Kratos Defense and Security Solutions Inc (KTOS) 2008 Q1 法說會逐字稿

Good day, everyone, and welcome to this Kratos Defense & Security Solutions First Quarter 2008 Earnings Conference Call. Today's call is being recorded. (OPERATOR INSTRUCTIONS).

For opening remarks and introductions, I would like to turn the conference over to Vice President of Investor Relations, Mr. Michael Baehr, who will read the Company's warning regarding forward-looking statements. Please go ahead, sir.

Good afternoon. 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'd 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 Webcast of this call for the public. A replay of our discussion will be available on the Company's Website later today.

During this call, we will discuss some factors 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 actual results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including [Form] 10-Q and 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 are made on this call as of today, May 8, 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 in expectations, or otherwise, for any reason.

Please note this conference call will include discussion on non-GAAP financial measures as that term is defined in Regulation G. The most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the Company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the Company's Website.

Now, for today's call, Mr. DeMarco will discuss our financial and operational results for the first quarter of 2008. He will then turn the call over to Ms. Lund to discuss the specifics related to our first quarter 2008 financial results. Deanna will also provide some comments about the status of our proposed merger with SYS Technologies and the related shareholder meeting. Eric will then make some concluding remarks about the business, and we'll then open the call up to your questions.

I'll now turn the call over to Mr. DeMarco.

Thank you, Michael. Good afternoon, again, everyone.

As you saw in our first quarter press release today, Kratos returned to operating profitability in Q1. Equally important, Kratos' EBITDA in the quarter was approximately 4.4% of revenues. Kratos was able to achieve this profitability and EBITDA performance in spite of the fact that, during the first quarter, we were still executing a substantial portion of our infrastructure right-sizing and cost reduction plan. Specifically, in the first quarter, we were still in the process of right-sizing the Company's general, administrative, and certain back-office infrastructure coming out of last year's major dispositions. Certain costs, such as audit, accounting, legal, consulting, and other fees, are still higher than what we are projecting for the second half of '08, also related to our just-completed transformation.

And we still have current excess facilities, which we believe certain of which will be substantially addressed once the SYS merger closes and we consolidate the organizations. Deanna will discuss the impact of the facilities consolidation in further detail later in her remarks.

We are well underway with our integration of Haverstick, which, as you know, is a key element of our strategy, along with our cost reduction initiatives, to achieve EBITDA margins consistent with those of our comparable industry peers later this year. Related to Haverstick, one of the most important considerations and positive benefits of this merger relates to the business development opportunities we envisioned for the combined organization. This is where the combined businesses are able to pursue prime contract opportunities which the previously independent organizations could not have pursued on their own. We are very pleased with what is occurring in the business development area after just three months of the two businesses working together, especially in the information technology area, with the United States Air Force, and also with our public safety and security (technical difficulty). Haverstick's non-federal and non-(technical difficulty).

As you know, we are targeting an annualized organic growth rate for the business of up to 10%, and the successful integration of the two organizations is an important factor to achieving this objective. We believe that we are well underway to accomplishing this objective, and we are currently in both the qualification and capture process on some sizeable contract opportunities. We also believe that we will have many of the Haverstick integration and cost reduction efforts completed by the end of this year, which is directly related to increasing Kratos' EBITDA margins as well.

Additionally, we have received word from the Securities and Exchange Commission that there will not be a review of our registration statement on Form S-4, and, therefore, once the revised proxy statement is filed to update the financials for both SYS and Kratos for Q1 performance, the joint proxy statement should be clear and effective shortly thereafter. Accordingly, we are currently targeting the end of June for the shareholder vote and the close of this merger.

Similar to the Haverstick transaction, the merger with SYS, once integrated, will position Kratos from a critical mass and revenue scale perspective to achieve further leveraged on certain fixed public-company-related costs and to achieve our EBITDA profitability objectives. Specifically, the elimination of certain duplicative public company, filing, disclosure, legal, and other costs, and the consolidation of several San Diego facilities in the third quarter will significantly reduce the combined company's cost infrastructure and improve our overall profitability.

Furthermore, and, again, similar in nature to the Haverstick merger, the combination of the Kratos' SYS contract vehicles, customer relationships, and past performance qualifications will position Kratos to pursue even larger contract and program opportunities in the prime contractor role. This will be a key element of Kratos achieving its internal growth targets and our overall growth targets of 20% to 25% annually as we move forward.

As I previously mentioned, assuming an end of June 2008 closing date for the merger with SYS, we expect the integration plan to continue through the first quarter of 2009, as related to SYS. The primary assumptions for the SYS integration plan timing we have assumed relates to the facility consolidation I previously mentioned and the related timing regarding when certain SYS San Diego facility leases expire. Other factors include Sarbanes-Oxley-related requirements, the December 30, 2008 financial audit, required 10-K disclosures, and the resources that must be maintained to accomplish these activities as seamlessly as possible.

