Kratos Defense and Security Solutions Inc (KTOS) 2011 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense and Security Solutions first quarter 2011 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator instructions) As a reminder, today's conference call is being recorded.

I'd now like to turn the conference over to your host, Miss Laura Siegal, Vice President, Corporate Controller. Please go ahead.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense and Security Solutions first quarter earnings conference call. With me today are 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 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 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 of May 5th, 2011, 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.

This conference call will include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Certain of the information discussed, including adjusted EBITDA and the associated margin rates, pro forma EPS from continuing operations excluding transaction expenses, and amortization of purchased intangibles using a cash tax rate and using a statutory tax rate of 40% and pro forma full-year revenues and adjusted EBITDA as if Herley had been acquired as of January 1st, 2011, are considered non-GAAP financial measures. Kratos believes this information is useful to investors because it provides a basis for measuring the company's available capital resources. The actual and forecasted operating performance of the company's business and the company's cash flow, excluding extraordinary items and non-cash items that would normally be included in the most directly comparable measures calculated and presented in accordance with generally accepted accounting principles.

The company's managers uses these non-GAAP financial measures, along with the most directly comparable GAAP financial measures, in evaluating the company's actual and forecasted operating performance, capital resources, and cash flow. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. And non-GAAP financial measures as reported by the company may not be comparable to similarly-titled amounts reported by other companies. As appropriate, 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 first quarter of 2011. He will then turn the call over to Ms. Lund to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business, and we will then open up the call to your questions. With that said, it is my pleasure to turn the call over to Mr. DeMarco.

Thank you, Laura, and good afternoon. I want to begin today by stating that Kratos had an extremely strong first quarter in the face of an incredibly difficult environment, including unprecedented budget uncertainty with just about a six month continuing resolution.

As I mentioned on last quarter's call, we were confident that if the Department of Defense were to get a fiscal 2011 budget by April, that Kratos' previously stated pro forma full-year guidance of $750 million to $760 million in revenue and $102 million to $105 million in EBITDA would not change, and I'm pleased to report to you today that Kratos is reaffirming our previously stated guidance and these numbers.

Since the continuing resolution ended and a fiscal 2011 budget has been approved, the number of contract awards, contract funded bookings and RFPs that Kratos has received has increased substantially and it has been accelerating. This includes the $123 million prime contract award we announced today, which is a continuation of our previous approximate $50 million contract that we held. As you can see, this $123 million contract has a substantial $73 million scope of work and ceiling increase over the previous contract, and this will be one of Kratos' key organic growth drivers going forward. This is a key element of why we are confident in reaffirming our previously communicated 2011 guidance, which we have done today.

This recent RFP and award activity is also particularly true in Kratos' products and technology business area, where we have recently received a number of new contract awards, RFPs or purchase orders, and we are expecting to receive an increasing amount during the second quarter and throughout the balance of 2011.

On a macro level, for 2011, the DoD budget is $513 billion, which is an approximate 1%, or $5 billion, real increase in defense spending. Additionally, the fiscal 2012 DoD budget request is now at $553 billion.

Of the approximate 20 DoD programs that have either been terminated or are expected to be terminated or scaled back, there is no significant impact to any of Kratos' contracts or programs, none. Additionally, a Pentagon proficiency savings initiative of approximately $100 billion, where over the next five years, these monies will be reallocated to several national security priority areas, includes some very favorable reallocation areas for Kratos, including electronic warfare, intelligence surveillance and recognizance, command control and force multiplication, and weapons systems and equipment upgraded and reset. These are all areas where Kratos is very strong and very well positioned.

On the operational and programmatic side, some of the highlights for the quarter include -- during the first quarter, Kratos was a critical supporter in the very successful and major ballistic missile defense test, Atlantic Trident. For this exercise, Kratos provided ballistic missile defense, or BMD targets and rocket launch and engineering services under our $100 million prime contract vehicle. Atlantic Trident was the first live sea-based BMD test held on the East Coast, with the targets being launched out of NASA's Wallace Island flight facility. The target launch and the exercise was part of Kratos' Aegis Readiness Assessment Vehicle, or ARAV, family of targets, specifically used to test the Aegis BMD system.

