Kratos Defense and Security Solutions Inc (KTOS) 2008 Q3 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Kratos Defense & Security Solutions Third Quarter 2008 Earnings Conference Call. Your speakers for today's call are Mr. Eric DeMarco, President and Chief Executive Officer; Deanna Lund, Senior Vice President and Chief Financial Officer; and [Rob Babbish], Vice President Corporate Communications.

(Operator Instructions). As a reminder, today's call is being recorded November 6, 2008.

I will now turn the conference over to Mr. Rob Babbish, who will read the Company's warning regarding forward-looking statements. Please go ahead, sir.

Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions third quarter 2008 earnings conference call. 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 today's 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 release, it is available on the Kratos corporate Website at www.kratosdefense.com.

Additionally, I would 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 our most recent 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 on this call are made as November 6, 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.

This conference call will include a discussion of 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.

In today's call, Mr. DeMarco will discuss our financial and operational results for the third quarter of 2008. He will then turn the call over to Ms. Lund to discuss the specifics related to our third quarter 2008 financial results. Eric will then make some concluding remarks about the business, and we'll then open up the call to your questions.

With that said, it's my pleasure to turn the call over to Mr. DeMarco.

Thank you, Rob. Good afternoon, and thank you all for joining us.

During the third quarter, Kratos continued to make progress on our previously communicated business plan. As noted in our release, third quarter revenues increased approximately 71% year over year, but, more importantly, Kratos' EBITDA margins increased to 27% sequentially above the second quarter's. Total contract wins and bookings for the third quarter were $77.3 million, and our book to bill ratio was approximately 0.95 to 1. Additionally, our current fourth quarter bookings have started out very strong, including the award of two significant defense agency IT contracts valued at over $20 million.

Directly related to this, from Kratos' weapons systems business, we have very good news to report to you today. During the third quarter, we successfully fired two separate missiles at two separate targets for our customer, successfully demonstrating the weapon system's performance. As a result, a letter of request has now been received, and we are currently expecting a large, follow-on, sole-source, multiyear prime weapons systems contract in early 2009. We had previously expected this award in the second half of 2008, but the customer requested these two additional capability shots, which we have now successfully executed. Once again, this is very good news for Kratos, as this award, once received, is a very important component of Kratos' 2009, 2010, and 2011 organic growth objectives.

From an operational standpoint during the third quarter, Kratos' rocket support services business performed very well with the delivery of a number of Oriole rocket systems to our customers, and we remain on track to deliver the expected 17 systems for 2008. For the third quarter, our rocket support business generated significant quarter-to-quarter organic growth and year-over-year organic growth.

Kratos' Navy business at the Naval Surface Warfare Center, Dahlgren, with NAVSEA and OpNav, continued to perform very well, with Kratos also being a contractor on the Navy's new electromagnetic railgun system.

Kratos' Air Force information technology and networking business out of Wright-Patterson Air Force Base in Dayton, Ohio also had a solid quarter, along with Kratos' defense-related information technology businesses.

Kratos' state information technology business had a softer quarter, with a large contract opportunity pushed out until Q4 and the business also being adversely impacted by the general overall adverse economic conditions with certain tasks being delayed. However, we have received good news, and we have now been awarded just last week this previously delayed contract which we will commence performing on. This is great news for this business unit.

Kratos' public safety & security business had a solid third quarter, generating quarter-to-quarter sequential organic growth with security system integration and access control system integration work being performed at critical infrastructure locations, national security-related facilities, and other locations here in the United States. Our PSS business performance was offset somewhat by weaker than expected performance at Kratos' southeast and southwest regional locations, with Kratos' Houston headquarters being adversely impacted by Hurricane Ike, which effectively shut down all of this region's work for approximately two weeks during the third quarter. However, even with the negative impacts caused by the Hurricane, we believe Kratos' public security & safety segment performed extremely well during the third quarter, generating overall organic revenue growth.

Other growth areas for Kratos during the third quarter included organic growth in our information technology and networking business at certain Department of Defense agencies, including the defense contract management agency and the defense logistics agency. Our network-centrics products area also had a strong third quarter, including certain intelligence agency work, missile defense-related work, and military communications work.

