Kratos Defense and Security Solutions Inc (KTOS) 2007 Q4 法說會逐字稿

Welcome to the Kratos Defense & Security Solutions' fourth quarter and full year 2007 earnings conference call. Your speakers for today are Mr. Eric DeMarco, President and Chief Executive Officer and Deanna Lund, Senior Vice President and Chief Financial Officer, and Mr. Michael Baehr, Vice President of Investor Relations. At his time, all listeners are in a listen-only mode. As a reminder, this is being recorded. Today is March 27, 2008. I will turn the conference over to Michael Baehr who will read the company's warning regarding forward-looking statements. Please go ahead, Mr. Baehr.

Thank you. Good afternoon, and thank you for joining us for this conference call today. With me today are Eric DeMarco, Kratos' President and Chief Executive Officer and Deanna Lund, Kratos' Senior Vice President and Chief Financial Officer. Before we begin the substance of this call, I would like to make some brief introductory comments.

Earlier this afternoon, we issued a press release which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos' corporate website at www.kratosdefense.com. Additionally, I'd like to remind our listeners that this conference call is open to the media and we are providing a simultaneous web cast of this call for the public. A replay of our discussion will be available on the company's website later today. During this call, we will discuss some factors that are likely to influence our business going forward. These forward-looking statements may include comments about our plans and expectations of future performance. These plans and expectations are subject to risks and uncertainties which could cause results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including our most recent Form 10-Q and Form 10-K and any of our other SEC filings for a more complete description of these risks. A partial list of these important risk factors is included at the end of the press release we issued today.

Our statements on this call are made as of today, March 27, 2008, and the company undertakes no obligation to revise or update publicly any of the forward-looking statements contained herein, whether as a result of new information, future events, changes and expectations or otherwise for any reason. In today's call, Mr. DeMarco will make some opening remarks about our financial results, as well as current trends and opportunities we see in the present federal government funding environment. He will then turn the call over to Miss Lund to discuss fourth quarter and full fiscal year 2007 financial results. Eric will make some concluding remarks on our plans to grow the business in the months ahead and we will then open the call up to your questions.

In terms of any comments relating to our recently-announced merger agreement with SYS Technologies, I would like to remind everyone that in connection with this transaction Kratos and SYS plan to file with the SEC a registration statement on Form S4 containing a joint proxy statement prospectus, and each of Kratos and SYS plan to file with the SEC other documents regarding the proposed transaction. Upon approval, the definitive joint proxy statement and prospectus will be mailed to stockholders of Kratos and SYS. We currently expect the transaction to close toward the end of the second quarter. I will now turn the call over to Mr. DeMarco.

Thank you, Michael, good afternoon, and thank you for joining us.

The company has come a long way since the beginning of 2007 and we have accomplished an incredible amount. A summary of major 2007 transformational activities are documented in the 10-K we filed today. Accordingly, clearly the financial statement filed today are not representative of Kratos in any way as to what our financial performance will like like going forward. This is primarily a result of the financial impact related to the transform of our company which, as we have previously stated, we hope to have substantially behind us by the end of the first quarter.

In 2007, we divested over $200 million in commercial wireless communication business along with approximately 1,200 employees. We are currently in the process of eliminating or reducing the indirect cost infrastructure related to these disposed businesses. We initiated in the fourth quarter, after we completed the sale of the wireless business, a business right-sizing and rationalization plan with the primary objective of reducing costs and setting our company's go-forward cost infrastructure to be commensurate with the federal government national and Homeland Security contractor. We hope to have this infrastructure cost reduction exercise substantially completed by the end of the first quarter.

We are also currently in the process of rebranding the company as Kratos with virtually all of our stakeholders. With the Haverstick transaction closing on December 31 of last year, Kratos is expecting to generate in excess of $300 million in revenue for 2008, the vast majority with contracts with the federal government, state, local and other government agencies and customers. Once the merger with SYS is completed, Kratos will be a business with an approximate $400 million annual run rate, 2,000 employees and with the size, critical mass and resources to credibly pursue and win larger prime contract opportunities in our strategic focus areas. These are weapon systems lifecycle support and extension, C5ISR, weapon range and target technical services, missile and rocket tests and evaluations and mission launch services, critical network engineering and advanced information technology solutions and public safety and security systems integration. This is the business Kratos is in today and the business which we are focused on building. This is why the financial statements we filed today are in no way reflective of what Kratos is and where we are going.