Kratos also provided certain threat simulation, nose cone products, and solutions and certain other electronic and aerodynamic-related hardware. Aegis BMD is the sea-based mid-course component of the Missile Defense Agency's Ballistic Missile Defense System. The Aegis system is designed to intercept and destroy short- to intermediate-ranged ballistic missile threats. Aegis BMD is a significant growth focus area for Kratos. This is an area where Kratos has very unique and proprietary technologies, products and solutions offerings.

The Missile Defense Agency and the Navy have modified approximately 24 Aegis BMD combatants, including very recently the USS. Gravely DDG-107 and the USS Jason Dunham DDG-109. The USS Gravely and the USS Jason Dunham are both Arleigh Burke-class guided missile destroyers.

The Aegis combat systems aboard these ships have also been certified as fully operational through tests or combat systems ship qualification trials, and the Navy is currently planning to have approximately 70 Aegis BMD-capable ships in the future.

Additionally, the U.S. Navy has revised its DDG-1,000 Zumwalt-class destroyer production line in order to restart the DDG-51 Arleigh Burke-class, partly because the Navy can equip and deploy the DDG-51s more quickly and cheaply with the BMD upgraded Aegis systems.

Also very importantly, as reported in just this week's Defense News, as a result of the success of the Aegis program, the MDA has recently increased Aegis BMD funding from 10% of the MDA's budget spend up to approximately 25%. And just last week Kratos was informed that we have been awarded a new significant ARAV-related contract for which we hope to be able to receive customer approval to more formally announce in the future.

These are just some of the reasons why we are looking at Kratos' Aegis business area as a future growth driver for our company.

During the first quarter, Kratos was also involved in other successful missile defense-related tests and exercise, however, these were classified. Kratos is also involved with the FAD and Patriot Missile Defense Programs. We believe that we are well positioned on both of these solid and well-funded programs providing critical hardware, products, technology, and solutions.

Since our last earnings call, the brand new and in development MEADS Missile Defense System, which was expected to replace Patriot, has now been cancelled, and we believe that this cancellation is going to lead to additional opportunities for Kratos on these proven field and deployed systems.

During the first quarter, we received significant new contract awards for continued program work for a number of very specialized products related to command and control systems for certain platforms and related to certain unmanned aerial vehicle systems. Kratos is currently supporting a number of UAV platforms and programs, including related to UAV ground control stations, and we are currently pursuing a very large and strategic UAV ground control station opportunity with a potential new customer, that if we are successful would be a significant win for our company.

During the first quarter, we continued to work also on a number of intelligent surveillance and reconnaissance-related platforms, primarily aerial, which I cannot specifically identify here. However, I can say that these intelligence gathering, surveillance and reconnaissance platforms are extremely critical to this country's national security, and we believe that these ISR programs will be insulated from material DoD or other agency budget cuts.

We have recently received new orders for additional specialized products and equipment related to ISR platforms, and we are currently in discussions with our customers for further orders under these programs later on this year. Certain of our work in the ISR area includes providing hardware and related products, including specialized ground control stations, intelligence and analyst stations, command and control stations, many of these being mobile in nature.

Many of these specialized products that Kratos manufactures and delivers includes electromagnetic interference or high-altitude electromagnetic pulse protective technology insertion or chemical and biological protection. The manufacturing and production of specialized mill-spec equipment for ground stations for C5ISR platforms and programs and unmanned aerial system platforms is an area that requires very specialized and unique capabilities, equipment, technology qualifications, and an employee base, and this is an area where we believe that Kratos is one of the best in the industry.

Also in the ISR area during the first quarter, Kratos continued our prime contract work in the exotic sensor technology design and development areas, including as related to photonics and flexible membrane optical mirrors.

During the first quarter, we were able to announce a new contract win for Kratos' proprietary NeuralStar and dopplerVUE cyber and situational awareness products for a certain national defense-related agency. Kratos' proprietary NeuralStar and dopplerVUE products are true technology or intellectual property differentiators for our company.

These products are being sought after by certain national security agencies, and this is enabling Kratos to receive significant positions on teams primed by some of the largest aerospace and defense contractors in the industry that are pursuing large cyber security, information assurance, and situational awareness focused contract opportunities.

A specific example of such an opportunity occurred during the first quarter for us, where Kratos was part of a winning team for a multi-hundred million dollar cyber program, and we were specifically sought after by the winning prime contractor for Kratos' proprietary software products. The total potential value of this opportunity to our team was just under $1 billion.

