Kratos Defense and Security Solutions Inc (KTOS) 2011 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the Kratos Defense and Security Solutions second 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 would now like to turn the conference over to your host, Miss Laura Siegal, Vice President, Corporate Controller. Ma'am, you may begin.

Good afternoon everyone and thank you for joining us for the Kratos Defense & Security Solutions second 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 August 4th, 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% 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 management 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 second 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. Good afternoon. Today Kratos reported another strong quarter in a very challenging federal government budgetary procurement and contracting environment. Deanna, as always, will provide all the financial details. I will only briefly hit some of the highlights.

For the second quarter, Kratos reported EBITDA margins of 13.3%, an approximate 300 basis point sequential increase over the first quarter. We believe that the continued expansion of Kratos' EBITDA margins is representative of the successful integration of the previously acquired businesses and the elimination or significant reduction of duplicative and redundant public company, corporate office related and other primarily general and administrative related costs. The significant expansion of profit margins of acquired businesses once combined with Kratos is a primary element of our stated acquisition strategy as we build the business.

We expect similar EBITDA margin expansion from Integral Systems over the next several months, as we rationalize and rightsize the business' cost structure, including potentially certain underperforming business areas. Specifically, we remain confident as we previously stated to you, that in 2012 the Integral business will generate at least $175 million in revenues and approximately $35 million in EBITDA as part of Kratos or a 20% EBITDA margin rate. Once the integration activities have been substantially completed, which we estimate will be by the beginning of 2012.

We also continue to expect Kratos' second half of 2011 to be stronger than the first six months were, as we have seen a pickup in bookings and orders in certain areas since the continuing resolution was resolved in Q2, though in certain other areas of the business we continue to see a slower pace of contracting and funding activity than we had expected. We believe this is due to the continued effect from the CRA, as well as the budget and debt ceiling battles that we've all been watching, which is causing uncertainty with certain customers about the future funding on certain of our programs.

However, Kratos is well positioned in several extremely high priority national security areas where we won significant contract awards and generated strong organic growth during the quarter and which we expect to continue in the future. For example, in the second quarter and very importantly, Kratos won the recompete of one of the largest contracts in our company; a $126 million five-year single award contract by the Naval Surface Warfare Center Dahlgren Division, which includes the support and analysis of intelligence, surveillance and reconnaissance technologies and weapons systems lethality and effectiveness.

This was previously a $50 million five-year contract. With the recompete win, we have received a $76 million scope increase up to the $126 million value for the next five-year period. With the win of this contract, Kratos' recompete win rate remains over 90%.

In the second quarter, Kratos' public safety and critical infrastructure security business generated organic year-over-year growth of approximately 23%. Kratos' critical infrastructure security business customers are primarily non-DoD and non-federal government related. Being substantially commercial in nature, including power generation, energy transmission, transportation related infrastructure, metropolitan transition authority, airports, rail companies and critical communication sites. The protection of strategic assets, critical infrastructure and proving public safety and security here in the United States, we believe will continue to be a very high priority area, as the risk of asymmetric threats continue to increase.

In the second quarter, Kratos' ballistic missile defense targets business generated organic growth in excess of 25%. I will talk more about Kratos' BMD and Aegis business and the growth opportunities we see, later on in my remarks.

For the second quarter, Kratos' book to bill ratio was approximately 1.6 to 1. This is one of the strongest in our company's history, which is reflective of the significant bookings Kratos began to receive with the resolution of the CRA in April and which we believe is reflective of the positioning of Kratos in mission critical national security priority areas. As I mentioned before, Kratos' profitability and EBITDA margins expanded approximately 300 basis points in Q2, with Kratos' increased profitability also occurring as a result of our business mix continuing to evolve more towards higher value specialty and technology based products and solutions, including in the C5 ISR areas.

Accordingly, as we enter the second half of 2011, we are increasing our previously communicated full year fiscal 2011 revenue and EBITDA guidance, which also reflects the Integral Systems acquisition which closed at the end of last week.

From a business mix standpoint, as we move forward, Kratos' pro forma business including Integral Systems is approximately as follows. Approximately 30% of Kratos' business space is related to specialized products and technology for unmanned systems, intelligence surveillance and reconnaissance systems and weapons system support, sustainment and test. Approximately 20% of Kratos' business is related to electronic warfare, electronic attack, ISR and weapons systems electronic products, including cyber warfare applications.

Approximately 30% of Kratos' business is related to satellite communications, command and control, signal monitoring, interference detection, geo-location protection and cyber security. Approximately 13% of Kratos' business is related to critical infrastructure and strategic asset security here in the United States. The final 7% of Kratos' business is related to command and control and range operations work.

From a products and services mix standpoint, as we move forward approximately 55% of Kratos' business is in the manufacture or production of specialized products, systems and software. With an additional approximate 15% of Kratos' business involving work performed on customer products, including weapon systems and in the C5 ISR area.

Organizationally, today Kratos is organized primarily by customer, with four business divisions and four division presidents. Kratos' weapon system solution division's customers include the US Army, the Missile Defense Agency, the Space and Missile Defense Command and foreign military sales customers which are fulfilled via US government contracts.

Kratos' defense technology division's customers include the United States Navy, the US Marine Corp and certain work we perform at the Pentagon. Kratos' technology and training division's customers include the United States Air Force, intelligence agencies and certain other national security related customers.