As we mentioned on our last quarter call, in the third quarter, we experienced reductions on low-or no-margin material pass through and other work on certain contracts, reduced weapons systems program revenue, and the impact of the Q2 conversion of our work as a prime to sub on one of our target range projects, which was the primary cause of our overall sequential revenue decline. However, with the expected early 2009 award of the large multiyear weapons system contract, along with several other opportunities which we are currently pursuing and which contract award is expected in '09, we remain comfortable with Kratos' prospects in the weapons systems area and our organic growth prospects.

Also encouraging for Kratos, this business unit is targeting and performing a significant amount of weapons systems life cycle extension, maintenance of aging stock, or equipment reset-related work. This type of contract work is a specific business development focus area of Kratos, and we believe that this can be an area of significant new business opportunity for Kratos moving forward. Contract work in this area during the third quarter included work at Fort Campbell, Kentucky and Fort Rucker, Alabama to support the OH-58 Kiowa helicopter and a gun platform system modification, onsite equipment reset support to the First Infantry Division, Schweinfurt, Germany on certain fire support team vehicles, and weapons systems work performed at Camp Casey, Korea related to certain night-sight equipment and other systems.

Also a key item included in the defense budget relates to the repair, maintenance, and replacement of used or destroyed equipment, weapons systems, and vehicles, which is expected to exceed $100 billion. This was an additional area where Kratos is also focused strategically.

Other areas of new business opportunities that Kratos is currently focused on include cyber security. We believe that approximately $15 billion will be invested over the next five years to protect this nation's information technology systems and attack the IT and other related assets and systems of our enemies; supporting BRAC and having significant points of presence in major base realignment and closure recipient areas, like Huntsville, Alabama; training and simulation, the need for which is increasing as a result of the continuously expanding sophistication and complexity of this nation's weapons and other systems; foreign military sales, or FMS, that specifically related to weapons systems sustainment and program management; and the support of the overall defense transformation to confront asymmetric threats.

Additionally, Kratos has a federal government civilian agency capability that is currently focused on the Department of Education, Department of Labor, and other areas and where we are currently assessing our now combined qualifications and capabilities as related to distance learning, e-training, energy, and healthcare. Directly related to this, Kratos recently was awarded a civilian agency contract that is focused on providing IT training in the healthcare area.

As you know, Kratos is in the process of integrating our two most recent acquisitions and rationalizing the Company's cost infrastructure, which are both key elements of our plan of action to continue to increase our EBITDA margins as we move forward. The integration of Haverstick and SYS continued on plan during the third quarter, with a significant cost reduction action effective during the third quarter from which we expect to see the full financial and operational impact in early 2009, once severance and other related costs wind down. Once complete, we expect these actions to further increase Kratos' EBITDA margins.

We are also on track in combining the business development and contract capture resources of our Company, as well as augmenting this capability with new hires and additional resources. This is an absolutely critical element of Kratos' strategy in building this Company and one which we are hopeful of having set and in place also by the end of the first quarter of next year. Once complete, this will enable us to target and successfully pursue incremental and larger prime contract opportunities.

There are also specific additional actions that will be taking during the fourth quarter of this year as part of our integration, cost reduction, and margin expansion plans, including potentially exiting certain acquired contracts or businesses that are either not core to Kratos' stated strategy or are not additive to Kratos' profitability. Certain of these actions, along with the reductions in low- or no-margin material pass-throughs and business exits will result in somewhat lower revenue generated in '09. We expect all of these actions to positively impact 2009 EBITDA margins once they are completed and the impact fully realized. Accordingly, we also remain on track to achieve our previously stated 2009 EBITDA objectives.

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

Thank you, Eric. Good afternoon.

Today we reported quarterly revenues of $81.5 million, a $34 million, or a 71.6%, increase from comparable revenues of $47.5 million in the third quarter of 2007, which reflects a full quarter of operating results for the Haverstick and SYS mergers, which occurred on December 31, 2007 and June 28, 2008, respectively. On a sequential basis, our third quarter revenues were up $9.2 million, or 12.7%, from second quarter revenues of $72.3 million.