For the first quarter, Kratos generated approximately $68 million in revenue. Important first quarter revenue-generating programs and activities for Kratos were as follows - a United States Army contract with the communications and electronics command, or CCOM, to provide end-to-end weapons systems lifecycle support; an aerial and seaborne targets program with the United States Navy, where Kratos flew a total of 58 successful jet-propelled aerial target missions and 50 successful high-speed, mobile-surface target missions in the first quarter; a United States Army contract for the maintenance, upgrade, and logistics for short- and medium-range surface-to-air missiles; a network development management and information technology contract with the Defense Logistics Agency; completion of numerous successful missions at the White Sands missile range, where the Kratos targets team successfully flew four aerial flights and two MQM-107 missions in January. We successfully flew a triple MQM-107 mission and a single MQM-107 mission, plus, deployed a team to Israel for two additional successful MQM-107 missions in February. And we also made preparations in March to support FMS target missions in Turkey in April. The MQM-107 is a high, subsonic aerial target used by the United States Army and the United States Air Force, in addition to other customers; Kratos participated in the planning and execution of the successful Aegis ballistic missile defense intercept of the failed communications satellite that was falling back to Earth; in the first quarter, Kratos received the award of two contract extensions running through September of 2009, valued at $6 million for the Defense Logistics Agency enterprise telecommunications network, or ETM; A C4ISR program with the space-enabled warfare systems command, where Kratos is integrating elements of the command, control, intelligence, surveillance, and reconnaissance system; program work at the Pacific Missile Range facility in Hawaii; and work related to ballistic missile defense, additional aerial targets, and test work at the White Sands Missile Range facility in New Mexico, portions of which are classified; work at the Naval Surface Warfare Center in Dahlgren with the mission of supporting weapons systems and gun systems programs; and rocket support services production work on several Oriole rocket systems, 17 of which Kratos is expected to deliver to customers in 2008.

On our existing book of business, Kratos' contract mix is approximately 25% T&M, 25% CPFF, and 50% FFP. Revenue by major agency during the first quarter was approximately 32% Navy; 18% Army; 6% Air Force; 6% foreign military sales or service, FMS; 13% other federal government agencies; and 25% non-federal government work, which is a combination of our commercial and state and local work.

Primary internal growth during the quarter included 11% organic growth in our Public Safety and Security segment and growth in certain command control, intelligence, surveillance, and reconnaissance programs. This was offset by reduced Q1 work on weapons system program, under which we will be making system deliveries later this year, and a communications system for a second weapons systems program, where we are expecting a follow-on contract and work and certain IT-related work.

Very importantly, during the first quarter just ended, Kratos announced a $100-million, prime contract win in the area of rocket support services. This $100-million vehicle, which we won in Q1, is to provide rocket launch services, engineering support, rocket assets, and systems to several government agencies at the White Sands Missile Range. As I mentioned before, Kratos is currently scheduled to deliver 17 Oriole rocket systems in 2008. And work performed on this $100-million contract win will be additive, or in addition to, this already-planned Oriole system work. Additionally, Kratos' qualified contract bid pipeline today is $1.5 billion.

These are just some of the reasons why we are optimistic about achieving our organic growth targets and growing the business year over year.

Within our Public Safety and Security segment, some of the major contracts or programs Kratos performed work under during Q1 included a subcontract to a major defense contractor for work on an information technology communications and security system at a major strategic facility that is providing national security assets, aspects of which are classified; a security contract, including access control, CCTV, and perimeter protection at a major information technology network data center in the United States; a second security contract, including IP-based video, CCTV, access control, and other non-disclosed security elements at a second major national data network center in the United States. Kratos' Public Safety and Security segment is in an area of business where we believe we will see both market synergy and business development opportunity once the SYS merger closes. SYS has a significant Public Safety and Security business in place today, which includes intellectual-property-based products, total solutions, and system integration services. We are very hopeful that several new business development opportunities will come from the combination of these businesses.

I'll now turn the call over to Deanna, who will provide more details related to the Company's financial performance in Q1.

Thank you, Eric. Good afternoon.

Today we reported quarterly revenues of $68.2 million, a $19.2 million, or a 39% increase, from comparable revenues of $49 million in the first quarter of 2007, which reflects a full quarter of operating results for the Haverstick merger, which occurred on December 31, 2007. Revenues for our government segment were $54.9 million, up from $37 million in Q1 '07. And revenues for our PSS segment were $13.3 million, up from $12 million in the first quarter of 2007.

Our gross margin for the first quarter of 2008 was 18.5%, or $12.6 million, up from 14.9%, or $7.3 million, in the comparable first quarter of 2007. The increase in gross margin is the result of both improvements in our PSS business, as well as an increase due to higher margin in our recently acquired Haverstick business.