In Kratos' public security and safety division, with its primary customers being state, local and municipal agencies, including related transportation agencies or their security related elements and certain commercial customers in the critical and strategic infrastructure industry.

Undoubtedly, as I mentioned before, the federal government contracting industry is very challenging or dynamic right now and I can say it may be as challenging as I have seen it in my career. However, we believe that Kratos' business is pretty well positioned as we work through this period and this includes the fact that as we move forward, no one or single Kratos contract is expected to contribute greater than approximately 4% to 5% of our company's revenues.

We believe that Kratos' contractual and programmatic diversification can significantly reduce the risk of contract delays or cancellations which could potentially have a materially adverse impact on the company.

Additionally and very importantly, as I referred to before, a large portion of Kratos' business is focused in areas we believe are mission critical, national security priority areas, including work related to intelligence surveillance or reconnaissance platforms, unmanned systems, command and control systems, electronic warfare and electronic attack systems, satellite communications, secure SatCom, MilSatCom and communications interference protection, cyber warfare and cyber security, the upgrade and sustainment of proven fielded and deployed weapon or combat systems, and public safety, public security and critical infrastructure protection.

Once again, we believe that these areas are all national security priorities, that they will remain priority areas and that they will be sustained, protected or even potentially increased in funding in a tightening budget environment, where there will be a lesser number of new planes, ships, ground equipment and platforms and an increased focus on force multipliers, information dominance, ISR, UAVs and overall C5 ISR. We also believe that the protection of strategic assets and public security and the protection of critical infrastructure here in the United States will remain a high priority and will also continue to be well funded.

Certain of the priority programs or areas where we are currently performing work across the company include the following. A major Kratos program today is the EA 18G or electronic attack growler, which has just recently commenced full rate production. Kratos is providing a number of electronic warfare and electronic attack related products for the EA 18G, with this program being one of the largest in our company today.

The Growler is the primary electronic warfare and electronic attack aerial platform in the US arsenal today and it's expected to remain so many years into the future. Each of the devices or pods hanging from the Growler's wings performs a different function, including pinpointing the location of enemy radar sites, intercepting and jamming radio signals and following changing enemy radar tactics.

Electronic attack technology, along with drones, unmanned systems and cyber security are the areas where the current Administration wants to increase spending, including as a result of foreign adversaries improving their radar capabilities and their air defense networks.

Other major EWEA and ISR programs where Kratos is currently performing work include the P-8 Poseidon, which is an ELINT or electronic intelligence platform as well as an antisubmarine warfare and shipping interdiction aircraft and which is now just commencing LRIP. Similar to the EA 18G, the P8 is expected to fielded well into the next decade.

The light airborne multipurpose system or LAMPS, surface warfare and undersea warfare ISR aerial platform system and the RC135-W Rivet Joint intelligence and reconnaissance aircraft.

In the weapons system and training area, Kratos is a major contractor for the M1A1 Abrams main battle tank maintenance trainers. There are approximately 6,000 M1A1 Abrams tanks in the fleet today, with Abrams being the United States and arguably the world's best main battle tank. The Abrams lifecycle is also expected to go well into the next decade, with continued upgrades expected to the tanks command and control, fire control, ISR, drive train and other systems. When the tank is upgraded with new systems and technology, newer modified training systems are required and these training systems are what Kratos designs, engineers, manufactures and delivers to our customers.

Additionally, there are several foreign military sales opportunities that we are currently pursuing in this area as well where friendly foreign governments' militaries are looking to procure M1 tanks with unique systems and gear specific to their particular mission or need and which will require unique trainers. The Abrams trainer program is also one of the top revenue generating programs in Kratos today and certain of our current contract orders are just now in the second half of 2011, hitting the major production phase which is expected to continue through at least 2012.

Kratos is also under contract and provides major training systems for the Blackhawk and Chinook helicopters, the Bradley fighting vehicle and the HIMARS high-mobility artillery rocket launch system. These are all systems whose lifecycles are also expected to extend well into the future, with new technologies and capabilities as a result of potential replacement platforms and programs being canceled, terminated or recently delayed.

The Trident II D5 ballistic missile program is another major revenue generating program for Kratos. The Trident II is the United States primary strategic deterrent system and the Trident II is expected to be service through approximately 2050 as a result of the planned replacement system recently being canceled for cost and budgetary concerns.

On the Trident, Kratos is involved in the production and delivery of certain specialized electronic products and equipment related to the continued sustainment and test of the strategic weapon system and its readiness. The Trident program is similar to much of the work Kratos performs, requiring very specialized and unique facilities, equipment and personnel to successfully execute on the program. Kratos also continues to perform work in the unmanned systems area, including and specifically as related to the design, engineering and production of specialized ground equipment that transports, protects and controls a number of the unmanned aerial systems.

The unmanned systems and robotics area, as I mentioned before, is expected to be a well funded and high priority area for the future, as the cost to produce, operate and maintain unmanned aerial systems is significantly below the cost of manned platforms, with the added benefit of unmanned systems keeping the war fighter out of harm's way.

In the public safety and critical infrastructure security area, Kratos is currently working on a certain metropolitan government agency contract where Kratos is engineering, designing, deploying and integrating a specialized security and surveillance system at one of the largest cities in the United States. This program is also a multiyear program, it is one of the top revenue generating programs in Kratos and it's currently expected to grow in the future.