Additionally, from a market standpoint, a new report just released by nextgov.com estimates that protecting military networks in fiscal 2012 will cost $3.2 billion, which is a $1 billion increase over the previous network projection estimate. This report stated that this increase reflects the growing number of programs being recategorized or reprioritized as cyber security related, and the report also stated that the Department of Homeland Security is requesting just under $1 billion in additional funding for its own cyber-related priorities.

Kratos' cyber information assurance and situational awareness business is one of Kratos' fastest growing and most profitable business areas. And this is an area where we believe we will have the opportunity to continue to grow in the future with our proprietary technology, our IP, and our specialized products.

During the first quarter, Kratos was also able to announce that our team won a $200 million contract opportunity which includes all options with the Program Executive Office for Integrated Warfare Support. Kratos' prime on this opportunity is a Alion Science and Technology, which is just an outstanding business that Kratos has a very solid and longstanding relationship with.

Under this contract, Kratos will provide specialized support to a number of important United States Navy programs and initiatives, including ongoing combat systems development and work on a number of C5ISR-related programs and systems.

In Kratos' weapons and combat system sustainment, upgrade, reset, and maintenance division, we believe this will be a strong business area for us as we move forward, as there are continued new program cancellations, reductions in new systems procured, and an overall trend towards extending the lifecycle of existing, proven, and deployed systems.

During the first quarter, we performed combat and weapon system sustainment, upgrade, and reset work on the following systems in the following areas. We performed maintenance training program work for the M1 Abrams Main Battle Tank, the CH 47 Chinook Helicopter, the Black Hawk Helicopter, the Armed Scout Helicopter, the High Mobility Artillery Rocket System, and the Bradley Fighting Vehicle. These are all multiyear program efforts on platforms and systems that will be in the United States and friendly forces' inventories for many years into the future.

We also continued work on Kratos' $49 million prime contract for the upgrade of approximately 1,400 Chaparral surface-to-air missiles and their related systems. This program goes through 2013, and we are currently pursuing certain other large surface-to-air missile upgrade program opportunities, including FMS. We believe Kratos has outstanding task performance qualifications.

During the first quarter, we performed work related to the [D-MILL certain] Hawk missile systems. And we are continuing to pursue FMS work in the combat system sustainment and upgrade areas, including for the Falcon surface-to-air missile system.

During the first quarter, we performed reset work for certain ground, vehicular, laser locator designator systems for man, portable, thermal, night sight, and we performed certain program work for both active Army and National Guard units in Texas, Alabama, Georgia, Virginia, Vermont, California, Hawaii, and also in Germany.

As you know, last year we acquired Henry Brothers. And we are pleased to report to you that the combined business is performing very, very well and is meeting all of our expectations. Jim Henry is a true icon of the critical infrastructure and public security industry, and we are truly blessed to have Jim part of the Kratos team helping lead our business development effort.

Our public security business has won a number of new contract awards recently which we will be formally announcing over the next few weeks, related to critical infrastructure security, surveillance, and population protection. Additionally, the business development integration between the businesses is now complete, and we are pursuing opportunities that are larger than the independent companies could have previously pursued alone.

Kratos' PSS Critical Infrastructure Security business is generating strong organic growth which we expect will continue throughout 2011. And we also expect PSS' profit margins to continue to expand throughout the year.

I want to emphasize here that the number of opportunities that we are seeing and pursuing in the critical infrastructure protection and security area is extremely strong, and we expect it to remain strong throughout this year, as discussions with our clients reflect significant interest in homeland security systems for strategic assets and population protection.

J.P. Freeman recently reported that video surveillance is a $9.2 billion market, and specialized security cameras properly deployed are a force multiplier to first responders and security forces, which is especially important in tough economic times where agencies' budgets are squeezed. We believe this is an opportunity for Kratos and this is an area where Kratos has outstanding capabilities and past performance qualifications.