Although the dust is still settling and we're coming clear from residual and collateral items and costs related to 2007's transformation activities, in the impact of legacy wireless business issues, we believe we are building a unique company with contract vehicles that are in the majority prime in nature and have been substantially won in full and open competition. Accordingly, Deanna and I today will be going through our business, our full year and fourth quarter 2007 accomplishments and certain financial items in order to clarify the progress Kratos is making. First I will start out with the tentative agreement we have reached with the plaintiff's counsel regarding settling the 2004 and 2007 class action securities litigation.

As we just recently announced, we have reached a tentative agreement to settle both of these matters for $16.5 million of approximately $12.2 million will be covered by insurance carriers and approximately $4.3 million by Kratos. We are currently in the process of documenting the agreement after which we will seek court approval of the settlement which is expected. The amount of the payment to be made by Kratos is due to the nature of our insurance policies and negotiations with our insurance carriers. The final settlement of this litigation will be another significant step in ultimately concluding our transformation process. The estimated Kratos cost of these proposed settlements have been reflected in fourth quarter and 2007 financial results, which Deanna will explain in her remarks.

We are also currently in the process of working to settle the related derivative cases which we hope to have resolved later this year. The tentative agreement to settle the class action lawsuits is obviously a very positive event for Kratos as the management distraction and related costs to defend these suits will now line down in the first quarter and even more so in the second quarter of 2008. Assuming the court approvals the settlement terms and matters are finally settled, which once again, we believe will occur and will directly and positively impact our EBITDA in the second half of this year. As we have previously stated, we targeted the end of the first quarter to try to have substantially all of the material impacts from the legacy WFI issues behind us in this proposed agreement to settle these suits is a major milestone in accomplishing this.

Another very important and positive event for Kratos, as we previously announced, occurred in the fourth quarter with the closing of the acquisition of Haverstick Consulting. This merger has significantly expanded Kratos's exposure with numerous federal government including very important non-DOD federal government, state government and other customers. These include the United States Air Force, the State of Indiana, United States Navy, the Departments of Education and Labor and certain other agencies and commercial customers. We believe the Haverstick operational management team is just outstanding and is both business development and execution focused. The combined Kratos and Haverstick organization is already in pursuit of several new opportunities including several opportunities with the Air Force which, of course, was a key strategic objective of this merger.

This fourth quarter transactions was an appropriate way for Kratos to conclude a pivotal year where we completed disposition of the wireless assets, renamed the company to Kratos and positioned the company to return to profitability once we are clear of the remaining residual items and costs primarily related to the transformation process. Concurrent with the acquisition of Haverstick, in the fourth quarter we also obtained an $85 million credit facility. This credit facility was obtained not only at the end of a very challenging 2007 for the company, but also during one of the most challenging bank lending environments in recent memory. The ability of Kratos to obtain this credit facility, we believe, is testimony to Kratos's pro forma expected EBITDA or profitability and the viability of Kratos's business plan and strategy.

From an operational standpoint, during the fourth quarter and throughout 2007, we won several important new contracts and expanded our client base. The following are just some of the key contracts Kratos was awarded, which I believe is very important to go through in some detail here, as we leave 2007 and enter 2008, as this is a significant part of Kratos's business base as we move forward. A $46 million contract with the United States Army Aviation and Missile Command located at Redstone Arsenal. For the security assistance management directorate to provide lifecycle sustainment support for the missile systems division, for various weapon systems which are fielded in over 23 foreign military customer sales customer locations. Two contracts with the defense logistics agency totaling $10 million to support the enterprise telecommunication network or ETN, which supports over 25,000 government personnel located in over 250 sites worldwide and the DLA's path diversity project to enhance redundant communications around 12 strategic locations. A set of contracts with the total potential value of approximately $22 million to support the defense contract management agency, DCMA with e-tools and WAN programs for network engineering, technical assistance and designing and implementing a web-based enterprise architecture. A $13 million contract to support the electronics maintenance group or EMXG at Warner Robbins Air Force base in Georgia. We obtained ceiling increases of more than $19 million to continue and extend our existing C4I operations center work for the Space and Naval Warfare Center, or SPAWAR, in the joint interagency task force south, JIATF South. We obtained ceiling increases of $20 million to extend our existing aerial and surface targets, operations and maintenance support for the NAWC Point Magoo.