Also, Kratos was just recently awarded a large multimillion dollar contract for the design, engineering, deployment and integration of a state of the art surveillance and security system for one of the largest cities in the country, which we will begin working on in the third quarter. We have not been able to formally announce this new contract award yet, due to certain customer related and other sensitivities.

Some of the largest near-term opportunities in Kratos' is current $3.9 billion bid pipeline are critical infrastructure and strategic assets, security and protection related and these would be single award, fully funded contract vehicles with agencies and customers other than the federal government. Kratos' critical infrastructure and strategic asset protection business, which this year we expect to approximate $115 to $120 million in revenue, is expected to continue to be one of our fastest growing business areas for 2011.

Another high priority area where we are currently under contract and doing work is in the cyber security and cyber warfare areas. At the end of last year, Kratos was awarded the largest cyber security award in our company's history up to that point with a certain federal government agency. This program calls for the network management, protection and situational awareness for thousands of IP points and connectivity points throughout this customer's global information and communications network and where Kratos is delivering our proprietary software products. This program, which we are unable to fully disclose, has continued to expand for Kratos since this initial award and we believe that it will continue to expand in the future.

We believe that the cyber security, cyber warfare and information assurance areas will see increases in funding in the future, as the number of reported or disclosed cyber attacks and information thefts continue to increase and these represent a clear and significant threat to United States national security.

Another major contract or program area for Kratos is ballistic missile defense. Kratos is one of the premier ballistic missile defense targets providers in the industry today and in particular as related to Aegis BMD. As I mentioned earlier, Kratos' Aegis and BMD business grew organically in excess of 25% in the second quarter and the pipeline in this business area looks particularly strong for us going forward. There are currently 24 Aegis BMD capable ships in the fleet and in April 2011 report, the Navy laid out its plans to have 94 BMD capable ships by 2024.

Additionally, the Navy's current shipbuilding plan, which extends through 2040, projects that there will be 93 Aegis capable ships in the next 10 years. We clearly believe that ballistic missile defense, including Aegis BMD, are and will remain United States national security priority areas with the expected continued proliferation of tactical and strategic missile systems, including those by rogue nations and countries, as well as by potential terrorist threats.

It's important to point out here that similar to the work Kratos performs in the electronic warfare, electronic attack, ISR, specialized war fighter products and missile systems areas, which generate approximately $450 million in annual revenue for Kratos. Kratos' Aegis BMD business is also extremely unique in nature, with specialized facilities, equipment and personnel and where competitive barriers to entry are extremely high. We believe that the specialized and unique capability space is an important, competitive differentiator for Kratos as we execute our strategy and build the company.

I'll now turn it over to Deanna.

Thank you Eric. Good afternoon. Today we reported second quarter revenues of $171.1 million and adjusted EBITDA of $22.7 million, or 13.3% of revenues, up sequentially from the first quarter revenues of $122.8 million and adjusted EBITDA of $12.6 million or 10.3% of revenues. 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 first part of the quarter, as well as the continued lingering impacts of a CR that have resulted in delayed contract awards and funding.

We are also very pleased with the accomplishments that we have recently achieved. We amended our current revolving credit facility to increase it from $35 million to $65 million of capacity, extended the term to July 2016 and reduced the borrowing rate slightly to LIBOR plus 300 basis points to 375 basis points, depending on the available liquidity. We also raised $121 million in gross proceeds in the issuance of our tack on note at a premium of 105% for an effective interest rate of 8.9%.

Both of these capital transactions were used to fund the acquisition of Integral Systems, which we closed last week, and we have an additional approximate $70 to $75 million in cash on hand after payment of the related transaction expenses with no borrowings on our $65 million line of credit.

Our quarterly revenues of $171.1 million compared to second quarter 2010 revenues of $99.1 million, reflect the aggregate contributions from the DEI, Southside, Henry Brothers and Herley acquisitions, as well as a full quarter from the Gichner acquisition of approximately $88.5 million, combined with organic growth in certain of our Aegis target and public safety businesses, offset in part by reductions in other areas, reflecting the impact of government insourcing in certain of our government solutions contracts, the impact of contract award and funding delays due to the continuing resolution and debt ceiling concerns, 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 $91.6 million to $145.3 million, reflecting the contributions from the acquired companies of $71.9 million and organic growth in certain Aegis target businesses, offset by the aggregate net reductions I previously mentioned.

Our public safety business has continued to grow organically and through the acquisition of Henry Brothers, from a top line perspective, from $7.5 million for the second quarter of 2010, to $25.8 million in revenues for the second quarter of 2011. Approximately $16.6 million of the revenues in the second quarter of 2011 were generated by Henry Brothers.

On a year-over-year basis, organic revenue growth was $1.7 million, or 23%, which increased from the $7.5 million last year, to the $9.2 million in the second quarter of 2011, excluding the Henry Brothers' revenue for the second quarter of this year.

Gross margins increased from 20.1% in the second quarter of 2010, to 26.5% in the second quarter of 2011 and sequentially was up from 22.3% in the first quarter of 2011, reflecting the increased mix of product based revenues which typically generates higher gross margins. Our mix of revenues for the second quarter is 56% product and 44% services, up from the second quarter 2010 mix of 28% product and 72% services and up sequentially from the first quarter of 2011 of 35% products and 65% services.