Revenues in our government solutions sector were up sequentially $9.3 million, or 15.7%, from $59.2 million in the second quarter to $68.5 million in the third quarter. On a year-over-year basis, our government solutions revenues were up $33.7 million, or 96.8%, up from $34.8 million in the third quarter of 2007 to $68.5 million in 2008. The year-over-year growth includes the impact of the Haverstick and SYS mergers, which contributed $20.6 million and $18.9 million, respectively, with [organic] in the recently acquired rocket support services business, as well as in our network and information technology work at certain defense agencies and security systems integration work at strategic locations performed by Kratos' mid-Atlantic public safety & security business, offset by expected reductions and lower-margin pass-through and subcontract work, expected reduced revenues as a result of the conversion of our work as prime to subcontractor that Eric mentioned earlier, as well as planned reduced shipments and work under certain of the Company's weapons systems contracts.

Organic revenue growth in our public safety & security segment from the third quarter of 2007 to the same period of 2008 was $300,000, or 2.4%, up from $12.7 million to $13 million, driven primarily by growth in our security integration businesses. On a sequential basis, our third quarter public safety & security segment revenues were down slightly from $13.1 million to $13 million due to the completion of certain projects, as well as the impact of Hurricane Ike on our Houston operation.

Our gross margin for the third quarter of 2008 was 22%, or $17.9 million, up from 17.3%, or $8.2 million, in the comparable third quarter of 2007. The increase in gross margins is primarily a result of margin improvements in our PSS businesses, as well as the impact of the SYS revenues, which have been historically higher gross margin businesses, due in part to the favorable mix in software revenues and due to the classification of costs incurred between costs of sales and SG&A, in accordance with government accounting standards.

SG&A as a percentage of revenues was down from 16.8%, or $8 million, in the third quarter of 2007, to 15.7%, or $12.8 million, in 2008. Sequentially, our SG&A increased from $9.7 million, or 13.4% of revenues, in the second quarter of 2008 to $12.8 million, or 15.7% of revenues, in the third quarter, reflecting the recent SYS merger, which traditionally has operated higher rates of SG&A as a percentage of revenues due to the classification of costs incurred between costs of sales and SG&A, mentioned earlier and, to a lesser extent, due to an increase in noncash stock-compensation expenses and the impact of previously discussed restructuring activities and employee actions that we took in our existing Kratos business, which are reflected as operating expenses. In addition, the SG&A cost for the third quarter of 2008 does not reflect the impact of the ongoing integrated actions that we are taking to integrate the SYS business and realize cost efficiencies.

Included in our third quarter operating expenses is a credit of $1 million related to the recent insurance reimbursement of previously recorded legal fees incurred related to the investigation of stock options. As we expected, we continue to improve our operating margins and EBITDA margins into the third quarter as we increased our revenues and were able to realize increased leverage on our infrastructure.

Our operating income was $3 million for the third quarter of 2008 compared to an operating loss of $8.4 million for the comparable quarter in 2007. Included in our current quarter operating income is the $1 million credit previously discussed, as well as a $200,000 noncash impairment of assets and a $100,000 charge for unused office space. Excluding this credit and impairment charge and facilities accrual charge, operating income was $2.3 million, or 2.8%.

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 due to our extensive acquisition activity.

Additionally, Kratos has approximately $150 million in net operating loss carry-forwards, which will result in Kratos paying minimum income taxes in future years as we utilize these carry-forwards. This will, of course, help increase our overall free cash flow.

Excluding the impact of the net $700,000 credit I previously discussed, our EBITDA was $4.7 million, or a 5.8% EBITDA margin, for the third quarter, up sequentially from second quarter EBITDA of $3.7 million, or a 5.1% EBITDA margin. On a sequential basis, EBITDA increased $1 million, or 27%, from the second quarter and improved 70 points as a percentage of revenues.

Income from continuing operations for the third quarter of 2008 includes $2.7 million of net interest expense, primarily related to borrowings on our credit facility, which was used to fund the acquisition of Haverstick. In addition, included in our income from continuing operations is other expense of 200,000 related to the interest swap arrangement that we have mark to market, which was unfavorable this quarter. We have excluded this loss from our EBITDA calculation, and it is specifically excluded from our bank's measurement of our EBITDA, as it is noncash in nature.

