aircraft has least published 50% greater rate.

Our aircraft has internal weapon space, right? We’re runway independent, which is critically important to the U.S. customers. We’re launched off a rail and recovered by a parachute including in water where we saw seal and turnaround time for our drones is incredible, right? Very importantly our drones exist today and they are flying today.

The competitors they have a model today, they say they will be flying late next year. So, again, as you said, we knew the competition would come, but we are very comfortable with our position and the affordability for the performance we believe it’s unmatched and that’s from our customers..

Great. Thank you very much. I'll pass it back there..

And our next question comes from the line of Noah Popanaki of Goldman Sachs. Your line is now open..

Hello, Eric..

Hello..

Is FTT included or excluded from the 2019 guidance?.

It is included for the period, for the period of the -- of the period of acquisition through the end of the year and so roughly 10 months..

Can you quantify how much revenue is in the $720 million to $760 million from it?.

Yeah. So it’s approximately $45 million..

Okay. So – okay. So that number from got it. So then the – that implies I guess sort of 12% organic revenue growth in the business, Eric you made some comments here about changing the growth curve going forward.

Are you saying you expect the growth rate in 2020/2021 to be higher than 12%?.

Yes..

Okay. And then, on the margins, the EBITDA guidance implies a relatively flat adjusted EBITDA margin, but you have pretty good growth you should have some drop through your layering in a business with a higher margin than the legacy business and you’re vertically integrating what you just described is a pretty significant cost component.

I would think that will all add up to a decent amount of margin left?.

Yeah. So, as we’ve demonstrated over the last few years and including Q4, we've typically end up being conservative on our margin guidance. We have routinely achieved or exceeded it and we’re hopeful to do that again going forward..

Okay. Is it possible to quantify how much of your cost of goods sold is the engine.

Just want to get a little bit any kind of way to frame a more precise degree of uplift from that vertical integration would be really helpful?.

Yeah. It’s approximately 30% to 40% of the bill material cost depending on the drone..

Got it. That’s really helpful..

Yeah..

On cash flow at one point you were pointing to getting to 70% of adjusted EBITDA translated to cash from ops, for 2019 that would be over $50 million, the guidance is $40 million to $50 million and you've got what seems like a not insignificant amount of slippage out of 2018.

When should we expect the cash flows to convert margin what we’re seeing on the P&L?.

As I had mentioned earlier on the call, Noah, there is a number of large training programs, which have milestones attached to final delivery, so we don't get to see those final milestones and the retention until the final delivery which is some of the slip into ‘19.

However, as we have continued to grow that business at a faster pace than the rest of the business those milestones will continue to as old milestones are achieved there is new milestone that we need to achieve for final collection.

So we won’t collect those amounts that we expected from ‘18 the new milestones will then be need to be achieved in ‘19 and ‘20 for the new training systems that we are building and then ultimately delivering in 2020 and 2021 as some of these programs are span a period of….

Okay..

… over two years..

I see.

I mean, I guess, I would thought you kind of knew that when you were targeting 70% of adjusted EBITDA is that fundamentally changed that target for the time being?.

Yes. Due to the mix of the business that we’re seeing and especially in on that training side and then also in our drone business as well because if milestones are similarly weighted in the drone business..

I see. Okay. Thanks so much..

Okay..

And our next question comes from the line of Josh Sullivan of Seaport Global. Your line is now open..

Hi. Good evening..

Hi, Josh..

Just for FTT, looks like they won a $50 million what ATA on contract in December.

Can you just expand on that? Is that something you're going to own the on the IP through or what's the vehicle there?.

The primary IP related to that program, the company had already developed and they -- the company has several 100 patents or patents pending. These are developing -- these are next-generation engine programs with specific platforms in mind.

So that is -- you found one, that is one of many that they have received in the past couple of years, which are pointing, Josh, to those 12 opportunities which are sitting right here in front of me as I'm talking to you, which we're getting designed into and which we expect to be the engine for going forward once again in the production..

