Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Second Quarter 2019 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 follow at that time.

[Operator Instructions] As a reminder, this conference call maybe recorded.I would now like to introduce your host for today’s conference Ms. Marie Mendoza, Senior Vice President and General Counsel. Ms. Mendoza, you may begin..

Thank you. Good afternoon everyone. Thank you for joining us for the Kratos Defense & Security Solutions second quarter 2019 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..

the F-22 Raptor and the F-35 Lightning engaged multiple Kratos BQM target drones in an exercise demonstrating once again that Kratos’ target drones are the highest performance direct representative drone systems in the world.

We are also under production contracts with United States Army for Kratos’ 167M and 178 fire jet target drones, both of which we expect its increased future production quantities.Additionally, a program with a confidential customer continues to ramp production with this expected to become one of Kratos’s largest long-term future production programs in a few years.

As I mentioned in our last report to you, in Q2 the next generation Aerial Target or NGAT RFI was issued by the United States Air Force, which Kratos expects to respond to in Q3.For competitive and other reasons I will not comment on this large new opportunity.

However, as I previously mentioned, if you take a look at the NGAT RFI, I believe you will understand why Kratos is extremely excited about what this new opportunity can mean for our company.

We believe that Kratos is uniquely positioned for the additional new large target drone opportunities that are coming.On Kratos’s unmanned aerial target drone business we see this business growing to approximately $250 million in annual revenue over the next few years and potentially significantly higher if we are successful on NGAT.

Kratos’s turbine technologies continues to perform as expected, including importantly our commercial and MRO businesses, which are jewels including their management teams.

And we also continue to make progress on our next generation class of jet drone and tactical missile propulsion systems.Our plan is KTTs technology and affordability to be disruptive to the tactical system market. Similar to Kratos tactical drone business and be a significant future revenue profit and cash flow generator for the company.

Kratos is an industry leader in ballistic missile targets and in the second quarter multiple Kratos missile defense targets supported exercise formidable shield 2019 in the exercise. Kratos supported the United States Navy’s Sixth Fleet and NATO's Naval Striking and Support Forces at the UK Ministry of Defense held the range in Scotland.

The multinational exercise featured ships, aircraft and personnel from 12 countries.Similar to Kratos’s target drone, Kratos’s ballistic missile targets are an integral part of weapon system and radar test evaluation and operational readiness.

Kratos also has important intellectual property or exclusive rights positioning and are affordable BMD targets suite. We currently expect to receive a large sole source BMD target contract award in late Q3 or Q4 of this year.

This award has been delayed from a previously inspected first half 2019 award period.We are also in pursuit of a competitive new, very large BMD target hypersonic system opportunity, which has also been delayed from a previously expected first half 2019 award period with the award now expected in Q3 or Q4 of this year.

This new opportunity if Kratos is successful is expected to represent one of the largest multi-year single contract award programs in our company's history and would be a very significant financial contributor to our company beginning next year.We have also just recently responded to a new hypersonic system RFP that we believe we are uniquely qualified for.

With this award expected late this year or early next year. And we have just recently been approached by a separate customer regarding an additional hypersonic program system opportunity, which we are responding to and which is expected to be awarded in early 2020.

In the hypersonic systems area where Kratos has successfully performed missions on a number of hypersonic programs, Kratos has proprietary rights or intellectual property on certain systems, which we believe provide us a clear competitive advantage at an affordable cost.Both Kratos’s BMD target and our hypersonic system businesses backlogs and opportunity pipelines are currently at all time highs.

Kratos’s microwave electronics products business had a 1.3 to 1, Q2 book-to-bill ratio. It performed as expected and as on schedule and on budget on all major programs.

Kratos’s microwave businesses designed in a number of potentially very large programs including missile, missile defense, radar, F-15, F-16 Gripen, Iron Dome, BARAK and certain guided munition systems, each of which are expected to begin production and to ramp over the next several quarters.For example, on the Barak 8 missile system it was recently announced, I believe last week that KRAS has placed an order with Rafael for 1000 Barak 8 missiles and where Kratos’s content is approximately 50,000 per missile.

As a result of this contract award we currently expect this program to begin ramping for Kratos in the second half of next year.Also, just a few days ago it was reported that the Arrow 3 missile achieved three successful test interceptions over Alaska. Kratos content per Aero 3 is approximately 10,000 per missile.

Once production on Barak 8 Aero and other Kratos designed in programs occurs. We expect a very strong organic growth trajectory for this business, which historically has generated some of the highest profit margins in the company.

Kratos’s microwave businesses backlog and bid and proposal pipeline are currently near all time highs.Kratos C5isr products business, which is missile defense, missile system and radar focused at a 1.9 to 1 book-to-bill ratio in Q2.

Major programs for this business include Patriot, FAAD, SHORAD, CPP, SBIRS [indiscernible] just recently Cutter announced a multibillion dollar weapon systems order with Raytheon, which included an undisclosed number of Patriot missile system batteries.