During the first quarter, our public security business had a number of significant new contract awards, several of which we are prohibited from announcing for obviously security-related and other reasons. However, certain first quarter awards we are able to discuss here include a $1.2 million new contract award for surveillance in biometric space access control to protect certain national infrastructure in this country. Kratos' client here is a leading national digital infrastructure company, and Kratos will be providing a range of physical security and surveillance products and solutions including a state-of-the-art surveillance and security system that includes access control with biometrics, smart cards, extensive interior and exterior IP-based CC TV surveillance, alarm monitoring photo ID, and total biometric enrollment.

Also during the quarter, Kratos received a multimillion dollar contract award to provide and support mobile security and surveillance solutions for a major municipal transit authority. Under the contract award, Kratos will deploy mobile video surveillance and wireless infrastructure which will include specialized day-night cameras, specialized listening devices, and digital video recorders. Its mobile surveillance and video security system will be integrated into a command and control system.

Additionally, this contract award has a multiyear recurring operational and maintenance contract as well. This type of recurring operation or maintenance contract for the surveillance and security systems we design, engineer, build, integrate and deliver is a very important part of Kratos' strategy, an important part of Kratos as we build our PSS business and we drive profitability going forward.

I'll now turn it over to Deanna.

Thank you, Eric. Good afternoon. Today we reported first quarter revenues of $122.8 million and adjusted EBITDA of $12.6 million, or 10.3% of revenue. We are extremely pleased with our financial performance this quarter, especially in light of the challenging conditions of operating under a prolonged continuing resolution for the last six months that has impacted our industry, delaying contract awards and delaying funding for contract vehicles.

We are also very pleased with the accomplishments that we have achieved in the first quarter. We raised over $61 million in net cash proceeds in our equity offering at a price per share of $13.25, and we raised $305 million in gross [proceeds] in the issuance of our tack-on note added premium for an effective interest rate of 8.5%.

Both of these capital transactions were used to fund the acquisition of Herley Industries, which we closed at the end of the quarter, and we have an additional $70 million in cash on hand as a result of taking advantage of the strong demand for our tack-on note, and, consequently, issuing an additional $70 million in notes to provide additional flexibility for future corporate initiative.

As the Herley transaction closed on the last day of our fiscal quarter, none of the operating performance for Herley is included in our first quarter operating results. Our quarterly revenues of $122.8 million, compared to first quarter 2010 revenues of $68.7 million, reflect the aggregate contributions from the Gichner, DEI, (inaudible), and HBE acquisitions of approximately $57.6 million, combined with organic growth in certain of our weapon systems, ARAV target, and public safety businesses, offset in part by reductions in other areas reflecting the impact of government in-sourcing in certain of our government solutions contracts, as well as the expected reduction in revenues previously generated under contracts that were originally awarded as small business awards to companies that we acquired and/or have been recently converted to small business awards by the customer.

Our government solutions business revenues increased year over year from $61.5 million to $97.4 million, reflecting the contributions from the acquired companies of $40.8 million and organic growth in certain weapon systems and ARAV target businesses, offset by the aggregate net reductions I mentioned previously.

Our public safety business has continued to grow organically and through the acquisition of Henry Brothers, from a top line perspective, from $7.2 million for the first quarter of 2010, to $25.4 million in revenues for the first quarter of '11. Approximately $16.8 million of the revenues in the first quarter of '11 were generated by Henry Brothers.

On a year-over-year basis, organic revenue growth was $1.4 million, or 19%, from $7.2 million in the first quarter of '10, to the $8.6 million for the first quarter of '11, which [excluded] the Henry Brothers' revenues for the first quarter of this year.

SG&A increased from $9.4 million in the first quarter of 2010 to $15.5 million in the first quarter of '11, primarily due to the acquired companies, offset partially by cost reduction actions we have taken. As a percentage of revenues, our SG&A decreased from 13.7% in the first quarter of '10, to 12.6% in the first quarter of '11, as we have continued to leverage on our SG&A costs and which does not yet reflect some of the cost reduction actions we have taken in the second quarter to integrate certain of the back office functions of Henry Brothers.

From an operating segment standpoint, our government solutions segments generated $6.6 million of operating income in the first quarter of '11, up from $4 million compared to the same quarter last year. Our public safety and security segment generated $1.2 million of operating income in the first quarter of '11, up from a breakeven performance in the same quarter last year.

The improvements in both of our operating segments reflect a contribution from the acquired companies, the growth in the businesses, a favorable mix of revenues, as well as the impact of certain of the cost reduction actions we have taken.