We were awarded new business task orders -- awards valued at more than $15 million with SPAWAR JIATF South to provide a range of command and control services and solutions, a $6 million subcontract award to continue our support of armies' radio frequency and transit visibility, or RFITV Program, a $5 million contract to support a command management system at Hanscom Air Force Base, a $4 million contract with the Naval Undersea Warfare Center and IDIQ contract with an estimated potential value of $15 million to support the anti-terrorism force protection or ATFP Assure project to assist in the procurement, installation and maintenance of various types of equipment at the Department of Defense facilities and, finally, with recently acquired Haverstick two contracts totaling $7.7 million, to deliver 17 Oriole rockets for the missle defense agency in the Naval Surface Weapons Center.

Once again, as I previously noted, the vast majority of contracts are full and open in nature with Kratos having a very limited amount of small business or other set aside contract work exposure. This adds a level of stability to our contract base and the quality of our backlog. Additional -- additionally, Kratos is a prime contractor working directly for the customer agency and the vast majority of engagements. This is also important to contract quality as the risk of being vertically integrated out by a large prime is mitigated. These are critical aspects of our strategy as we continue to build the company going forward.

2007 was also a critical recompete year for Kratos and I'm proud to say that Kratos was successful in winning every major recompete except one, which related to an IT help desk contract vehicle that was bundled into a much larger contract procurement which is common in the industry today. In 2008, Kratos has only one significant recompete which occurs later in this year, and which we believe we are very well positioned for. Accordingly, as we look ahead into 2008 and coming off of a very successful recompete year in 2007 we believe that Kratos's contract base, including task orders and follow-on contracts, is extremely solid with the balance book of business in both defense and civilian agencies and with a significant portion of 2008's federal work already identified. Our contract base is approximately one-third time and material, one-third firm fixed price and one-third cost plus fixed fee.

Major programs we worked on in the fourth quarter or in 2007 include the following: The United States Army contract related to Hawk and Chaparral missle systems to provide engineering, technical support, supply support, logistics and manufacturing resources. This contract has a $92 million ceiling and we generated approximately $14 million in revenue in 2007. The contract runs through 2011. A contract with the United States Army Aviation and Missile Command to provide engineering and technical support for certain weapons systems. The contract ceiling is undefined with the current funding at $22 million. We generated approximately $8 million in revenue in 2007 and this contract runs through 2010. A contract with the Naval Undersea Warfare Center to perform work related to submarine C4I system upgrades and other systems modernization. This contract has a $30.1 million ceiling and 2007 revenue is approximately $3 million. The contract runs through 2010.

The contract with the Space and Naval Warfare System Command, JIATF South, to provide engineering, technical and research and development services and solutions. The contract's ceiling is $47.8 million, and Kratos generated approximately $8 million in revenue on this contract in '07, and the contract runs through 2012. The contract with the United States Army Aviation and Missile Command to provide engineering technical services, components and other assets to support Sidewinder and Chaparral missiles and other systems. Contract ceiling is $36 million, the contract is funded at $36 million. We generated approximately $18 million in revenue on this contract in '07 and the contract runs through 2009. And finally, a contract with the DCMA to develop and maintain software applications and provide information technology solutions. The contract ceiling is $14 million and we generated approximately $6 million in revenue on the contract. The contract runs through 2010.

As we look to further develop our key areas of differentiation and weapon systems, range and targets, O & M, command and control systems, other national security and public safety programs, and with certain non-DOD government customers, we believe our sizeable exposure to high priority federal government programs will continue to drive our business. In terms of continuing opportunity, we remain optimistic about the long term outlook on defense related spending, federal information technology service spending and out service sourcing of government contracting services in general. As trends indicate, the federal government tends to increase reliance on subcontractors, with outsourcing representing approximately 85% of its current spending. As you know, with Haverstick Kratos is a very strong non-DOD federal government and state government focused business, which provides information technology and networking solutions.