Got it. And then just on the current drones using third-party jet engines for propulsion.

Is there going to be an opportunity to use FTT engines at some point in the target drone business at some point?.

Probably on the existing Target Drone, probably not, because once they're designed in, they're qualified and they're approved by the customer, you don't want to change it out in the middle of production run, a multi-year production run.

However, on our Tactical Drones going forward, virtually all of them and on new target drones, the answer is yes, KTT, FTT, will be the vertically integrated engine. That's the objective..

And then is there any way to update the anticipated size of the orders that we should be looking for following the successful Valkyrie test?.

I am not – I -- as I've said on my prepared remarks, Josh, we in the past month. We've recently met with a number of customers including at the Pentagon and which is why I said that this is going to happen. If this is happening, it's no longer a question of if it's when and the when is coming in.

So I don't want to get ahead of the customer and I'm not going to do that. So, not yet, not yet. Josh, importantly on the question I think that, Ken asked; the fact that Boeing is making the investment that they're making and them coming after this, that validate this market that we've been going after and we've got the lead in. That's how we see it.

It is about that -- that's probably the best validation external data point there is..

Got it.

And then just one last one, on the new Oklahoma facility, I think, you made some comments there, but can you just provide any color how that's coming along, any progress there?.

Yeah. On track. The first drone came off the line last month. We're going to have a significant function there with the Senator Inhofe and his staff and I think Senator Lankford is going to be there also. This is a big deal. These are -- we understand this facility, we are going to be the only provider of entire aircraft ready to fly in Oklahoma.

So they are big supporters of ours. We're going to ramp-up throughout the year and the next year quantities are very, very significant once we're 100% set up there..

Okay. Thank you..

Sure..

Our next question comes from the line of Michael Ciarmoli of SunTrust. Your line is now open..

Good afternoon. This is George Fica [ph] on the line for Mike..

Hi, George..

First congratulations on the margin performance. Multi-year high. That's awesome..

Yeah. thanks. Thank you. As we've been talking, we've been receiving inbounds on that. Thank you and….

Yeah..

… we're looking forward to continue to ramp going forward..

Yeah. I come from industry. I know how hard it is to get it up. So great job..

Thank you, George..

What changed that made you pull the trigger on the acquisition now? What was different now versus previous times?.

So if you could see me I'm smiling and the reason I'm smiling is, we have been working with the owners, the founders surely enjoy for a year-and-half.

So we have been tracking this, we have been working with them, understanding the technology, understanding what they want to do and their ambitions which are big, very large, understanding the programs they were going after and additionally over the past year and a half and most recently the past three months and six months, we know this next-generation of drones is about to happen.

We know this next-generation of extended range weapon systems is happening. You can see that out there. Just take a look at JASSM-ER, Harpoon-ER, you can see the extended range weapons that are coming. And this market, the small engines, the technology is not current.

And this company is disruptive, they are favored by the government customer, favored by them. And we've been working with the customer, we've been working with this company and this has all come together and so that's the picture of why we did it now..

You mentioned something very interesting in your comment about 2019 about the drone mix. You mentioned that for 2019 most of it is going to be driven by Target Drones.

When does mix shift and become more equal, where tactical is an equivalent portion of the revenue mix versus target? Is that something that you can expect in 2021?.

That's a very fair question. So the mix in 2019 does not include any what I'll call production units for Tactical Drones, okay? The Valkyrie is going to fly very soon as the Air Force announced in December.

We could get – if we were to receive an order for 25 or 30 Valkyries before the end of the year at $3 million each, 15 months – 15 months, 18 month production period, that mix could substantially change in 2020..

And in terms of….

You know….

Yeah. Go ahead. I am sorry..

Another one I want to mention is Program F, that system is flying today and it's being pulled to the left and we're going to be doing a number of demonstrations including some expected very interesting demonstrations in the middle of the year.

If those are successful and that program goes end of this year, next year, we can get an order for a couple of 100 of those at $300,000, $400,000 each..