From an operational adjusted EBITDA metric standpoint, our government solutions segment generated $10.7 million of adjusted EBITDA, or 11% of revenues, and our PSS segment generated adjusted EBITDA of $1.9 million, or 7.5% of revenues for the first quarter.

On a consolidated basis, our adjusted EBITDA for the quarter was $12.6 million, or 10.3% of revenues, up year over year from adjusted EBITDA of 5.9 million, or 8.6% of revenues in the first quarter of '10. Our adjusted EBITDA excludes the impact of approximately $5.8 million of acquisition-related expenses and stock compensation expense of $600,000.

On a GAAP basis, net loss for the first quarter was $3.5 million, which included the $5.8 million of acquisition-related expenses primarily related to the recently closed Herley acquisition. As we have stated on previous occasions, we believe that our cash income tax payments more closely represent the economics of our earnings, rather than our GAAP income tax provision which may be subject to variations on a period-by-period basis.

For instance, our first quarter GAAP net income reflects a net $1.2 million tax credit, primarily related to one-time -- a one-time $2.1 million tax refund that was filed in a prior year, offset by state tax obligations. We believe it is most appropriate to compare this to our average quarterly estimated cash tax payments of approximately $700,000 this year -- this quarter. Excuse me.

In addition, as we have stated before, we think it is important to note due to our inquisitive activity that purchase intangibles which are part of the purchase price allocation of the acquisitions that we complete are required to be amortized or expensed over the estimated useful lives of those intangible assets which range from an 18-month to a 10-year period.

For instance, our first quarter GAAP operating income includes an amortization charge for the purchase intangibles of $3.4 million, which is equivalent to approximately $0.16 per share, as a majority of the purchase intangibles are not deductible for tax purposes. We expect the amortization charges to increase for the balance of 2011 and 2012, as we have recently determined our purchase price valuation for the Herley acquisition, and as a result of the estimated useful lives of certain of the intangible assets, we expect our quarterly amortization to increase to approximately $9.2 million from the $3.4 million in the current quarter for the balance of 2011.

On a pro forma basis, utilizing an expected average cash pay income tax provision of approximately $700,000, EPS from continuing operations, excluding the acquisition-related expenses of $5.8 million, and the amortization of intangibles of $3.4 million, or $4.2 million before a cash tax provision of approximately $700,000, was approximately $0.16 per share.

Moving to the balance sheet and liquidity. Our cash balance was $45.5 million at March 27th, plus $112.3 million in restricted cash, which consists of approximately $80 million related to the funds necessary to complete the two-step merger of the Herley acquisition in which we acquired 94% of the shares of Herley as of our quarter end of March 25th, with the remaining shares acquired in the first week of our second quarter.

In summary, as of May 4th, 2011, after reflecting all the payments aggregating approximately $15 million that are necessary to complete the Herley acquisition and related acquisition expenses and related change and control payments that we assumed in the transaction and related to the prepaid interest due for the note, our total unrestricted cash balance on hand is approximately $80 million, plus restricted cash of $8.5 million, which primarily represents escrow amounts held for the indemnification obligations related to the Gichner acquisition.

Our cash balance reflects proceeds from the additional tack-on notes we issued in excess of the amount necessary to fund the close of the Herley acquisition to provide us with the flexibility to fund future corporate initiatives and working capital requirements.

As expected, as a result of the prolonged continuing resolution, as well as a payment of merger-related expenses of $1.7 million in the first quarter, our cash used for operations was $3.2 million. Excluding the payment of the merger expenses, our cash used from operations was $1.5 million. As discussed earlier, the prolonged continuing resolution resulted in delays in contract awards and contract funding and increased work performed prior to contract funding, which contributed to the increase in our DSOs from 76 days at the end of 2010, to 91 days for the first quarter of 2011, excluding the impact of the Herley acquisition. We currently expect DSOs to come down over the balance of the year now that the industry has a federal fiscal 2011 budget.

Other key balance sheet and capital structure elements at March 27th are as follows. Accounts receivable, which are primarily from the US Government and other agencies in contracts for which the US Government is the ultimate end customer, was [one -- $61.8] million. Debt under our outstanding notes at March 27th, was $510 million, which includes the additional $285 million in tack-on notes that we issued during the quarter, net of an issuance premium of $20 million, with no borrowings outstanding on our line of credit.