SG&A as a percentage of revenues was down from 21.6%, or $10.6 million, in the first quarter of 2007 to 17.4%, or $11.9 million in 2008. Excluding approximately $1.5 million of stock option investigation fees in the first quarter of 2007, SG&A was down from 18.5%, or $9.1 million, to the 17.4% in 2008. As expected, our SG&A for the first quarter of 2008 included approximately $500,000 to $600,000 of professional fees related to the securities litigation settlement that we entered into in March and higher than normal yearend audit fees as compared to our industry peer companies as a result of legacy matters. We expect to continue to incur certain legal and other costs related to legacy matters until complete settlement and closure is achieved.

As we have previously stated, we expected the restructuring and transformation actions and activities to be substantially completed in the first quarter of 2008 and to return to operating profitability by the first half of 2008. The first quarter of 2008 is the first quarter in which we have returned to positive operating income since we exited our legacy wireless businesses and began our transformation activities in 2006. Our operating income was $700,000 for the first quarter of 2008 compared to an operating loss of $3.3 million for the comparable quarter in 2007.

As we have discussed previously, we continue to measure our progress and performance in terms of EBITDA, or earnings before interest, taxes, and depreciation and amortization. We believe that EBITDA from our continuing operations is a meaningful measurement of financial performance, especially since our entire federal business has been built through acquisitions that we have made since 2004 and our public safety business was built through acquisitions that were made in 2003. As a result of the acquisitive nature of our business, the amortization expense related to these acquisitions is significant in relation to our operating income. We believe that EBITDA is a commonly used measure of financial performance in comparable peer companies that have been acquisitive as well and is provided to help our investors evaluate companies on a consistent basis, as well as to enhance an understanding of our operating results. Barring any unforeseen surprises, we expect to achieve increased EBITDA, GAAP EBITDA profitability in the second quarter of 2008 with increased overall EBITDA profitability in the second half of 2008 through revenue growth and leverage on our SG&A infrastructure.

Loss from continuing operations for the first quarter of 2008 includes $2.3 million of net interest expense, primarily related to borrowings on our new credit facility, which was used to fund the acquisition of Haverstick. In addition, included in our loss from continuing operations is other expense of $700,000 related to the interest swap arrangement that we entered into in February.

As we discussed earlier, we entered into a waiver and amendment to our credit facility in March to provide the mechanism to record the fourth quarter litigation settlement charge. The waiver and amendment included a LIBOR rate of 4.25%, which consequently impacts the swap arrangement that we entered into and requires us to record any market fluctuations in our swap arrangement through the income statement rather than through the other comprehensive income section that's shareholders' equity on the balance sheet, which would have been the treatment if we would not have entered into the amendment. This additional expense does not result in additional cash interest paid, and it's specifically excluded from our bank measurement of our EBITDA, as it is noncash in nature.

Our EBITDA for the first quarter of 2008, in accordance with the EBITDA definition of our credit agreement, excluding the swap market fluctuation, was approximately $3 million.

Our cash balance was approximately $11 million at March 30, 2008, which included the $3.4-million recovery from the theft of our stock option in March and the $2.3 million we collected on remaining working capital adjustment from the sale of our domestic engineering business in 2008.

Our cash flow generated from operations was approximately $2 million. Other key balance sheet and capital structure elements at March 30, 2008 are as follows. Accounts receivable, primarily from the U.S. government and other agencies, was $79.3 million. Accounts receivables day sales outstanding, or DSOs, were 106, 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 scheduled for collection later on in 2008 once the systems are delivered and accepted. Bank debt at March 30, 2008 was approximately $77.5 million, including $50 million on our five-year term note, $17.5 million on our line of credit, and $10 million in subordinated debt. Our debt-to-equity ratio at quarter end was 0.46 to 1.

Related to the Haverstick acquisition, the integration is well underway with both the Kratos and Haverstick integration teams executing the integration plan which is currently focused on certain back-office functions, IT, communication, other general and administrative areas, and business development. 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 and pending SYS merger. As you all may know, we filed the Form S-4 for the SYS merger on April 10, 2008. We recently received a no-review letter from the SEC and plan to refile the amended joint proxy statement during the week of May 19, with a scheduled shareholders' meeting for June 25, 2008. We expect the transaction will close by our second quarter end. Once the SYS transaction has closed, we will continue integration actions to drive efficiencies and profitability from this transaction. One of the first steps, as Eric mentioned, is the consolidation of SYS' facilities in San Diego to our facilities in San Diego. As our San Diego facility will become more occupied and utilized once SYS moves into our facility, we expect that a portion of the excess facilities charge that we accrued in 2007 will no longer be required and will be reversed in that period. From a cash perspective, once substantially all the SYS lease arrangements expire at the end of 2008, the combined company should realize overall savings in lease payments going forward. Part of our integration process includes establishing a consistent definition of backlog across our business units, after evaluating and considering the various contract vehicles we have. Since we are still in the process of integrating the recently closed Haverstick transaction and will commence integration activities once the SYS transaction has closed, we anticipate that we will be in a position to report our consolidated backlog, incorporating all of our recently acquired and soon to be acquired businesses once we have a full quarter of operating performance including the SYS transaction.