We believe there is more up-side for government contractors such as Kratos who provide highly differentiated services with unique past performance qualifications and who maintain a base of non-DOD federal agency focused employee, capabilities, contracts and contract work with other customers, especially in the federal IT area. It is our belief that potential change in administration as a result of the 2008 election should have minimal impact on the fiscal '08 budget priorities with an ongoing need for weapons systems, life cycle extension, weapons testing, command and control systems, foreign military sales and target and range work. However, should the administration change, we anticipate a potential reallocation of funds to support federal non-DOD initiatives in our growing base of civilian work with non-DOD agencies positions Kratos to benefit, should this occur. I'll now turn the call over to Deanna who will provide more details related to the company's financial performance.

Thank you Eric, and good afternoon.

As Eric mentioned, and as we previously stated, we expected fourth quarter and 2007 year-end financial statements and results to be very busy due to the major transformation activities in 2007. However, before I go into details on the financial statements, I will go through certain key fourth quarter and 2007 highlights of the company. During 2007, we divested our wireless engineering services businesses located in the United States and in Europe, the Middle East, and Africa and our wireless network deployment business for a total cash consideration received to date of approximately $57.3 million, plus $1.8 million we received from our European operations prior and subsequent to the closing date as payment on outstanding intercompany debt. These cash proceeds included approximately $21.9 million in cash, Kratos received from the sale of an LCC note payable held as part of the transaction of the engineering sale of which approximately $2.3 million of the proceeds under the LCC note payable were collected in February 2008. These cash proceeds were redeployed to pay down our then existing debt outstanding related to the MRC acquisition that we made in October of 2006, to position Kratos to obtain its new $85 million credit facility and to acquire Haverstick on November 31, 2007, utilizing approximately $69 million for that acquisition.

As Haverstick was acquired on the last day of 2007, no results of Haverstick's operations, including revenues, profits, et cetera are reflected in the income statements we reported today. However, Haverstick's balance sheet as of November 31, 2007, is included in the Kratos consolidated balance sheet. We will include Haverstick's operating results in our income statement beginning on January 1, 2008. Related to the Haverstick acquisition, the integration is well under way with both the Kratos and Haverstick integration teams executing the integration plan, which is currently focused on certain back-office functions, information technology, communication, other general and administrative areas, and business development as Eric previously noted.

On the civil suit litigation proposed settlement agreements for the class action securities litigation that we recently announced, we reflected a charge of $4.9 million in our fourth quarter 2007 financial results. This charge represents the estimated Kratos share of the proposed settlement of the 2004 and 2007 securities class action litigation which also includes the estimate of potential and yet to be settled contingencies related to the outstanding derivative actions. This fourth quarter charge does not include legal and other costs incurred in 2008 related to those matters -- to these matters, or the settlement, which will be recorded in the first quarter of 2008 as incurred in those periods. Accordingly, in 2008 Kratos will continue to incur certain legal and other costs related to these legacy matters until complete settlement and closure is achieved. As a result of these legal settlements and the resulting fourth quarter charge, Kratos obtained an amendment and waiver to our credit facility. This amendment and waiver, which will be filed as an 8K, among other things, waives the impact of the legal settlement amount on our financial covenants under the credit facility. The amendment also called for an amendment fee, an increase in the LIBOR floor rate of 4.25% and certain other items. Key balance sheet and capital structure elements at 12/31/2007 are as follows.

Cash on hand at 12/31 was $8.6 million. Accounts receivable, primarily from the U.S. government and other agencies was $77 million, which includes the Haverstick receivables. Excluding the Haverstick transaction, accounts receivables or days sales outstanding were 101 days, which includes amounts unbilled due to milestone achievements and shipment requirements, particularly on the company's contracts to provide Chaparral, Hawk, and other weapons systems which are not anticipated to occur until later 2008, once those systems are delivered and accepted. Bank debt at 12/31/07 was approximately $75.5 million including $50 million on our 5-year term note, $15.5 million on our line of credit, and $10 million in subordinated debt. Kratos' debt to equity at 12/31/07 was .45 to 1, and debt to market cap, including all Haverstick related transaction shares are assumed issued was .40 to 1.