Total net debt, net of the $45.5 million unrestricted cash at March 27th, was $471 million. Total net debt, net of the approximate $80 million of unrestricted cash at May 4th, was approximate $437 million.

Our revenues generated from product sales for the first quarter was approximately 35% of our total revenues and our contract mix for the first quarter was 67% of revenues generated from fixed price contracts, 15% from CPFF contracts, and 18% from T&M contracts. Revenues generated from contracts with the Federal Government were approximately 76.7%, including revenues generated from contracts with the DoD of 71%, and revenues generated from contracts with non-DoD Federal Government agencies of 6%.

We also generated 9% of our revenues from state and local governments and 14% from our commercial customers. We expect that our revenues generated from product sales will increase in the future with the Herley acquisition.

Moving on to guidance that we have reaffirmed today for 2011. We have reaffirmed our annual guidance for 2011, which includes Herley from the date of acquisition of March 25th, of revenues of $700 to $710 million, and adjusted EBITDA of $91 to $94 million. Pro forma EPS, excluding amortization, acquisition expenses, and using an expected cash pay income tax provision of $3 to $4 million for the year, is $1.25 to $1.35 per share. As expected, our pro forma EPS has been impacted by the interest expense related to the $70 million in additional tack-on notes that we issued above the amount we had originally forecasted.

As I stated earlier, due to the demand for the notes and the effective interest rate, we believed it was an opportune time to enhance our flexibility to fund future corporate initiatives.

Using a full statutory 40% tax rate, excluding amortization expense and acquisition expenses, we estimate pro forma EPS to be $0.85 to $0.95. On a full-year basis, as if the Herley acquisition had closed January 1st, our pro forma EPS, using our estimated cash tax payment is estimated at $1.35 to $1.45 per share, and using a full statutory tax rate of 40% pro forma EPS is estimated at $0.90 to $1.00.

We estimate the annual amortization expense for purchase intangibles for 2011 to be approximately $32 million, reflecting the impact of the acquired companies. As we have mentioned previously, the amortization expense is quite sizeable on a relative basis as a result of our acquisition strategy, and we believe it is meaningful to present a pro forma EPS, excluding amortization, along with GAAP EPS.

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

Great, Deanna. Thank you very much. Before we turn it over for questions, I'm going to comment on Kratos' M&A strategy, Herley, and Kratos' current positioning the DoD and national security environment. As you know, Kratos' strategy is to build the premier national security and defense technology-based business in the industry, focused on priority areas with our primary competency across our company being C5ISR solutions, products, and services, and where we can clearly differentiate our technology, products, and solutions to our customers, and, thereby, reduce competition.

Kratos has an experienced M&A team, with a number of our executives and management team coming from the Titan Corporation, where they built an extremely valuable $2 billion business both organically and through acquisitions. As I have stated before, I believe that Kratos' management team is second-to-none in this industry.

In addition to operating the business, Kratos' management team is also extremely experienced in the integration of acquired businesses, which is reflected in Kratos' profit in EBITDA margins, which have increased steadily over the past several quarters and years and are expected to continue to increase throughout 2011. I believe that the Kratos team and their expertise and experience in M&A and in the integration of acquired businesses is a clear strategic differentiator and advantage for our company, as we execute our strategic plan and as we build the business.

As you know, there is incredible financial leverage in eliminating the duplicative and redundant required public company costs and infrastructure when Kratos acquires another small or mid-size public company. Additionally, the vast majority of the work that Kratos performs and the work at companies that Kratos acquires performs, is either on or adjacent to a military base or at a secure or very specialized facility. As a result, there is virtually no facility, manufacturing site, or operational site consolidation required within Kratos' M&A strategy, with integration being primarily the elimination of duplicative or redundant G&A, which significantly reduces the overall integration risk profile.

We also have no future acquisitions included in the financial guidance we provide, as there is no way that a company can or should plan these things, and there are no assumed acquisitions in the guidance we provided today. I want to reiterate that point. We intend to remain extremely disciplined in our M&A strategy. We will not deviate from our core C5ISR capabilities and competencies, and we will continue to be opportunistic when we identify situations that further Kratos' strategic plan, add value to our business, and are accretive to our earnings, profit margin rates, cash flow, or cash flow per Kratos' share, and we are comfortable with the integration.