From an operating segment standpoint, our government solutions segment generated $9.7 million of operating income in the second quarter, up from $6.6 million compared to the same quarter last year. Our public safety and security segment generated $1.7 million of operating income in the second quarter, up from a breakeven performance in the same quarter last year.

The improvements in both of our operating segments reflect the contributions 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, our government solutions segment generated $20.5 million of adjusted EBITDA, or 14.1% of revenues, and our PSS segment generated adjusted EBITDA of $2.2 million, or 8.5% of revenues in the second quarter.

On a consolidated basis, our adjusted EBITDA for the second quarter was $22.7 million, or 13.3%, up year over year from adjusted EBITDA of $9.2 million, or 9.3% of revenues in the second quarter of 2010 and up sequentially from $12.6 million or 10.3% of revenues in the first quarter of this year. Our adjusted EBITDA excludes the impact of approximately $1.8 million of acquisition-related expenses and stock compensation expense of $800,000.

On a GAAP basis, net loss for the second quarter was $5.2 million, which included the $1.8 million of acquisition-related expenses primarily related to the Integral acquisition, which closed last week, as well as $9.2 million of expense related to amortization of intangible assets. As we have stated on previous occasions, we believe that our cash income tax payments more closely represents the economics of our earnings, rather than our GAAP income tax provisions, which may be subject to variations on a period-by-period basis.

For instance, our second quarter GAAP net loss reflects a net $900,000 tax provision or expense against a pretax loss of $4.4 million, reflecting the non-deductibility for income tax purposes of our amortization expense of approximately $9.2 million, therefore resulting in taxable income of approximately $4.8 million as well as state income tax expense for states for which we do not have state net operating losses to offset against or for which we must file separate returns.

We continue to believe that it is meaningful to provide the average quarterly estimated cash tax payments of approximately $700,000. Including the recent acquisition of Integral, we expect our cash tax payments to be in the range of $3 to $4 million per year. This reflects our estimates of our ability to utilize our over $220 million of federal net operating losses which expire through 2029, to significantly offset and reduce our overall federal income tax payments.

As a reminder, we can utilize up to $28 million of federal NOLs for the next five years, with the carryover into the next year if not fully utilized and thereafter we can utilize up to $11.6 million of federal NOLs until all NOLs have been utilized through their expiration date. We believe we will be able to utilize all of our NOLs prior to the expiration date.

In addition, as we have stated before, we think it is important to note that due to our acquisitive 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 a 10-month to a 10-year period. For instance, our second quarter GAAP operating income includes an amortization charge for the purchase intangibles of $9.2 million, which is equivalent to approximately $0.39 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 with the close of the Integral acquisition in the third quarter. With the preliminary results of our purchase price valuation for the Integral acquisition and as a result of the estimated useful lives of certain of the intangible assets being fairly short in length, we currently expect our quarterly amortization to increase to approximately $12.4 million from the current $9.2 million for the balance of 2011. The valuations will be finalized during the third quarter, so we should be able to finalize the amortization expense at that time.

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 $1.8 million and the amortization of intangibles of $9.2 million, or $5.7 million before a cash tax provision of $700,000 or $5 million after giving effect to such provision, was approximately $0.21 per share.

Moving to the balance sheet and liquidity. Our cash balance was $100.4 million at June 26th, plus $2.8 million in restricted cash. Our cash balance today is approximately $95 million, which reflects the net use of approximately $5 million of our cash on hand, combined with the proceeds from the recent tack-on notes of $121 million to fund the Integral acquisition and related expenses. We expect to use an additional approximate $19 million of our cash on hand to fund the remaining acquisition related expenses of the transaction and expect to have cash on hand after payment of these expenses of approximately $75 to $76 million.

In addition, we have an undrawn revolving line of credit of $65 million with approximately $15 million of letters of credit outstanding.

As a result of the payment of merger-related expenses and other related costs of approximately $11.9 million in the second quarter, our cash used for operations was $6.9 million. Excluding the payment of the merger expenses, our cash generated from operations was $5 million, which is after the payment of approximately $16 million of interest.

Although the continuing resolution was resolved in mid April, the timing of contract funding and awards continued to impact our cash flows from operations for the quarter. Our DSOs decreased slightly from the first quarter of 2011 from 88 days to approximately 87 days. We continue to expect DSOs to continue to come down over the balance of the year now as contract funding is received and expect to generate approximately $20 to $25 million in cash flow from operations, excluding the payment of transaction related expenses but after interest payments for the second half of 2011.

Other key balance sheet and capital structure elements at June 26th are as follows. Accounts receivable, which are primarily from the US government and other agencies, and contracts for which the US government is the ultimate end customer, was $162.9 million. Debt under our outstanding notes at June 26th was $510 million, which does not include the recent additional tack-on note of $115 million, used to fund the Integral acquisition.

Total net debt, net of the $100.4 million unrestricted cash at June 26th was $418.3 million. Our contract mix for the second quarter was 69% revenues generated from fixed price contracts; 12% from cost reimbursable contracts; and 19% from time and material contracts. Revenues generated from contracts with the Federal Government were approximately 72%, including revenues generated from contracts with the DoD of 63%, and revenues generated from contracts with non-DoD Federal Government agencies of 9%.