Kratos is the sole source provider of a significant portion of the hardware for the Patriot System with our content being several millions of dollars per system.Additionally, Lockheed Martin recently received approximate $1.5 billion THAAD Award from KSA increasing the total value of this to $5.3 billion.

Kratos is a major THAAD system hardware provider and our content is several millions of dollars per system. Kratos’s C5isr backlog and bid and proposal pipeline are currently at multi-year highs.

Kratos’s training systems business continues to perform well, with this business leading virtual environment technology being a key contributor to Kratos receiving the honor of best in show for its Best in Show for Booth Paris Air Show.We are currently in production and working on a number of programs including helicopter and fixed-wing training systems.

The KC-46 and on an U.S. Navy FMS program in Saudi Arabia, which is now in a recompete and the largest contributor of this business.

Prior to the recent RFP for the recompete, the funding for the remaining period of performance through the end of the year on this program was descoped by approximately $5 million, contributing to our adjusting the high-end of our expected revenues for the second half of the year.Kratos’s training bid and opportunity pipeline is one of the strongest in the company.

Kratos’s space and satellite business continues to adjust and position itself for the changing market, including the extremely large number and size of opportunities I discussed in great detail on last quarter's report, which I encourage you to review.

The space and satellite areas of the DoD budget are seeing some of the largest increases as a result of the perceived peer threat environment, which is driving significantly increased funding for new capabilities, functionality, spacecraft and ground infrastructure.Existing systems like the United States Nuclear, Command, Control and Communications Architecture are aging with this systems last major upgrade occurring in the 1980s, which are driving an important opportunity set for Kratos.

Also the rapid expansion of commercial space bringing new low-Earth orbit capability is an area that government is looking to leverage allowing for redundant and resilient communications.The Air Force is also looking for cost savings by leveraging off of the commercial space assets, which also brings new opportunities to Kratos.

A result of these changing requirements Kratos is becoming a key enabler of the space industries movement to virtualize a cloud-based ground operation through our next generation digital infrastructure systems that are supporting traditional satellites as well as the next generation of small satellite constellations.A recent example has been Kratos’s work with Lockheed on the MBMM Program.

We're Kratos virtual software modem allows for the ability to quickly scale for handling a large number of users.

Other examples include supporting efforts to create ground systems as a service offering, including Lockheed's Verge, KSat and others were Kratos is under contract and I cannot mention due to NDAs.Kratos’s technology here is revolutionizing the way missions are managed, reducing costs and enabling new defense and commercial services.

As a result of the changing market Kratos’s satellite business is transitioning to more of a software based solution versus legacy hardware based solutions, resulting in somewhat reduced expected revenues by the increased EBITDA margins.

Representative major space programs we support include WGS, AEHF, SBIRS, MUOS and GPS and I can now inform you that we have a sole source position on OPRI.From a capital allocation standpoint there are no changes in our plans since our last report to you.

We expect the company's future cash flow to continue to increase year-over-year with the current primary expectation for this cash flow to continue to deliver and strengthen Kratos’s balance sheet.

We intend to maintain adequate cash on the balance sheet to enable us to successfully execute on our business plan and to fund the expected growth in existing production programs and growth in production programs that we believe we're going to receive.We currently foresee no major acquisitions in our strategic roadmap.

We believe the production programs, development programs and opportunities that we currently have are industry leading.

They're significantly differentiating and that Kratos is positioned for long-term revenue, profit and cash flow.For Kratos’s guidance, the first half of 2019 came in somewhat stronger than we had initially forecast including a favorable business mix with higher product, systems, software and solutions revenues and lower than expected service business revenues, which trend we are currently forecasting to continue.Also, as I mentioned at the beginning of this year, Kratos was in pursuit of three BMD target or hypersonic opportunities, which we had factored probability of win and value amounts in our 2019 forecast based on timing expectations at that time.

Off the three Kratos has been successfully awarded the first opportunity, it’s under contract.On the second opportunity, which I previously mentioned has been delayed from an expected first half of 2019 award. It is now currently in source selection and is expected to be awarded in the next few months.

The third opportunity solicitation has also been delayed and is now expected to be released late this year with an anticipated first half 2020 award date.So as a result of the favorable business mix, these delays and the expected future trend of reduced services revenues.

We're reaffirming our EBITDA or profit and our cash flow guidance and we're reducing the high end of the revenue range. Importantly, we have lost nothing here. A couple of opportunities have moved to the right and on the second BMD target hypersonic opportunity the one currently in source selection.

The Kratos team is successful here as I previously stated, this is expected to be one of the largest single award contracts in our company's history with an ultimate value to Kratos of several hundreds of millions of dollars single award.

We remain optimistic that we will be awarded these opportunities.In closing, the trajectory of Kratos is directionally up and increasing. The two year budget deal has positioned us for a new program and increased production on a number of programs, key elements of our future significant organic growth expectations.

We believe that Valkyrie is on track for initial production and a program of record.Redlands is scheduled for beginning demonstration flights in Q3, Q4 of this year and we expect an initial production once all demonstration flights are successfully completed with Program F, Thanatos and others expected to follow.