The Herley transaction, which closed at the end of the first quarter is the most recent example of the successful execution of this strategy. With Herley, we have effectively eliminated the duplicative and redundant costs, primarily comprised of public company G&A, and we have integrated Herley's outstanding President, Rich Poirier, and Herley's outstanding team of business unit presidents in Kratos. Rich's team and the Herley business have been plugged into the Kratos infrastructure, if you will, without missing a beat. This is just an outstanding team, Herley's.

There are no facilities consolidation plan with Herley, and the only operational consolidation has been in the business development area. We believe that combined with Kratos, Herley will generate substantive value for the Kratos shareholders as a result of Herley's entrenched positions on many of this country's most important and mission-critical, electronic attack, electronic warfare, ISR, missile system, and strategic deterrent platforms. Approximately 65% of Herley's work is single source, a significant additional portion being basically dual source. And there being a very limited number of companies in existence today with Herley's leading-edge technology, qualifications, capabilities, and highly skilled workforce with the ability to credibly pursue these types of EW and EA programs.

Herley's business is performing great. It's right on track [for] $200 million in revenue and $40 million in EBITDA for 2011. And we could not be any more pleased as an organization to be joined with such an outstanding team and an outstanding business.

In wrapping up, we believe that in the current DoD environment, that Kratos' existing business and our focus on our strength areas have a lower exposure to potential [cuts], and, in many instances, we are positioned very well in areas that we believe will receive increased funding or will benefit from the reallocation of funds.

Clearly stated, we believe that Kratos' business is well positioned today for the current national security and government contracting environment. We have a great company, a great business, and an outstanding management team, and I'm convinced we have the correct strategy.

With that, we're going to turn it over for questions.

(Operator Instructions) Our first question comes from Mark Jordan of Noble financial. Please go ahead.

Thank you. Two quick questions. One, with the consummation of the Herley acquisition, what will be the interest expense run rate in the second quarter?

Mark, this is Deanna. It'll be roughly $13 million per quarter. That will include both the cash interest and also the amortization of deferred financing costs.

Great. Secondly, SG&A, where does that [go] with the combined companies? And, now, Eric did mention that he'd take -- you'd taken out some expenses very quickly. But what other longer term efficiencies might you be able to ring out of that annualized run rate that you'll show in the second quarter?

As we had mentioned, I think both Eric and I had mentioned, there are some additional integration actions that we are taking in the public safety business that we will initiate in the second and third quarters. So you'll see some of that impact in the second quarter, but not all the impact in the second quarter, probably -- mostly likely not until the third quarter.

Okay. Do you have a run rate that you can share with us for SG&A?

That would be roughly approximately $21 to $22 million, and that would exclude depreciation and amortization.

Okay. Thank you very much.

Thanks.

Our next question comes from Mike Crawford of B. Riley and Company. Please go ahead.

Thank you. First, regarding Herley, can you give us a sense of what Herley's performance was in Q1?

Yes. We -- it looks like it's going to be in the high $40s in revenue, and may touch $50 million in revenue, right on track. And as I mentioned in my prepared remarks, EBITDA for the year, we looked at it quarter to quarter, is tracking for about 40 million bucks for the full year.

Okay. Thanks, Eric. And then on this new upsize contract at Dahlgren, I mean, that's a pretty big jump for five years. What -- can you say what level of revenue you were actually achieving on the old related business at Dahlgren?

Right. We -- yes. As you said, Mike, this is a huge win for us, and this is a vehicle that had been tied up because of the CR. We expected to get this at the beginning of the year. We had been running between 10 and 15 million a year, depending on op tempo on the previous $50 million vehicle. And as you mentioned, we were very fortunate on the scope increase we got of about $75 million.

Okay. And related to Aegis test engagements, what percent of that market do you expect to have in terms of Kratos targets and/or participation?

With what's happening with budget cut austerity and the philosophy of many government agencies going from an award based on total -- [best] total value with the previous award criteria, now it's lowest cost, technically qualified, which is just fantastic for a company like us. Mike, we -- we're positioning, we think for the next three, four years, we're going to -- we're going to get the vast majority of this work with our systems. That's our plan.

Okay. Thanks. And then, maybe, Deanna -- I'm sorry -- if you could just walk through the cash situation again.