Our cash balance was approximately $2.5 million at September 28 plus $1.5 million in restricted cash. As anticipated, our cash balance at quarter end reflects expected payments that were made during the quarter to fund the 2007 securities litigation settlement of approximately $1.8 million; payment of $2 million to the buyers of our wireless deployment business that we sold last year; repayment under our credit facility and related interest payments of $5.6 million; payment of the SYS-related transaction expenses of approximately $3.1 million; payments for attorneys' fees incurred on legacy matters at $1.6 million; and payments to vendors, including those due on our milestone shipments of weapons systems. The remaining funding of the 2004 securities litigation settlement of approximately $2 million is not expected to occur until later this quarter. In October, we funded $1 million for the 2004 litigation settlement from the Company's restricted cash account, which was specifically set aside to fund the requirements of the pending legal settlement.

Our cash flow used for operations was approximately $5.4 million for the first nine months of 2008, with approximately $9.3 million used in the third quarter. The principal uses of operating cash flows were related to the funding of the litigation settlement; the debt service payments of interest, of which we made a $2.1 million payment of accrued interest ahead of schedule, which will not be required to be paid in the fourth quarter; the payments for attorneys' fees for legacy matters; and the vendor payments noted previously. Excluding the payment for these legacy legal items and the accrued interest payment ahead of schedule, all of which aggregated approximately $4.9 million, cash flow from operations for the nine months was nearly breakeven or a use of $500,000.

In summary, there were a number of nonrecurring payments that were made in the third quarter. We expect that we would generate positive cash flow from operations in our fourth quarter, consistent with previous quarters. Cash on hand today is approximately $6.6 million.

Other key balance sheet and capital structure elements at September 28 are as follows. Accounts receivable, primarily from the US government and other agencies, was $90.7 million. Accounts receivable day sales outstanding, or DSOs, were 101 days, up slightly from 98 for the second quarter. Our receivables include amounts billed due to milestone achievement and shipment requirements, particularly on the Company's contracts to provide Chaparral, HAWK, and other weapons systems, which are scheduled for collection later in the fourth quarter of 2008, once the final systems are delivered and accepted. Our DSOs are clearly impacted by the timing of the milestone achievements and shipping timelines of these weapons systems contracts. We expect that our DSOs should reduce in the fourth quarter as we achieve certain of these milestones.

Bank debt at September 29 was approximately $79.6 million, including $48.2 million on our five-year term note, $21.5 million on our line of credit, and $9.9 million in subordinated debt. Bank debt, net of cash, at September 28, is $77.1 million. Our debt to equity ratio at quarter end was 0.37 to 1. As we have stated previously, our ultimate objective is that Kratos achieves EBITDA profitability consistent with our comparable industry peer group as we head into 2009.

Our total backlog at the end of the quarter was approximately $500 million, consisting of $156 million in funded backlog. As we have stated previously, we will continue to refine a consistent definition of backlog across all of our business units.

Our contract mix for the third quarter was 42.3% of revenues generated from fixed-price contracts, 32.6% of revenues generated from CPFF contracts, and 25.1% generated from time and materials contracts.

For government revenues, approximately 74.4% are performed as a prime, with the remaining 25.6% performed as a subcontractor. Revenues generated from contracts with the DOD were 69.9%, with 7.1% generated from non-DOD federal agencies, 7.5% from state and local governments, and 15.5% from commercial customers.

With that, I'll turn the call back over to Eric.

Thank you, Deanna.

In closing, as of the beginning of the third quarter just completed, we have brought together three fairly equally sized businesses in approximately six months' time to create what is Kratos today. We are in the process of organizing and integrating these businesses for sustained future growth and increased profitability as one cohesive business. As we have discussed previously, we hope to have this integration process substantially complete by the end of the first quarter 2009, and we are currently on track to achieve this objective. These integration actions include significant cost-reduction actions being taken and the exiting of certain non-core, underperforming acquired businesses.

An absolutely critical element of our strategy and integration plan is to increase the combined Company's profitability. We have done that with Kratos' EBITDA margin increasing in the third quarter over 27%. All of these integration activities we have discussed are fully expected to further increase Kratos' EBITDA margins in 2009, once the full impact of the actions are realized.

With the exiting of certain non-core or underperforming businesses and the reduction of material and other low-margin contract pass-throughs on certain contracts, we're now currently targeting the high $300 millions in revenue for next year. However, we remain on track to achieve our previously stated EBITDA and profitability objectives.