Okay.

And I mean that seems like those are your two top opportunities in the near-term, Valkyrie and Program F?.

Gremlins with our partner Dynetics. The Gremlins are going to – the demonstration is scheduled in the second quarter. I am not going to get ahead of our partner Dynetics, but there is significant customer interest in this system. So, we've got a Fanatos [ph] is going to be significant next year..

And I guess my last question; could you just familiarize us all again just once more on how many programs do you have in the hypersonic domain? And does FTT have any ongoing work in that domain and that's my last question? Thank you..

Yeah. So, FTT, I'm going to go in reverse order. FTT absolutely has work in the hypersonic domain, right? There are two programs that I can tell you about that we have been or are involved in on a hypersonic side; High Fire and High Cause. I cannot talk to you about any of the other ones and I'm just not going to do that..

Thank you very much..

Sure..

And our next question comes from the line of Mike Crawford of B. Riley FBR. Your line is now open..

Thanks.

Can you remind us the margin you're getting now on for SSAT production and the steps that might my take to increase margin on targets like SSAT towards those levels as you get more experienced in producing those drones?.

Including the drone, ancillaries, payloads, et cetera, et cetera its mid-teens..

On SSAT now, you say, SSAT, I would imagine be mid-single digits at best this year?.

Yeah. Yeah.

And we’re looking for that as we get the full rate production again assuming the aircraft payloads, spares, ancillaries, similar margin profile?.

And what about the Tactical Drones?.

Similar margin profile..

Okay.

And then in your RSS business has been using these carrier, Malmous [ph], Oriole, sounding rockets, where -- what is the status of your, I guess, ability or exclusive ability to use these rockets for ballistic missile purposes?.

The primary ballistic missile target system includes a rocket called Oriole. We have exclusive perpetual rights including a capped pricing grid for these for three purposes, ballistic missile targets, sounding rockets, and sub-orbital systems and if you look up sub-orbital systems, that’s a hypersonic system.

So we have a very important and valuable asset here which is we believe one of the reasons why there are three large opportunities that are expected to be awarded this year. One of them imminently none of which we've included in our forecast and that I feel that system we think is a big differentiator for us..

Okay. All right. Thank you..

Sure..

And our next question comes from the line of Joe Gomes of NOBLE Capital. Your line is now open..

Good afternoon..

Good afternoon..

Just wanted to go back to FTT for a second here, you said you've been working with them for like 18 months, were you the only bidder year, why did the owners decide to sell, I mean, it’s great that they are staying, but just trying to understand why, what’s your thought process was as to why they decided to sell to you guys?.

They see -- yeah. They see -- that one is easy. They see a very large production ramp coming and they are – they felt more comfortable doing it with a similar partner that focuses on affordability that is highly technical, we are a highly technical company as you know.

They are very good at rapidly developing, demonstrating and fielding something so are we are, okay. Obviously, they see our drones. They know where are drones are going to be over the next several years.

They can integrate their engines into our drones, this is why they agreed to structure it this way with the selling 80.1 and keeping 19.9, because they – where they can put that 19.9 to what so we call it in the future, because their business plan is phenomenal and they believe that they are going to hit a grand slam and they are going to participate in that grand slam with us with that 19.9..

Okay. And you say they’re -- I think they are working on, bidding on 12 different type programs, is there any potential for conflict of interest so to speak once you start putting these engines in your drones or some of these programs.

They are working on where some other outside customers would feel uncomfortable using their engines?.

We see no risk of that at all, none..

Okay. And then one last one, I think, you mentioned that, Valkyries expected to fly soon and happened to see an article today that said it's to take flight next week.

Is that accurate?.

We are coordinating closely with the United States Air Force on any official information related to this. That’s all I am going to say..

Okay. Thank you very much..

Thank you..

And our next question comes from the line of Sheila Kahyaoglu of Jefferies. Your line is now open..

Good evening, Eric, and thank you for the time.