We also generated 7% of our revenues from state and local governments; 11% from commercial customers; and 10% from foreign customers. We expect that our revenues generated from product sales will remain in the 50% to 55% range, with the estimated revenue mix from the Integral acquisition which is approximately 60% products and 40% services.

Backlog at quarter end, which excludes Integral, was $932 million, with $378 million funded.

Moving on to guidance that we have increased for 2011. We have increased our annual fiscal year guidance for 2011, which includes Herley from the date of acquisition of March 25th, and Integral from the date of acquisition of July 27th, from revenues of $700 to $710 million, and adjusted EBITDA of $91 to $94 million, to revenues of $765 to $775 million and adjusted EBITDA of $99 million to $102 million.

As Eric stated earlier and as we have stated previously, we expect that the revenues from Integral will range from $40 to $50 million on a quarterly basis, based upon timing of shipments and that we expect overall annual revenues to be approximately $175 million. We expect that the annual EBITDA contribution from Integral will be approximately $35 million after non-performing businesses have been rationalized, as well as the back office operations and other functions and facilities have been fully integrated into Kratos, which we currently expect will take at least six months.

As a reminder, Integral's existing corporate and public company infrastructure costs, nearly three times the amount of Kratos' corporate infrastructure of approximately $11 million. The increased fiscal 2011 guidance reflects the estimated impact of the Integral financial performance after taking into consideration the timing of cost reduction actions and facilities consolidation actions that we are taking. We expect interest expense to increase to approximately $16 million per quarter, which includes the amortization of deferred financing costs incurred to raise the indebtedness.

Pro forma EPS for 2011, excluding amortization, acquisition expenses and using an expected cash pay income tax provision of $3 to $4 million, are estimated at $0.89 to $0.97. Using a full statutory 40% tax rate, excluding the amortization expense and acquisition expenses, we estimate pro forma EPS to be $0.60 to $0.65. We currently estimate the annual amortization expense for purchased intangibles for 2011 to be approximately $36 million, reflecting the impact of the acquired companies.

As we have mentioned previously, this amortization expense is quite sizable on a relative basis as a result of our acquisition strategy and we believe it is meaningful to present a pro forma EPS, excluding the amortization, along with GAAP EPS. The amortization expense related to the Integral acquisition is expected to be finalized in the third quarter.

As we stated previously, once the Integral integration activities and rationalization of underperforming businesses has been completed, which we believe will be in early 2012, and Integral is contributing the estimated $35 million of annual EBITDA, we expect the impact to pro forma EPS will be accretive.

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

Thank you Deanna. We believe that as the United States draws down its troops in Afghanistan and Iraq and cuts back on defense spending, the country's reliance on technology will only increase and that this will benefit companies focused on satellite communications, unmanned systems, ISR and EW and EA. These are some of the primary reasons why earlier this year Kratos acquired Herley Industries and just last week we completed the acquisition of Integral Systems. We believe that Herley's current electronic warfare, electronic attack, ISR and missile systems business base is extremely stable, including in the current budgetary environment. As Herley's products are designed in to some of the most important mission critical proven and deployed systems protecting the United States today.

Additionally, there are some major new program opportunities out in the future that we will be pursuing that focus on the increase in technology, signal intelligence and ISR thesis I just mentioned. For example, the next generation jammer or NGJ, which is a jamming system to blind enemy radars, disrupt communications and execute certain cyber warfare missions.

The miniature air launched decoy program or MALD, which is the next generation electronic warfare system, the surface electronic warfare improvement program or SEWIP, which is a Navy program to replace all legacy electronic warfare systems with the new electronic warfare capability for all ship classes and the air and missile defense radar program or AMDR, which is an S-band and X-band air and missile defense radar system.

Kratos' focus on building a unique capabilities, high-technology national security products and solutions business, continued with the completion of the merger with Integral Systems and I want to personally welcome Integral's most important assets, its employees and its workforce, to Kratos. The Integral team has many of the same values as Kratos, including an entrepreneurial spirit, being highly technical in nature and driven to succeed and win.

We believe strongly that Integral's business positioning is also very similar to Kratos', with Integral being one of the dominant players in their primary market space. The command control, signal monitoring and signal interference detection and protection for satellite based and related terrestrial communication systems. We believe that a substantial amount of Integral's business is currently focused on priority or stable programs and initiatives with the opportunity for future growth as a result of expected increased funding in the mission critical satellite communications area.

The demand for satellite bandwidth has been and continues to grow rapidly and this demand has been outpacing existing capabilities. For example, the defense satellite communications system or DSCS was launched in 1982 and this system does not meet today's satellite bandwidth requirements, especially with the rapid proliferation of unmanned aerial systems, including UASes used for intelligence surveillance and reconnaissance purposes and the related increasing demand for live streaming video.

There are currently three major US defense force space programs underway, all designed to increase satellite bandwidth and which provide opportunity for Integral Systems as we move forward. These include the advanced, extremely high frequency or AEHF program, which is a four-satellite constellation that is intended to have 10 times the operating capacity of the current Milstar or Military Strategic and Tactical Relay Satellite communication system which is a constellation of communication satellites operated by the United States Air Force that provides secure communications for the United States Armed Forces. The first AEHF satellite was launched in 2010 and is expected to move into operational orbit later this year, with a second AEHF satellite scheduled for launch in 2012.