Over the next six months, we expect to receive a number of new contract awards including in the hypersonic or BMD target areas, which is successful to be major catalysts and growth drivers for the company.

Deanna?.

Thank you, Eric. Good afternoon. Kratos’s second quarter 2019 revenues at $187.9 million exceeded our expectations of $175 million to $185 million and increased $36.7 million or 24.3% year-over-year. Excluding the impact of the recently acquired FTT entity, which contributed $17.2 million in revenues.

Kratos revenues grew organically 12.9% in the second quarter.Our adjusted EBITDA came in at $19.2 million above our expectation of $16 million to $18 million, primarily driven by a favorable mix of revenues and execution.

Kratos’s adjusted EPS of $0.08 per share also exceeded our forecast of $0.05 to $0.07 per share for the quarter.In the second quarter, KGS generated revenues of $145.4 million, up 25.8% from $115.6 million for Q2 2018.

Adjusted EBITDA of $15.7 million or 10.8% of revenues, up from $8.4 million in Q2 of 2018 and operating income of $10.7 million, up from $5 million in Q2 2018 which included a $2.8 million of expenses related to a legal settlement.Excluding the impact of the FTT acquisition, KGS revenues grew organically 10.9% year-over-year.

Operating income and adjusted EBITDA were impacted by a favorable mix of revenues and leverage on fixed manufacturing, overhead and administrative expenses.

Revenues in our unmanned system segment increased 19.4% from $35.6 million in the second quarter of 2018 to $42.5 million and adjusted EBITDA decreased from $3.7 million to $3.5 million in the second quarter of 2019.Our Q2 operating income was $9 million, up from the second quarter of 2018 operating income of $2.6 million.

Our adjusted EBITDA for the second quarter is from consolidated continuing operations including net income attributable to non-controlling interest and excludes non-cash stock based compensation costs of $2.8 million, separates related costs of $300,000 and transaction related costs of $600,000.On a GAAP basis net income for the second quarter was $3.9 million, which includes income from discontinued operations of $3 million, resulting from a $3.6 million gain related to the release of an indemnification liability following the lapse of the statute of limitations associated with the potential tax liability that was recorded in 2015 as part of the sale of the company's electronic products division.

Net income also includes a tax provision of $2.5 million.Moving on to the balance sheet and liquidity. Our cash balance was $176.2 million at June 30th, at quarter-end we had zero amounts outstanding on our bank-line of credit and $5.7 million of letters of credits outstanding.

Debt outstanding was $294.6 million at quarter end and net debt was $118.4 million.

Our LTM adjusted EBITDA was $71.4 million with a net leverage ratio of 1.7 to 1.Cash flow generated from continuing operations for the second quarter was $4 million and capital expenditures were $5.8 million including approximately $3.6 million related to the unmanned systems division, primarily reflecting the build-out of the company's new manufacturing facility in Oklahoma.Our DSS or day sales outstanding decreased from 136 to 115 days, due to the contractual milestone payments and long-term delivery contracts in our training solution, modular systems and unmanned systems businesses.

The reduction in DSL was one of the primary drivers for the operating cash flow generation for the quarter.Our contract mix for the quarter was 83% generated from fixed price contracts, 12% from cost plus contracts and 5% from time and material contracts. Revenues generated from contracts with the U.S.

federal government during the quarter were approximately 71% including revenues generated from contracts with the DoD, non-DoD federal government agencies at FMS or Foreign Military Sales contracts, which were approximately 8%. We generated 11% from commercial customers and 18% from foreign customers.

Our book-to-bill ratio for the quarter was 1 to 1 and for the last 12 months was 1.1 to 1.

Our bookings were $188 million for the quarter.Today we are providing third quarter revenue guidance if $175 million to $185 million, adjusted EBITDA guidance of $16 million to $18 million, and adjusted EPS guidance of $0.05 to $0.07 per share, and our adjusting the high end of our full-year revenue guidance to $720 million to $740 million and reaffirming our full-year guidance for adjusted EBITDA of $71 million to $77 million.We are also reaffirming our 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 have $10 million to $20 million plus the expected final cash receipt of the routine working capital of the companies divested PSS business of approximately $4 million to $6 million.

Approximately $1.4 million of these amounts have been collected through June 30th.We expect capital expenditures to be at elevated levels for 2019 with continued expected significant outlays in Q3 as we make the necessary investments for manufacturing and test equipment for our new Oklahoma facility and a new secured facility of approximately $6 million to $8 million and approximately $4 million to $6 million related to aerial target drones the company plans to manufacture in preparation of fulfilling expected customer requirements.

We expect our estimated cash taxes to be approximately $2.5 million to $3.5 million for FY 2019 reflecting the impact of the over $300 million in net operating losses that we have, Eric?.

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

Thank you. [Operator Instructions] Our first question comes from Mike Crawford with B. Riley FBR. You may proceed with your question..