Can we talk about your $6.8 billion bid pipeline, kind of maybe can you talk about what’s in there, how it’s changed and how much of it is unmanned?.

So, Sheila, this is Deanna. So in total so we got about $1.8 billion that’s been submitted already, of that $6.8 billion and the unmanned piece is roughly $1.6 billion. So there are a number of opportunities that actually could be entered at weighted value of much less than what is expected.

So for instances there are some large opportunities that for purposes of tracking are guys only put in as a dollar of value. So it actually it’s higher than the number that we actually report, but it is as I said about $1.6 billion of unmanned and $1.8 billion of the total has been submitted already..

Okay. Understood. And then in terms of unmanned revenue profile of $250 million potentially. How could we think about the contributors of that I am guessing SSAT obviously is good base and how do we think about the timeline of when contracts come in..

Yeah..

Eric you went through that on the call it seems like make us in Q2 now you’ll have Gremlins coming in, you mentioned Apollo with the new one, I was wondering if you could elaborate on that a bit?.

Yeah. So the $250 million number you had mentioned that is substantially all Target Drone related, okay. Substantially all of that we have the programs. They are ramping.

So we have the Air Force program which is our 167 Target Drone, that is in full rate production, but quantities are increasing as off tempo increase for peer, near peer threat or fight. The SSAT program I mentioned today with the U.S. Navy. We are in LRIP 2, LRIP 3 is coming full rate production is going to be next year.

We’re going to that award and that’s why initial operating capability today was so important. So that U.S. Navy contract SSAT that is going to be one of the big drivers again the 250 of that goes from LRIP 2 this year, LRIP 3 next year at a full rate production. We have two programs with the U.S. Army they are both new, two different drones.

They are both ramping. We have a program with the customer it is ramping to full rate production in two years from now. The international program we announced with Sweden well they are doing target drone threat representation for other militaries that is going to begin in the middle of this year and that one is going to ramp. That’s $100 million base.

We have program with Kinetic, they are our teammate. They run the weapon ranges for the U.K. called the Tacts program [ph]. They have a 20 year contract. They’re 10 years into it. They signed a 10 year contract with us we’re providing them target drones. That is ramping.

So those are all the Target Drone programs we have under contract sole sourced that are going to drive us toward that $250 million. And then in addition to that we provide drones to multiple international customers. International customers that buy U.S.

weapon systems, they want to exercise them against the best and state-of-the-art drones in the world, those are ours. So we have programs with Taiwan, I can only mention some of these, South Korea, France. I'm not going to mention the other ones, because I'm not sure I can..

Okay. Okay. Appreciate the color. Thank you..

Yeah. Yes..

Our next question comes from the line of Seth Seifman of JP Morgan. Your line is now open..

Okay. Thanks very much and good afternoon..

Hi..

To start off, a quick question about the acquisition, what made you decide to structure it the way that you did in terms of the mix of cash and equity?.

It was a sit down with the owners, and as I think, as I mentioned a minute ago, they are – they believe that they are going to hit a grand slam home run. They believe what does, they're going to hit a double grand slam home run and they wanted equity.

They -- as part of this work since they took software, they did due diligence, they understand all of our drone programs, they want to get their engines in those drone programs, they see what that's going to do for the performance of the drones and the affordability. So they see a very significant upside in the Kratos stock.

So, they took some cash now and they got big uppers with Kratos stock and with the 19.9..

Okay.

And then I apologize if you mentioned this earlier but in terms of the guidance for ‘19, can you break that down between the two segments on the sales and the adjusted EBITDA?.

Seth, are you talking about between KGS and unmanned?.

Exactly..

Okay. We actually don't provide that guidance. We only provide it on a consolidated basis..

Okay. Okay. Okay.

I mean, any qualities color maybe?.

Qualitative color? Okay. As I mentioned on the drone side LRIP2 is coming in a little bit – LRIP3 looks like it's going to come in a little lower than we initially -- and the Navy initially announced for SSAT.