With that, I'll turn the call back over to Eric for his final closing remarks.

Very good. Thank you, Deanna.

So, to conclude, I'd like to highlight the following key points as they relate to the progress of our overall business and our operational strategy. Kratos has returned to operational and EBITDA profitability. We've substantially completed our transformation and the related infrastructure right-sizing and cost reduction initiatives at the end of the first quarter, with the final reductions to be made by the end of the second quarter. The Haverstick integration is well underway, and we are on track to have this substantially completed and the related cost reductions made by the end of the third and fourth quarters of this year.

Additionally, the combined Kratos/Haverstick business development teams are also well underway and collaborating and are pursuing new opportunities which the independent companies could not have previously pursued. This is one of the most critical elements of our acquisition strategy - to position Kratos to bid on larger, prime contract opportunities to drive internal organic growth.

We recently received a no-review letter from the SEC and consequently expect the previously announced SYS merger registration statement on Form S-4 to be declared effective when we refile the joint proxy statement, updated for our first quarter results and SYS' results for the quarter ended March 30, 2008. We anticipate this transaction will close by the end of June.

And, finally, we expect the combined Kratos/Haverstick/SYS business - once the integration activities are complete, we'll have the scale and critical mass to achieve our previously stated EBITDA, or profitability, objectives and our combined corporate revenue growth targets annually of 20% to 25%.

That concludes our prepared remarks. Thank you for joining us today for this conference call. We would now open the call up for any questions you may have.

Thank you, sir. (OPERATOR INSTRUCTIONS). We'll take our first question from [Ken Witty] with Wachovia Securities.

Congratulations on the quarter. Do you expect to remain at operation profitability?

We sure do.

And do you expect any one-time charges in the next couple quarters for the SYS merger?

The one significant one that we're expecting ties directly into the number of facilities that we're going to consolidate. So when it closes, we're expecting to take a charge. And there will be a reversal of a similar charge, but that will be in purchase accounting, related to some excess space accruals we've taken in the past. So that would be part of the transaction. So the answer is yes.

And do you expect to realize all of SYS' revenues in your third quarter, or the largest portion of that?

Yes. If we close as expected, the last week in June, our fiscal third quarter we would expect to have a full quarter's revenue from SYS.

And do you have any expectation of an annual run rate as far as revenues?

We've been modeling them out annually between $70 million and $80 million, annually.

Okay. And as far as the growth in this past quarter - the organic growth - is that anticipated to be a realistic number year over year?

Yes. Ken, because we do so much work with weapons systems and delivery schedules, we're looking at our growth more year to year than sequentially because it depends on the workload we're doing on the various systems. We're targeting, as we've said, 5% to 10% internal growth - organic growth - year over year. We feel that that is very achievable for our Company.

And was this quarter--? Had you expected to return to operational profitability so soon?

Let's say, yes, but we were pleasantly surprised at the EBITDA rate that we did achieve.

Right. And were revenues higher than you were targeting for the quarter?

No. They were right within the band that we were looking at.

And I missed part of what you were commenting as far as the backlog. Can you comment on any of the backlog at this point?

As I had said before, we're going through our integration process of developing a consistent definition amongst all the companies we've acquired, since Haverstick was just recently acquired at the end of the year, and we're still in that process of defining a consistent definition after taking into consideration all the contract vehicles. But, at this point, what we do feel comfortable saying is that the funded backlog is approximately $100 million.

Okay. Great. Thanks for taking my questions.

(OPERATOR INSTRUCTIONS). We'll take our next question from [Ronald Guffin] at Burnham Asset Management.

Great quarter. I have a question concerning the Oriole rocket system. Where do you see that developing over the next few years? Do you see any possibility of expanding into foreign military sales, or this is something that will be solely domestic?

Yes. This is one of the business areas in Kratos that we're looking at to potentially-- could really help drive this Company's growth. We're looking at opportunities in two areas. One of them is going to be in the testing relative to the Aegis command and control and battle system and the requirements for that over the next few years, and that will be domestically. And, in addition to that, yes, Ron, in the area of FMS, with our range work, we're looking to combine our rocket and RFF capabilities with our range capabilities and hopefully expand that into FMS as well.

All right. Thank you.

And that does conclude our question and answer session. I'd like to turn it back to Mr. Michael Baehr for any additional or closing remarks.

That's it. I just want to thank everyone for joining us for this conference call today. Thank you.

And that does conclude today's conference. Thank you for participating, and have a nice day.