Thank you. Just first, quickly the equipment for the new secured facility, that is not in Oklahoma or in the CEI operations in the Sacramento area.

Is that somewhere else?.

It is….

It's somewhere else..

It's not – yes, somewhere else, Mike..

Okay, all right, thank you.

And then just, Eric, please on hypersonics, I think it would helpful if you could differentiate it into kind of three different sub-components if you could and discuss maybe the possibilities related to like a KTT type of small engine replacement versus what you might be able to do on the suborbital side with your Oriole rockets or just all together as a whole system?.

You've got it. So, in our rocket support services business we have exclusive rights, perpetual in nature for a specific solid rocket booster stack that is very well positioned to do – to put hypersonic vehicles in the right place at the right time at the right speed at a very affordable cost. This can include a hypersonic target.

This can include testing hypersonic front end. So we do not do the front end, for example, a glide vehicle, but we can put that glide vehicle in the right place at the right spot at the right time with our stack. So that would be in the solid rocket, so the non-air breathing side. In our – in KTT, this would be on the air breathing side.

And I just cannot say a lot there other than we are involved in propulsion systems for air breathing hypersonic systems..

Okay. Great, thank you very much..

You got it..

Thank you. And our next question comes from Seth Seifman with JPMorgan. You may proceed with your question..

Thanks very much and good afternoon Eric and Deanna. I wonder if you could talk a little bit more at the Saudi training contract, the recompete that's coming up.

Can you tell us when it is? And also, you know, to the extent on the recompete that there is any remaining risk for 2019? And what the risk might be for 2020?.

Yup. So 2019 is bolted in..

Okay..

So the period performance goes through then it's in solicitation right now. Contract award and you heard me talk about some delays, so this is just most recent. Contract award is expected sometime between now and the end of this year, all right. The contract has – I don't want to get too far ahead here.

The nature and the scope of the contract vehicle have changed in the recompete. So the future potential exposure is around $25 million to $30 million a year, but margins are significantly reduced..

Okay, okay. And then as a follow up, when you talk about the satellite business and how it's evolving. And I think you spoke a little bit about this last quarter and it sounds like maybe it's moved forward even a little bit more.

When you think about that business becoming more software oriented and less hardware oriented, what does that mean about the size of it as we think about maybe next year or something like that, the growth rate of it and the profitability?.

Yup. So, think of that business right now and this specific satellite product business is being somewhere between $90 million and $100 million in revenue, this specific piece in its current configuration. Think of margin somewhere around 13%, 14%, 15%, all right.

I'm looking at that probably on the revenue side year-over-year going forward, 2% to 5% going up, but the margins increasing significantly because it's shifting away to more being software-based, think like a software defined radio..

Okay, okay..

Yup. And that's not only for the margins. The modeling is looking very good for future cash flow as well..

Excellent. Okay, well, I'll hop back in the queue for now, but thank you very much..

Hope you do..

Thank you. And our next question comes from Josh Sullivan with Seaport Global. You may proceed with your question..

Hey, good afternoon, Eric and Deanna..

Hi..

Hi, Josh..

On the Valkyrie, the 2020 markups in the House and the Senate, the Valkyrie related programs at $150 million, a little over $200 million. It seems to be above the 25 unit assumptions at $3 million a piece.

What is that incremental dollar content composed of?.

Yes, so I'm going to talk generally, so I don't get ahead of people integrating weapons systems, integrating ISR systems, okay. The cost of sending teams out as they're flying to develop concepts of operations..

Got it..

So it's getting the planes ready very similar to what's been publicly reported. So, these are operationally capable by 2022-2023 and they're with the forces..

And would those be your systems or your electronic packages?.

They most likely would not. We very well may be the system integrator which would then increase the sales price per plane up from the current estimate to a higher number of where the prime system integrator. But if we're not the system integrator then either the government or the prime would do the system integrating. There were two models.

We're doing both models right now literally..

And then, I guess, related to that, the capacity at the Oklahoma facility for Valkyries program F et cetera, you mentioned the potential next year to have some pretty significant orders.

Do you have the capacity to meet those orders? Or are you going need to reach out or engage any other manufacturing partners at this point?.

Yup. This is – so as we talked about last time, we've got 100,000 square feet under contract with two additional approximate 100,000 square foot facilities connected to that facility. Autoclaves are going to be up and going in the next few months.

We've developed the factory with absolute cutting edge next generation technology manufacturing processes and process flows. So based – if you recall about six months ago we talked about our base case anticipation and then the pie in the sky are the – the stars align case that we had.

We can handle a base case scenario over the first couple of three years with what our current plan is. Under stars align case that we would have to increase the build out there..

Okay, got it. And then just one on program F, I think you mentioned a need for thousand units over three years.

Can you just talk about the funding status of that? And then just an idea of what the individual ship set value to Kratos might look like?.

Yup. So I'm tying into your previous question. If we're the system integrator and we integrate the system and deliver it excluding one element, which I believe the government would integrate, take approximately 500,000 to 600,000 per system.