Related to do our fourth quarter and fiscal 2007 financial statements, attached to our press release is a schedule of major costs and other non-operational item which will -- which I will summarize here. Stock option investigation costs and related fees of $1.1 million and $14 million for the fourth quarter in the year ended 12/31/07 respectively. Legal and other related costs associated with all litigations, legal settlements and other matters of $5.8 million and $6.8 million, for the fourth quarter and year-ended 12/31/07. Charges for asset impairments related to non-core and non-operating businesses of $1.8 million in the fourth quarter and $3 million for the fiscal year. A write-off of $1 million of previously deferred financing costs in the fourth quarter and year-to-date as a result of the termination of our prior credit facility. A credit of $3.4 million relates to the recovery of the assets stolen by the company's former stock option administrator in 2002 and 2003 are also reflected in our fourth quarter and year-to-date results.

Our fourth quarter results also include costs related to general and administrative costs associated with our disposed businesses which we are in the process of reducing, legal accounting stocks and other related costs which we intend on reducing during 2008. Costs related to transition services agreements for certain of our disposed businesses. Costs associated with changing the company name to Kratos, including branding, internet communications and various other marketing-related costs. As you can see from this summary in the fourth quarter 2007, there are a number of significant one time non-recurring costs directly related to the transformation from WFI to Kratos and all of the ancillary or collateral activities that have gone with it. The good news is that we have completed a significant amount of this cost reduction work in the fourth quarter just ended and we are targeting to be substantially complete by the first quarter of 2008.

Barring any unforeseen surprises, we expect to achieve GAAP EBITDA profitability in the second quarter of 2008 with increased overall EBITDA profitability in the second half of 2008. Our ultimate objective is that Kratos achieve EBITDA profitability consistent with our comparable industry peer group later on in 2008. Finally, an update on the previously announced impending SYS merger. With filing of 10-K today we now expect to file the merger related form S4 shortly and we are looking for the transaction to close in the second quarter pending approval of the joint proxy statement by the SEC and the required shareholder approval. Once the SYS transaction has closed, we will commence integration activities to drive efficiencies and profitability from this transaction. With that, I'll turn the call back over to Eric for his final remarks.

Thank you, Deanna.

In summary, in 2007 we radically transformed the company and as we enter 2008 we're a $300 million revenue run rate, federal, state and local government focused security, engineering information technology and networking solutions provider. Once the SYS merger is complete, Kratos will be an approximate $400 million run rate business with the employee based scale and critical mass to bid on and win larger contracts in the prime contractor role. Throughout 2008, with the integration of Haverstick, and then the integration of SYS once that merger is complete, we will continue the right-sizing and rationalization of the business infrastructure in order to reduce G&A, increase efficiencies and improve EBITDA profitabilities. With Haverstick and then SYS on board, and once our cost reduction and integration efforts are complete, we believe that Kratos can achieve EBITDA margins consistent with those of our comparable industry peers, as Deanna noted. Additionally, we're already seeing business development synergy with Haverstick, and our combined company is targeting larger contract opportunities in the prime role.

We fully expect that once the SYS transaction is closed, this business development collaboration will not only continue but accelerate, as we see a number of additional opportunities that once combined, we can pursue. We intend on growing this company top line organically at 5% to 10% per year, and an additional 10% to 15% growth per year for acquisition for a combined estimated top line growth rate of approximately 15% to 25% annually. As we execute our growth plan, we will strive to achieve, with leverage on our fixed SG&A infrastructure, increases in EBITDA rates as well. We plan on utilizing our free cash flow to both grow the business and pay down the debt, positioning Kratos to continue to successfully execute our strategy. As I mentioned, and as you can clearly see from our business today, we believe that we have accomplished a great deal in '07 but it goes without saying we have a lot of work to do '08. We're committed to executing our strategic plan as approved by our board of directors and as we have summarized for you here today, and we are committed to delivering the maximum value to our shareholders, investors, customers, employees and all other key stake holders. We would now like to open up the call for any questions you may have.