Next is the wideband global SATCOM system or WGS. The WGS currently has three satellites in orbit, with three more scheduled to launch in 2012 and the seventh in 2014. And finally, the enhanced polar satellite system, which is a secure communications system that is expected to become operational in 2018. The more satellites there are in the sky, the greater opportunity for communication link optimization, multiple signal interference correction, surety and reliability in the com link and for overall optimized space asset management and command and control, all of which are core Integral capabilities.

Additionally, the United States Strategic Command recently reported that they are becoming more concerned about the threat of adversaries jamming United States satellite communications. Without getting into details here, the area of jamming satellites and satellite protection is another core Integral capability and this is an opportunity area for Integral and an area where Integral has a unique expertise and where Integral is currently under contract.

Additionally, a June 6, 2011 Satellite Today report stated that satellite spending is expected to significantly increase in the public safety sector, with spending on wireless broadband technologies in this sector expected to increase from $15.2 billion in 2009 to $22.3 billion in 2015, representing a large opportunity for global satellite broadband providers, which would present opportunity for Integral Systems. The report also stated that a major driver in the increased adoption of satellite technology for public safety and security included the access diversity of satellite systems, terrain independence, the reach to remote to highly inaccessible areas, clear and faster connectivity and priority access that can only be provided by a satellite system.

Also related to market opportunities we see for Kratos, including Integral, the just released Wireless Broadband In Public Safety - Advanced Technologies And Global Market report, which forecast that the public safety market is expected to have total spending of approximately $34.7 billion by the end of 2020 or a compounded annual growth rate of 9.3%. I mentioned earlier in my prepared remarks the organic growth we are seeing in our public safety business today.

These are just some of the reasons why Kratos is excited about the merger with Integral Systems, the potential growth opportunities we see, the potential for real synergies between the Integral Systems business and Kratos' public safety and security business, as well as the potential synergies between Integral and Herley and the continuing convergence in the electronic warfare, electronic attack, ISR, SatCom and cyber warfare areas.

With that, we'll now turn it over for questions.

(Operator instructions) Mark Jordan, Noble Financial.

Eric and Deanna, I'd like to talk a little bit about your goals for EBITDA margins over time. With Kratos at 14%, your public safety at 8.5% and I think you said that Integral Systems should be running at 20% EBITDA margins when things are fully restructured; what are your targets for both Kratos Defense in public safety and what do you think, once everything's put together and running well, should be your steady state combined EBITDA margin?

The target for the company is mid 14s; that's combined for the defense business and the public security business. As we said, we expect the public security business to show some significant growth and we expect that business to get some good leverage on its G&A, so its margins should continue to lift along somewhat with the defense business. But 14.5 is what we see for the combined company next year.

Could you talk a little bit about what you think would be the company's free cash flow that you should be able to generate in 2012?

Rough numbers, about $2.00 a share, roughly.

And a final question, you talked about a $3.9 billion pipeline, could you talk about who is your competition that you're typically facing? Is it everybody or is it a limited profile and what is your competitive philosophy or how are you presenting yourself that gives you confidence you're going to have some real success in this area?

That's a very good question. For about two-thirds of our business space, the competition on procurements is very limited. It's a handful of bidders or less on the majority of bids. And it has to do with how over the past couple or few years we've transitioned the business more towards these very unique and specialized products and solutions in the electronic warfare area, in the ground support area for unmanned systems and ISR platforms and now, with Integral Systems in the satellite communications space. That's about two-thirds of the business. As we mentioned, we're looking for our public security business to be somewhere around $120 million this year for that business.

On the smaller procurements it's a lot of competition. Now that we're bigger, with the closing of Henry Brothers last year, we're going after, and as I said in my prepared remarks, some pretty big opportunities and it's a very limited field of guys, a handful or less that have the capabilities, the qualifications and the depth and breadth to bid on it. Okay?

The rest of the business, in the weapon systems sustainment area, it's extremely limited. The largest contract we're working on in that area right now is a missile system upgrade, there was one bidder, it was us. And this is where we've identified a certain select group of systems where we've aggregated to qualifications, both with people, personnel that worked were in the military and worked on the systems and people that worked in government agencies that worked on the systems and we go after these. And so you can see the thesis I'm building here.

We're trying to build a business where the vast majority of which it's very unique and specialized in nature, it's on sustained and deployed platforms and where it's very difficult to get the qualifications or the facilities or the equipment to do the work.

Could you just address quickly how you feel your competitive position from a pricing standpoint, is there a material difference on pricing or are you competing on qualifications? What exactly does it get down to?

The world has changed, particularly in the last year, where it used to be best total value to the government, where it wasn't always a price shootout, but cost was important. Where now, more and more of the procurements are being awarded based on lowest cost technically acceptable. And very candidly, this is playing into our hands, because as of today, for example in the targets business, our competitor, it's just not possible for them to get their cost down to where we are and we are winning the vast majority of the work.

And it has to do with our infrastructure and that we're a smaller company and we're very lean and as Deanna mentioned, our corporate infrastructure basically is one-third of the size of what Integral Systems was and we're three times bigger and that's part of our strategy, how we built this company. We want to have some of the lowest G&A rates in the industry, which is going to make us more competitive when we bid on these and this ties into our acquisition strategy of these other small public companies.