If we deliver the system and then I'm going to use the word payloads are integrated on to the system, I think 300,000 a system..

Got it..

And on the funding question, Josh, I believe as soon as we complete the final demonstration, which is scheduled for Q2 of next year. I believe this will be funded very rapidly because of the requirement and the threat..

Got it. Thank you..

You’re welcome..

Thank you. And our next question comes from Ken Herbert with Canaccord. You may proceed with your question..

Hi, good afternoon, Eric and Deanna..

Hi, Ken..

Hey, Eric, I just wanted to first ask about the $10 million sort of reduction in the guidance or $20 million at the upper end of the revenue range.

Can you just parse out the timing of that relative to some of the mix impact you're seeing? I mean, how should we think about maybe the pieces of that?.

Yeah, so, as I said, we had factored – there were three BMD target hypersonic opportunities that we were chasing – we've been chasing from the beginning of the year. And as I said, we had factored timing, we had assumed we would not get all of them, but we had a factored timing.

If we get two of them and we get two of them by the first half of the year, we're good. If we get three of them and we get three of them at certain times of the year, we're good or we could even be better off than what we guided to.

As I mentioned, one of them we won and – and on this the second one, the large one, I am – it's so frustrating because it's – there were continuing responses with the customer question set. And so, I'm saying between now and the end of the year that will be awarded.It could be awarded imminently.

But we're virtually pulling it out and pushing it out to the very end of the year because we're just not – we can't tell what it will be awarded. And the other one, the third one, and this is why we factor things. The third one is most likely move now to 2020 award. So that is the primary reason.

Along with that the defunding, we had a solid contract, but we've got customers from time to time defund on the training contract. They defunded the $5 million for the second six months of the year. The profitability that we are seeing in our C5isr business for example on the weapon systems we're working on is phenomenal. The mix is very strong.

The software mix in the space business is very, very strong. And we see those trends continuing, which is why we're very comfortable with the EBITDA, the operating income, the EPS and the cash flow. And if we had gotten those – if those other ones that are being awarded where we initially thought we'd really be sitting pretty..

Okay, that's very helpful. Thank you.

And is there anything contemplated in the fiscal 2019 guidance around Valkyrie in terms of revenues?.

Not production..

No..

No. We're – not production. We're under the original contract with AFRL and we're going through the flight series, so that that is included in there. And we mentioned late last year, Ken, I think that we had mentioned we had gotten three spirals that are tied directly to the base contract.

Those spirals on the development contract are in there, but nothing for production. And so that's an upper – that's an upside if we receive an award..

Okay. Okay, that's very helpful. If I could, Deanna, just one final question..

Sure..

It looks like you've given nice third quarter guidance. If you think about the free cash flow, I know typically you're very strong seasonally. How should we think about that, especially in light of your, I guess, assumption that we have some sort of continuing resolution into the calendar fourth quarter.

Do we – is there a risk to things maybe get pushed out of your fiscal fourth quarter? Or how should we think about that?.

So, for the third quarter, as I had mentioned in my prepared remarks, CapEx is going to continue to be quite elevated and that's going to be our highest CapEx quarter for the year, anywhere probably in the $10 million to $11 million range. So that that will certainly impact our free cash flow.

The other piece is going to be the timing of milestones and when we achieve those milestones. Second quarter was very favorable with a number of those milestones being achieved. But as we achieved some of the new ones need to be achieved as well.

So the rest of the second half and the timing of the cash flow in Q3 and Q4 is going to depend on the achievement of those milestones. At this point we believe we're going to achieve those milestones that we expected, but that can move sometimes..

Okay. So I guess it sounds like even if there is, based on your assumption, some sort of continuing resolution, it doesn't jeopardize the cash flow outlook for the year..

It shouldn't. The bigger impact is really from an operational milestone perspective and when we have those milestones..

Perfect. Thank you very much..

Sure, thank you..

Thank you. And our next question comes from Peter Arment with Baird. You may proceed with your question..

Hey, good afternoon, Eric and Deanna..

Hi, Peter..

Eric, a question on just R&D and I guess this is more of a response to just what we're seeing in the industry. Get your thoughts on just the step up and requirements in the industry for more internal R&D investments. If I look at your most recent quarter, you're in about 2.5% of sales.

Are you feeling, I mean, just given all the opportunities that you have that you're going to have to step that up? Maybe just get some color on that initially..

unmanned systems, space and satellite communications and our microwave electronics business. And then, of course, our turbine business is behind that. So our 2.5% or 3% on the surface is a little bit of a misnomer.

It's really close to the 6% overall.And then in addition to that 6%, where we've really refined our comp – ourselves over the past several years where we are a rifle shot. We're not chasing dozens and dozens of R&D programs in this company.

We are rifle shotted on one or two in unmanned systems of any – of significant one or two on our sat based business, one or two on our microwave business. Again, I'm talking of significant – there are more in that, but of significant. So, I don't know what the other companies do, but I'm very comfortable.

We are one of the absolute leaders in very focused research and development on leading technology systems in our core competencies..