Also, as part of our integration plan, we are building our business development organization by combining the resources from across the acquired businesses and augmenting our existing resources with additional capability. We are hopeful of having this process also complete and in place by the first quarter of '09 so that we can begin pursuing even larger contracts in the prime contractor role.

Strategically, we continue to believe that Kratos is very well positioned to take advantage of certain long-term industry growth themes, regardless of the nature of the upcoming administration change, including - information technology outsourcing and specifically related to the aging government work force and the continued trend of the federal government to outsource to government contractors; military equipment life cycle extension or equipment reset; BRAC, with Kratos' major points of presence today being at key, major BRAC recipient locations in the United States; cyber security; C4ISR; and other mission-critical and essential areas.

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

Thank you. (Operator Instructions). Our first question will come from Mark Jordan with Noble Financial.

Your decision to prune some of your underperforming acquired contracts and contracts with high pass-through obviously will make you a little bit smaller, but also, in theory, should it not free up capital and free up accounts receivable and others? Could you quantify what amount of cash that pruning might do in terms of free working capital?

Your point, Mark, is absolutely correct. It's not only going to free up capital that's tied up in receivables that are related to no- or low-profit-bearing subcontractor or material, but, in addition to that, it's also going to help streamline the contracting function, the procurement function. It's going to help ease out a lot of the processes because we're not going to have to deal with it. We're not talking about a lot that we're looking at here as we go forward, but it can be significant. And so maybe a handful of millions of dollars once we're complete because we won't have that tied up in receivables.

Okay. You mentioned this missile opportunity contract - that you had a couple of additional trial shots here in the third quarter. How does this opportunity differ from the March 28, $100-million, multiyear Oriole contract that, again, was announced in March of '08? And could you talk a little bit about the application? Why is this additive and not folded into that previous [IDIQ].

Right. So, the $100-million contract that we received earlier this year was specifically related to our rocket support business, which ties into our Oriole rocket business and the targeting work that we do for missile defense and AEGIS and other customers. That contract award was earlier this year. We are currently performing underneath that contract and doing very, very well under it. That is a completely separate contract, a completely separate customer, and a completely separate system than from the one I mentioned we were on successful on two shots in September.

The one in September is not related to strategic or ballistic missile defense. It is related to surface-to-air missile systems, both short-range and mid-range surface-to-air missile systems. It is a contract that we have been working on for quite some time. This is very good news. It's a multiyear-- just about a three-year contract. And it looks like it's going to be sole-source. Once we get that bolted in, Mark, it's going to position us pretty well for the growth targets next year.

Could you give us--? Again, you mentioned, at least, in the release that it runs through, potentially, 2011. While, obviously, these types of contracts can vary quarter to quarter and year to year, could you give us a sense of sort of an average high and low revenue that might be realized in a year?

Right. This contract could annually be $15 million or $20 million - annually.

Okay. All right. I think that will take care of me for the time being. Thank you.

(Operator Instructions). And we move next to Mike Crawford with B. Riley.

Eric, it's my understanding that this big-- There's a big Air Force IT procurement coming along. Maybe it stretched into next year? [NetSense 2]?

Yes, NetSense 2.

This is like a multi-billion award. How many different award-winning teams are expected here, and what's your strategy?

It's an interesting vehicle. It's an approximately $8 million to $9 million, multiyear vehicle. It's divided up into basically three primary pieces - a full and open piece, a small business piece, and a product or equipment piece. Those pieces are approximately, right now, broken up a third/a third/a third.

There are going to be multiple winners on this. There will be multiple large business winners, and there will be multiple small business or other satisfied winners on it. Without getting too deep into our strategy on how we're going after this, and something like this would be purely incremental to us if we were to win, we are positioning ourselves on teams to be involved in each of those three major segments I mentioned underneath the contract and numerous sub-segment elements under each one of those. That's how we're coming at it with different potential team members.

Okay. Great. Thank you.

And, at this time, we have no other questions standing by on our question roster.

Very good. Thank you for joining us today and being interested in our Company. We'll be talking with you again at the end of the fourth quarter. Thank you.

Thank you, everyone, for your participation in today's conference. And you may disconnect at this time.