When we put these public companies together, we eliminate duplicative audit fees and Board fees and D&O insurance and blah blah blah and it lowers our rates, which makes us more and more competitive on the bids. And this is a big big deal with Integral Systems. This is why we're cautiously optimistic once we get everything together, their rates are going to be down, they're going to be far more competitive on a cost position than they were in the past and we're going to go after some big programs.

John Parker, Jefferies.

I'm wondering why you're guiding to $175 million of revenues that ship for ISIS. If I look at their last 12 months of reported revenues is around 200 and I'm wondering if you can give us any indication of how their recent quarter was?

Sure. That most recent quarter has not been publicly disclosed yet. It will be formally in the future. We have to, per the SEC regulations. But to answer your question specifically, if you look back in the last year or last 1.5 years, they have been very lumpy. They have had a $39 or $37 million quarter, they had a $40 million quarter, they've had a $50 million quarter and it has to do with programmatics and deliveries and shipments.

And so we have looked very very closely at their business and their pipeline, their backlog and we believe that they're going to do $40 to $50 million a quarter and if you divide that by two it's 45 and that's about $175 million a year and that's where we feel comfortable just taking a look at their history and their backlog and the delivery schedules they have.

Then how far along are you in achieving your targeted cost savings from both the Henry Brothers and the Herley acquisitions? I think you said it was going to take six months for ISIS so should we assume you're all done with Henry Brothers and you're just partway down the road for Herley?

John, as far as for Herley, that's substantially complete, so most of those cost reductions if you recall when we acquired Herley we had said the cost reductions would be in the neighborhood of $4 to $5 million; most of those were public company costs and corporate infrastructure costs; most of those have already been eliminated. There's some final cost that will be eliminated in this quarter.

Henry Brothers, a big chunk of that has been eliminated; there's some additional reductions, but the heavy lifting, if you will, of the reductions has already been completed. As far as Integral, that is going to take a little bit longer. We're estimating at least six months because it is a larger infrastructure, as we discussed, from a corporate standpoint, they're almost three times the size from a public company infrastructure standpoint that we are.

So, it's going to take a little more time to make those reductions as well as on the other two acquisitions we did not have any facilities consolidation. We are going to have facilities consolidation on Integral, specifically their corporate office, so that is going to take a little more time.

Finally, it looks like your products gross margins were quite strong in the quarter, stronger than I would have guessed, mixing, blending together Herley and your prior results. Is that something we can expect going forward or was it just a product mix in the quarter that drove your margins so high?

It was primarily a product mix. It had to do with prioritization by the customers and with the funding issues with the continuing resolution that we had, then we had a great booking month of half of April and half of May and then all the shenanigans started in Washington about the deficit ceiling and so it had to do with mix and prioritization of shipments, including in the C5 ISR area, where the unique products have a higher margin.

Okay, so going forward we perhaps should expect something a little bit lower than that?

Perhaps, but John, we're going to be very cautious because we see the budget deal that was just reached and now there are these triggering events and we have to see what's going to happen with that and if they can't come up with the other 1.3 trillion and then there's an across the board cut that hits defense, prioritization may happen again and the higher priority systems we work on carry higher margins, which would mean lower revenue but higher margins. So it just depends right now.

Mike Crawford, B. Riley & Company.

Regarding the electronic warfare, so the Growler is now in full rate production, does that mean that you expect to get about the 20 million in contribution that Herley was doing annually on the Growler or might that step up? And then also, how does that capability, the more strong that capability is for the DoD, how does that let them, if they decide that then they can let go of something like a JSF and do less on that platform because we can grab control of the skies, then how does that play into the other microelectronics work you do in electronic warfare?

We're looking for at least $20 million a year in revenue on the AG18, at least and it could be higher, exactly as you alluded to because of where it is in production right now. What you're talking about from electronic warfare and electronic attack capability is a strategic area of ours that we're focused on. What that means is where the electronic warfare area is going, you can do things electronically that are far less costly with stealth materials and stealth technologies and we think it's possible that if it were to happen it could be very very good for us, that if there is a reduction or a truncation in the F35, which means that there is going to be an upgrade in capability and potentially in numbers of F18s, F15s, that could be good for us because that's where we're focused and that's kind of what our strategy is and that's a lower cost way to very candidly, to do some stealth purposes.

And then on the radar side, where the technology is going stealth isn't necessarily what it used to be and the identification techniques are getting much much better, which is another item that's squeezing the potential deployment of $150 million per copy airplane.

Right now, as far as F35, I think you just work on maybe some Amram systems and maybe some shiners and that's about it.

Right now today, we are absolutely on Amram. The Amram is the primary; it may be the sole air to air missile medium range in the fleet and it's used on virtually every fighter we've got, including the F22 and the F35 and that is today that is correct relative to the F35.

Then regarding the cyber security business, so you have these new releases of NeuralStar primarily for defense customers and we've seen this really unprecedented level of espionage and theft and disruption from commercial enterprises into the deepest pockets of intelligence agencies where thousands of files are being stolen. So, are your cyber products something that can address this or what else is needed to help defeat or at least offset this threat?

The answer to the first part of your question is, yes on our cyber products. It's part of the solution. It's not the solution but it's part of the solution to identify, detect and protect these networks. What is needed, very candidly in my opinion, is just more emphasis, more focus which ties into more funding. Because the United States in general and the United States military and the United States infrastructure including the power infrastructure and the energy infrastructure is one of, if not the most dependent on networking and internet protocol and systems in the world, which means we're the most vulnerable. And we're behind the power curve as a country, because again, we're the most technologically advanced and we're the most susceptible and so the answer is prioritization, focus and funds.