That's very helpful. And just as a follow up, when you look at the government solutions business, it's pretty much split between half services, half products.

When you look out just given the opportunities of the growth that you're seeing, is this a segment that's still could easily get into the low double digits for operating margins when you think about the – where defense spending is going? Thanks..

Absolutely. It's going to happen and let me tell you why it's going to happen, okay. Number one, our microwave business, these are my words now. There's a bow wave of good stuff coming in the next year or two. I mean that’s the [indiscernible] program, that's just the beginning. I've read reports.

They're looking at 5,000 to 6,000 missiles and again our content is 50,000 a missile. The Gripen fighter, they're in blocks chipset 1 of the100 of them - our content is 250,000 per. We are about to receive very soon a very large order for an upgrade on an F-15 system, on an F-16 system.

Then on our satellite business, the shift that's occurring, it's reducing revenue a little bit. The margins are going up. I mean this is moving towards being a software business. And then Peter, the biggie that could be not a trend like I'm talking about, but a step function.

If we're successful on this opportunity we're pursuing in the BMD hypersonic area, that's going to be a step function increase in production sales, product sales and margins..

Appreciate the color, Eric. Thank you..

Got it..

Thank you. Our next question comes from Noah Poponak with Goldman Sachs. You may proceed with your question..

Good afternoon. Good evening..

Good evening..

Eric, which tactical programs have pulled to the left to contribute to the end of 2019 that you’d previously didn't think would do so?.

Pulled to the left of 2019….

No, pulled to the left of what you thought three to six months ago and now contribute to the end of 2019 when you previously didn't think they would..

Oh that contribute to the end of 2019, it really hasn't yet. I mean if we get a Valkyrie god willing a Valkyrie ordered by September 30, the answer to your question would be there is one right there..

It sounded like in your prepared remarks like maybe F or ATHENA had.

Am I reading that incorrectly?.

Those are still – and so they are in development. So, let me be very clear. Program F isn’t the airplane. The vehicle is flying. It is in the test flight phase. And those were assumed – those development revenues were assumed in our guidance..

Okay. So it's not like you're – it's not like they're going through development faster and you're getting more development revenues on those programs than you thought you would..

No, no, no..

Okay..

Not now, but on the converse to that like Spartan or ATHENA, those are going to be more additive to 2020 than I originally thought because those have been pulled to the left into their occurrence than I thought. I thought they were going to be – I thought we'd get funding in 2020..

Right. So those are moving faster. So I'm hearing you correctly that those are moving faster, but they're not contributing to 2019..

Right. That is correct..

Okay. Yeah, because I mean where I was kind of going with that is, you know, in your prepared remarks, listing through all of the major opportunities and I totally understand that these are beyond 2019 major movers.

It sounded like even if it's the development revenues of things that are still in development that some things were moving to the left a bit. You beat the 1Q revenue guidance. You beat the 2Q revenue guidance where you guide the quarters specifically. You've been telling us you're embedding budget conservatism into the fourth quarter.

The budget now looks better than anybody thought it was going to be for the – with this two year deal. And so, I'm just surprised you haven't had enough incremental upper surprises to offset the one thing that slid to not have to lower the guidance..

Well, it's – on the one thing that's slipped. I might – no, I might not have been clear. There are two opportunities in the BMD target and hypersonic area, both of which we expected to be awarded in the first half of the year. In my assumption, I assumed we would win one of those other two..

Okay..

Okay, both of those have been pushed out, one of them to the third one. It looks like it's going to be the first quarter of 2020. The other one has been pushed into the second half. As I mentioned, I think, to Ken, it could be imminently awarded, but I'm saying by the end of the year, because now I'm gun shy. I'm just gun shy..

Can you just guide those for us?.

Okay, so the big one. It could be – it's – again a single award. It could be an incremental $50 million to $75 million a year in revenue beginning next year..

Okay..

It could be more than that depending on op-tempo of missions. The third one that has been pushed to 2020 that can be an incremental $25 million to $50 million a year. These are new specifically related to op-tempo of missions..

So – and what you lost from the plan, which was the factored versions of that?.

Yes..

Is what you lost from the factored versions of that more than the $10 million to $20 million depending on how you define it at the high end or the new midpoint of what came out of the revenue guidance such that there were actually some offsets?.

And there's one other definitive piece, the de-scoping of that Saudi training contract took $5 million that I had bolt – I had that in hard because you don't expect to get de-scoped. I had that $5 million hard in the second half of the year. That funding is gone. So there's that piece..

Okay..

And there's another – this is softer. Approximately $5 million of satellite revenue, $5 million to $7 million that has converted from hardware to software, which were the margins are great. That is also out. And so that that bundle, let's say that that is $20 million. I have offset that $20 million by 2020..

Okay, got it..

You know what I mean?.

Knocked out. Last year there was the DIU program in that split and then there were two services programs that moved around a little bit on you. Are those all now….

Yup….

Totally….

Yes, DIU is under contract. The services contract, the services ones, they're under contract. They are absolutely ramping up. The number of bullets are ramping up. They are still not where I thought they would be, okay..