Sure.

You had $45.5 million of unrestricted, but then --

Yes.

-- you mentioned some additional needed for Herley, but then there was another gap of $32 million that was also restricted and it looks like now it's --

Yes.

-- not restricted. What is that? What is that all about?

That's correct. And it is a bit confusing. So the restricted cash at quarter end, which was the $112.3, as a result of the two-step merger that we did with Herley and with the way the bonds were structured, since we did not have full 100% ownership of Herley at our quarter end, we were required to put certain of our proceeds of the equity raise into that restricted cash bucket, if you will.

So that's what I was trying to walk through. Of the $112.3, approximately $80 million of that was really related to fund the remaining obligations related to the Herley acquisition. So the true, unrestricted cash is the $80 million that we have today. It's actually more than that right now that we have on hand. But there are still some payments that, transaction-type expenses, that are due. So what we've tried to do is net those numbers for purposes of this call to be able to provide what the actual unrestricted cash on hand after all those expenses are paid. And that is all unrestricted now. So we actually have more than $80 million on hand today. But there are still some expenses that need to be paid out related to the transaction.

Okay. Thanks. And the final question relates to maybe as you stand today, backlog, funded, unfunded, been in proposal pipeline.

Sure. So our total backlog is, I believe it's 563 -- let me double check before I say that. Yes, it's -- no, I'm sorry. It's a total of 766, of which the total funded is 396 and the total unfunded is 370.

And the bid pipeline, Mike, and, again, this excludes anything for any GWACs or IDIQs and anything like that, is between $2 and $2.5 billion right now, fully qualified, no IDIQs.

Okay. Thanks. And, Deanna, thank you.

Sure. No problem.

(Operator Instructions) Our next question comes from Jonathan Richton of Imperial Capital. Please go ahead.

Hi. Good morning. Good afternoon.

Good morning.

One quick question regarding the gross margin on the product side. I guess maybe you can -- if you can breakout what portion of that was Gichner or what portion of that was more organic [created].

Right. We -- Gichner has been fully, fully, 100% integrated into our weapon systems business. It is in its infrastructure. We're bidding jointly right now. And we're winning contract awards with Gichner that they never would have won if it wasn't integrated into our weapon systems business. In addition, part of our plan with Gichner, there were some opportunities on the public security side. We are right now positioned, we believe, really well for a very large public security win relative to Gichner's products.

So from a Gichner versus Kratos it's gone now. It's kind of blended into us, and so we don't track it that way anymore. It's literally, it's been integrated into the company.

Okay. And then in terms of the foreign military sales, and I'm kind of looking at, I guess demand in the Middle East for missile defense and kind of the phase adaptive approach. Is there going to be a tradeoff that Kratos will be affected by? Meaning, with the demand for newer systems, you're kind of -- some of the older systems, the, I guess a fixing in the work on the older systems will decline or it's kind of they're totally independent of each other in terms of the opportunities.

Right. The -- couple of points. First, cancellation of MEAD is huge. We are heavily involved with Patriot.

All right. Okay.

The amount of activity we are seeing right now for Patriot is the most significant I have seen since I've been at this company. On FMS, putting aside missile defense for a minute, the number of FMS opportunities we are chasing right now is also at the highest level it's ever been [in] our company. And this has to do with surface-to-air missile systems, but also ground combat systems and the upgrade and sustainment of existing ground combat systems, including heavily armored systems and light tactical armored systems.

So we -- we're not seeing any negativity going on right now in FMS, quite to the contrary. It's been -- it's all been positive. And relative to phase adaptive approach on the missile defense system, as I mentioned, the two new DDG-51s now are Aegis BMD capable. The Navy's going to go to 70 ships, which is all -- which is, as you know, Aegis is the focal point to the phase adaptive approach. And as I think Mr. Crawford asked, we -- we're intending on providing the targets for the fleet. And so knock on wood, so far so good.

Okay. Thank you very much.

I'm showing no further questions at this time, and I would like to turn the call back over to Mr. Eric DeMarco for any closing remarks.

Very good. Thank you for joining us this afternoon. We will be [circling] up with you at the end of the second quarter. Thank you.

Ladies and gentlemen, this does conclude today's conference. You may all disconnect and have a wonderful day.