The question-and-answer session will be conducted electronically. (OPERATOR INSTRUCTIONS) We'll pause for a moment to assemble the queue. Our first question comes from Mike Crawford with Riley Investment Management.

Thank you. Eric, what was Haverstick's revenue in 2007.

Haverstick revenues in 2007 was approximately $95 million.

Okay. And is that growing maybe 5% to 10% organically? You would --

Very consistent with our profile.

Okay. Can you provide a bookings and backlog numbers?

No. Take a look at our -- at the filing today, Michael.

Okay. I'm kind of picking through it right now.

Okay.

And then you said you had a set of contracts with the DCMA worth $22 million. I think the number was smaller than the release? That was just for one contract. Is that --

Yes, and there were some others, yes. So it was a set.

And then -- thanks. The final question is, if you can provide a little additional color on the $400 million run rate, given SYS is about $80 million? So you're expecting your current business to kind of pick up that $20 million slack in the first six months? Is that --

Right. We're, as I stated, Mike, we're right now, with the contract base we have and the book of business we have, and where we believe SYS will come out as I'm assuming we close mid-year, somewhere around mid-year, in the second half of this year. We think that we can achieve a run rate at the that time of about 400, a run rate.

Okay. Great. Thank you.

You're welcome.

(OPERATOR INSTRUCTIONS) We'll hear next from Michael Potter with Monarch Capital.

Hey, guys. I'm just trying to get my arms around, again, the acquisition between the three companies. Have you, since the announcement of the SYS acquisition, have you been able to put your fingers on some of the immediate cost savings that you anticipate for 2008?

Oh, yes, we've already moved out with SYS and started putting together an integration plan. Let me give you an example of that. Our corporate headquarters, as you know, is in San Diego. SYS' corporate headquarters is in San Diego. We have several, it's four, five, or six facilities between us. We are going to, as these leases come off, and just coincidentally, a vast majority of leases come off in Q3 of '08, Q4 of '08 and Q1 of '09. We are going to consolidate facilities maybe not all into one but probably into two, which is going to result in a significant cost savings and a reduction in rates for the military.

Can you give us -- can you quantify what the savings should be?

For that -- for that it could be, depending upon the scheme, somewhere from just a loan from $800,000 to $1 million. And that's gross, not taking into any consideration on cost-plus contracts, just gross cash payments. So that is the type of item that is in the plan we're putting together.

Right. I don't know if you mentioned this earlier, but what was the breakdown for Kratos' business between defense, Homeland Security, and commercial?

Right, it's -- the commercial is more, just to be clear, is more public safety-oriented. And so on the numbers we just reported, it's approximately, roughly 70/30 or 75/20, 25. Federal government, DOD, versus public safety or commercial.

But would safety side also include municipalities?

Yes, yes, for what we just reported, and so with the merger with Haverstick, that will skew much more heavily toward federal government versus public safety.

Okay. And when you put in your target is industry margins, I'm assuming that is somewhere between the 8% to 10% EBITDA range.

Yes, yes, sir.

And in what time period do you think those margins are going to begin to materialize?

We -- as Deanna and I tried to communicate, one by one we're knocking out these final matters like the legal, the civil suits, and now we're negotiating on the derivative suits to get those knocked out, and so, we're hopeful, no later than next year, but we're hopeful some time in the second half, depending upon how we -- if we can wind these down. We'll wind down everything that we can control. There are a couple of things we just can't control the timing.

Okay. And just one last question. The S4, do you anticipate that will be filed in the next couple weeks?

Yes.

And at that time will you and, I'm assuming, Cliff Cooke, hit the road and start talking to some of the institutional investors?

There is a very large schedule sitting on my desk to do just that, yes.

Okay. Terrific. We look forward to seeing you at that time.

Okay, Michael.

Thanks.

And that is all the questions that we have. I would like to turn the conference back to our speakers for additional or closing remarks.

Very good. Thank you very much. We look forward to getting together with you again after we report our fourth quarter and we've made more progress on executing the strategy. Thank you.

That does conclude today's conference. Thank you for your participation. Have a great day.