Okay, they’re moving..

But they can – absolutely, they’re moving, yes..

Okay.

Your comment on a new separate customer looking at Valkyrie, I think you said, it’s sounded like you said could buy it in the fourth quarter or is that purely order or is that potentially revenue producing in the fourth quarter?.

one is the United States Air Forces and two are Kratos’. It's possible that customer or another one – I didn't talk about in the prepared remarks. It's possible we could sell one or both of our Valkyries by the end of the year. And so that would be a sale if possible. My tummy tells me – I'm going to tell you what I think is going to happen.

I think we're going to get an – I believe we're going to get an order from this customer. We're going to get an order for the 5 to 10. And I think this customer or the other customer, they're going to start leasing the other ones to doing integration work into them and doing testing with them, but I could be wrong. Okay..

And then, Deanna on the margins, the guidance implies lower margins in the back half versus the first half.

Can you just walk us through why that happens?.

And that's on the mix of what the expectations are on software content versus left software content in the second half..

You guys have talked in the past about having this cyber business with software like margins. Did you have that in the first half and it doesn't happen in the second half? Or have you not had that at all and you're not assuming it at all? And it could happen or where – what’s the status of that….

We had some in the first time..

Noah, no, I remember our discussion – I remembered, Noah, this discussion with you. We typically don't put in our internal plan for these software sales..

Right..

Because they're very hard to predict when the – these are very unique systems.

And historically – and this is why in the second half of the year for the past two or three years, our margins we've just – we've just killed it around that federal fiscal year of September 30 either because my opinion, the government, the customer, they want to spend the funds they have are obligated before the next fiscal year.

We get significant software sales in Q3 and Q4..

Okay. That's going to happen this year..

Sure..

Absolutely could historically – at – absolutely could..

And it's not in the outlook..

Correct. There's some, but just – but we'd very – we're very conservative on that, which we've demonstrated in prior years..

Can you size what you had from that in the first half?.

I don't know..

That’s okay..

No, I don't have that….

Yes, I don't know..

Okay. Thanks so much for answering my questions. I appreciate it..

Okay, thank you..

Thank you. And our next question comes from Joe Gomes with NOBLE Capital. You may proceed with your question..

Good afternoon..

Hi, Joe..

Good afternoon..

You talked a little bit about the exercise with the Swedish FMV and Germany.

Has that led to any more or increased interest in your products for them?.

Absolutely. We are working on a similar, if not significantly larger exercise next year now. Absolutely, good question. Yep..

Okay. And then a couple of quarters ago and that Boeing Australia made their announcement. And I know if you had heard anything or seen anything more on where theirs, ours is – that potentially could be viewed as a competitive to your guys on manned..

So I understand they gave a briefing on that in Washington just yesterday. As you know Joe, it's a concept right now. It’s a model. It rolled out a model..

Right..

I'm going to – let me answer at this way. I am extremely comfortable and confident that being one way independent, being able – being less than 30 feet long. There’s just 38 having or our published un-refueled range published is at least 3,000 miles and our price at quantity without payloads of approximately 3 million.

I am not worried about that that airplane one bit..

Okay, that's great. Thanks..

You got it..

Thank you. And our next question comes from Michael Ciarmoli with SunTrust. You may proceed with your question..

Hey, good evening guys. Thanks for taking the questions. Eric, can we just talk about – I think you said you placed the order for 20 engines and long lead time, you're getting those. I think you said we'd be getting them in the second half.

So how should we be thinking about the trajectory of free cash flow as you guys are presumably starting to ramp up production and you're going to have various aircraft and work-in process. Just – how should we think about that? Just given that you've started to order some materials here..

Right. And Michael, I was probably not clear, so I'm glad you asked the clarifying question. We have a – think of it as a single award IDIQ contract we gave to the engine manufacturer that single award IDIQ contract is for 24 engines. We have placed an order for the first 5 to 10 on that single award IDIQ..

Okay..

We expect based on our interactions with our customers, et cetera, et cetera, to place another order before this year is out. And then we expect to place another order in either Q1 or Q2 of next year and it's possible Deanna and I on a call could say to you if things happen, we've placed them all in one shot..

Okay..

Okay. We have – and I don't want to – okay, we have negotiated. Our customer here has worked with us on very favorable payment terms that we believe will align with receipts we will receive as they're being built..

Got it..

Okay. And I know you appreciate why I'm being delicate there..

Sure. What about – I mean you gave us sort of the laundry list of the programs, the updates, what – where they stood. It seems like a lot is going to happen in first half 2020 second half 2020. You just – I think to know Noah's question, you just said the BDMs could add $100 million to $125 million alone.

Can you give us a sense as you kind of knock down some of these orders, secure them? What is this exact pipeline look like from an order standpoint? Again, just with the varying programs that you've mentioned, the size of them, everything decisions expected to be made late this year, early next year.

Can you size the pipeline?.