And the issue with the government shut down and we have a number of international drone customers that we pushed out as the backlog on the export licenses gets cleaned up. So our unmanned business, the trajectory, it's significant. But I don' want to get into the details here because I guess – I don't want to get into the details..

Got it. Okay. And then maybe just as the last one, you talk about the opportunity on the tactical side being greater than on the target side, which I think makes sense. And you kind of talked about a timeframe when you'd ramp up to that $250 million on the target side being kind of over the next three years or four years.

To see a ramp pass that level on a tactical side is something that would be -- the timeframe on that is that a few years beyond when you'd reach that point on the target side?.

Well, obviously, it depends, I gave an example a few minutes ago if – I'll give a separate example. I mean Gremlins with our partner Dynetics successfully demonstrates at the -- in Q2 of this year. And by the end of this year or early next year an order was to come in for 200 Gremlins at $700,000 each.

That would significantly change the mix, as I mentioned before, and if we get some Valkyries on top of that at $2 million or $3 million each, it could – couple of three years out, it could flip entirely, with the Tactical business revenue and profit is passing the Target business which is what we see..

Okay..

As I mentioned, we've got six customer funded programs. Right now, Valkyrie, Mako, Program F, Fanatos, Eton [ph] and Gremlins, and we have three more that I think are going to be funded before this year is out. Spartan is going to be funded, Apollo is going to be funded and Fena [ph], they're all going to be funded.

So, this is happening and as I said before, this is not if anymore. This is when and the when is coming..

Great. Okay. Excellent. Thanks very much..

Yeah..

And next we have a follow-up question from Noah Popanaki of Goldman Sachs. Your line is now open..

Eric. Do you have the revenue slippage out of the fourth quarter out of the end of 2018? Certainly, there are multiple large growth opportunities in the business. But I think in the industry in general not to specific deal when someone is growing quickly or ramping it's easy to have things slight to right, or easy to have slippage..

Yes..

And you've got a little bit of a backend loaded year.

So, question is, what are the two or three pieces of your 2019 revenue guidance or specific programs where there's the most concern or the most risk of slippage from 2019 into 2020?.

Our Unmanned Systems business is pretty substantially bolted in with the Navy and the Air Force and the Army program. So, Unmanned Systems is – I'm going through my head, pretty substantially bolted in. The one in the unmanned area that that moved on us, the DIU program as you know [inaudible] we knew very well, he left.

Michael Brown took over, I know him, I met with him. We're tracking for Q2 award there, we're tracking. I think we're going to get it, that's the one maybe but I'm highly confident we're going to get it based on recent discussions. Our Modular Systems, our C5ISR business is bolted in with primes on weapon systems like the ones I went through.

The one I see potentially, those two services contracts we won. We won the radar contract and we won the high powered laser contract. And we've won and they reach multi years but they're ramping slower than the customers bid plan.

And so those two which are lower margin, so I think we're going to be fine on margin, those are the two that I think don't ramp up. If we're not ramped, headcount where we think we should be by the middle of the year that could be a flashing yellow light..

Okay..

Yeah..

Okay. Great. That’s helpful. Where to keep an eye..

Yeah..

Thank you..

Yes, sir..

And next we have a follow-up question from the line of Michael Ciarmoli of SunTrust. Your line is now open..

Just one quick question, it seems going back to again what you previously mentioned, the larger players are really qualifying this opportunity, it's real, it's coming. You've got other multi-billion dollar competitors entering the market and you've kind of shown a little bit of your strategy.

You're picking very critical technologies, bringing them in-house, giving yourself a long-term discriminator in terms of the product offering.

It seems like this OK sea facility, is this going to be some type of center of excellence for all of the Target Drones and will it serve a dual use manufacturing capacity target and tactical? That's my question. Thank you..

It will ultimately be the tactical drone center of excellence, okay..

Thank you very much..

Yeah. You got it. Okey-dokey. There are no further questions. We look forward to speaking to you when we report Q1 in a couple of months. Thank you..

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