So our published pipeline is $7.6 billion. I can assure you that that number we look at very closely. So that is a very conservative number based on what our divisions are chasing. In that $7.6 billion, Mike, there is zero for Valkyrie production that we're publishing. We're waiting for the first order and better clarity.

I'm just giving you an example of the conservatism on this. That $7.6 billion, there are no IDIQs. There were no MACs. There's nothing like that. These are very discreet programs where you can find a program element number in the budget line items, and as you can see over the past few quarters, I don't know how many, it's been increasing.

It’s very helpful – it’s probably as healthy right now as it's been since 2011 – Budget Control Act 2011-2012..

But can you give us a magnitude if we think about all these decisions, Gremlins, Thanatos, F, Spartan, AETHON, Mako A and Z.

Can you size those?.

Okay, so between now and say the end of next year, let's go with – let's go with Valkyrie. Based on current information, I think it's going to be 20 to 40, and the 40 is on top of the 10 that the air force mentioned – at the top of the 30 the air force mentioned just to other customer, okay.

There are other things happening, but that's where I would put that.On F that’s not in the – there’s a piece. It's not a very big piece in the pipeline.

That would be –I would put the 1,000 units in at – let's be conservative but let's say that we are not the system integrator that 300,000 or 400,000 a point over three years.On Gremlins, I'm talking about in the next 18 months.

On Gremlins if the test schedule holds and I think in the second half of next year, we could see an initial order for 100 or 200.

So you had a million each and although, I know the numbers 700,000, that's in the BCA, but I believe initially because I know we are on the learning curve with be near $1 million.Thanatos will be in development – would be under development contract as I've told you, that's a few tens of millions of dollars for us over the development period.

So Thanatos would not be beyond that in there or within Thanatos is the next one that's coming along. And so those would not be ready for production until the out year starting in 2021-2022..

Got it. Okay. And then just can – can you tell us last one, status of Oklahoma.

I mean, you think you talked about the line of sight there to potentially 40 Valkyrie units, I mean, is there any production happening right now? Is it still sort of outfitting the facility or what's actually happening in Oklahoma?.

Absolutely. So it's been producing since the beginning of the year. A government customer, last week was out there I think they signed off and accepted – I'm going to say approximately five drones. It was four to six, so I'm being told six, he signed off on six drones last week that we were manufactured there.

It is ramping rapidly and that's where we're going to build Valkyrie and that's where we're going to build F, and that's what we're going to build Gremlins..

Got it. All right, perfect. Thanks a lot guys..

Yes..

Thank you..

Thank you. And our next question comes from Sheila Kahyaoglu with Jefferies. You may proceed with your question..

Hi, Eric. Hi Deanna..

Hi Sheila..

Fairly comprehensive line of questioning. So I'll be quick, just two questions. Maybe on Valkyrie as we look through the fiscal 2020 budget coming together.

How do you think about risks to it? And what's your ultimate upside Erik with regards to that budget on Valkyrie?.

Yes. So my understanding and I went through this, we have a consultant that helps us go through all the program outlined. On the current – in the current existing budget request in the 750 and I know that the house – it came out at 738 because the house started at 733. My understanding is there was about $119 million in there, okay.

I don't believe that that's going to take a haircut unless let's take – let's say that takes a haircut and it gets haircut to $100 million, all right.

But on top of that, the house and their $733 billion request had a $50 million plus up in there for Valkyrie.In the center and the $750 billion request had a $100 million plus have been there for Valkyrie, right. I believe based on – I was just in Washington earlier this week meeting both congressionally and with customers.

I believe truly we're going to see that 100 is very close to it, but let's be conservative and let's say it 75. So between the budget request and plus it’s that we've all read about that have been publicly available, I'm thinking about $175 million. And then I think the question that Josh asked developed very relevant.

How much of that is that? Well its plain relative to weapons integration, systems integration and tested operations, I don't know that yet..

That makes sense, okay. And then as we think about the bridge to 2020 revenues, I haven't been able to keep up with all your programs. I don't know how you do like – how do we think about what sets up in development funding next year? It doesn't seem like anything steps into production..

It doesn't Sheila. Say that again. It doesn't seems like lot….

Does anything increase in terms of production? Like for instance, program math it seems like next step is by test so, you wouldn't get a production contract for 2020?.

Yes, so the hard increases for production next year that are just – that are very hard. The Navy SF program..

Yes..

We've got LRIP3. [Indiscernible] We're going to get full rate production in the first half. That has gone a step up so significantly. We have a confidential program. That is heading into full rate production next year. That is going to step up significantly.Thanatos.

Thanatos will begin – Thanatos will begin at the beginning of this year – at the beginning of next year. That's brand new, that will be additive. We have a drone program with the United States army that is forecasted. Production is supposed to increase beginning next year as well.

So we have some hard programs under contract that are funded that we can clearly see significant step ups in 2019 to 2020..

Thank you. Thanks for clarifying..

You got it, okay..

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

Thank you all for joining us this afternoon. We look forward to updating you at the end of Q3. Thank you..

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