Then final question relates to SMS, so given the likelihood that the US budget will probably flatten is the best case, maybe even contract a little bit over the next decade, how much revenue or growth do you really see from working with allies ranging from Israel to South Korea to Egypt?

We see significant growth opportunities on the missile system side, tactical with Israel and this would be on the Arrow, the Spider, the Iron Dome, the Sling of David, also the Barak missile. We see significant opportunity there. Some of those systems tie into India, where India procures those systems from Israel and we are one of the high end electronics providers on those systems that Israel sells to India. In addition to that, in areas like you're recently reading about, Iraq has potentially doubled their order for F16s. That could be potentially very very good for us. There was a multibillion dollar order announced in the last few weeks internationally for Rivet Joint; that is very very good for us. That's very very good for us!

Euro Fighter is one that we're involved with and that has to do with India as well and if that comes to fruition, that could be very very good for us. Back in the Middle East on missile systems, these are legacy missile systems like the Hawk and the Chaparral, we are pursuing some very large for us tens of millions of dollars per contract opportunities for the upgrade of those types of systems. And so, as you know, it's been a focus area for us since 2006. It's been one of our strongest and most profitable areas and with potential flattening or declining US DoD budgets, we're looking for international, both direct and FMS to be one of the growth areas to cushion some of the offsets for us.

Josephine Millward, The Benchmark Company.

Eric, can you comment on the macro spending environment; do you still think Kratos can grow 3% to 5% organically with the $350 billion defense spending cuts and what if the trigger happens and that amount gets doubled, if you can comment on that?

I think with the $350 billion spending cut, which is kind of sort of consistent with what the president had previously looked for was a $400 billion cut. We can achieve 4% to 5% organic growth. I believe that. We are having and we will have areas that will grow strongly. The critical infrastructure area will grow strongly, the Aegis and ballistic missile defense area, that is not going to be cut; that is going to go strongly. Electronic warfare and attack in the cyber areas, those are going to grow. Some of the IT areas and program management areas, those are going to continue to shrink. But with the $350 to $400 billion cut over 10 years, absolutely we can grow the top-line organically 4% to 5%.

Now, if the triggering event comes in and it is doubled or worse, and the best numbers that we're seeing it would be an additional $500 billion, okay, my initial read is that will impact that top line growth somewhat but it won't profitability wise, because things are going to be prioritized. Kind of what John was asking about before and the higher priority items carry the higher margins and so it could impact it and so 4 to 5, maybe it's 3 to 4. But the margins I think would be sustained because it would be prioritized.

And I want to emphasize very importantly, Josephine, as I said about $120-$125 million of our business is the public security and public safety business, which is non DoD budgetary and it's literally the fastest growing business in the company today because of the asymmetric threat and that's a huge hedge for us. So if it can continue to grow like that, we should be okay in the 4 to 5 range, assuming nothing of a biblical impact occurs.

That's helpful, Eric. Can you help us quantify your revenue exposure to war related activities? Just trying to isolate areas funded by the OCO.

I would like to say zero, but I'm sure there's something out there, so it's less than 1%.

Okay, that's what we like to hear. Finally, I think Deanna, you said your funded backlog at the end of Q2 was $378 million; can you help us compare that to last year on a pro forma basis?

Josephine, I don't have that data on a pro forma basis; I only have that on a historical, which obviously is apples to oranges because I don't have the whole historical data at my fingertips here.

Would you be able to get that?

I should be able to, yes.

Michael Ciarmoli, KeyBanc.

One I guess just cleanup, you guys are assuming a share count of 34 million for next year?

Michael, it's 34.5, because it's about 10.5 related to the Integral transaction and our share count will be - I think our Q is filed now, it's at 23.9.

And Eric, just to follow-up on Josephine's questions, even assuming the $350 billion in cuts, do you think there'll be more of a challenge to grow that top-line over the next year or so? It seems like it's going to be hard to take those cuts from force structure, given the lead times and planning so it seems like the procurement accounts will get raided in the near-term. And maybe that softens up in the out years as force structure gets modified. How do you think about that?

In my opinion, and again, I'm not objective on this and you know that Michael, but in my opinion, the only ways to get that type of magnitude of cuts is personnel cuts in the forces or big platforms. So the major platforms right now are F35s and as we talked about, we're not on that directly. The aerial tanker; we are not on the aerial tanker. The Virginia class submarine; we are not on the Virginia class submarine. The next generation nuclear missile sub; we are not involved with that; what we are involved in is the Trident II D5 which is currently on the Ohio class and if the new submarine doesn't happen, the Trident D5 is going to continue. If it does happen, the D5 is going to go into it. And so we're hedged either way on that one.

So at the highest level, that's how we look at it. We may take some nicks here and there, but the programs that we are on, the big programs in the company right now, and again, none of them are greater than 4 or 5%, is the EAG18, the Trident D5, with Integral Systems there are two large satellite communication programs that they are on that are extremely important and tied into some of the things I was talking about before. Those are not - I don't believe those are going anywhere. Because if you're going to have less field forces deployed, you're going to need more ISR, you're going to need more video, you're going to need more space assets. We think that that ties into that. So that's kind of how we're thinking about it.

We're on virtually every old legacy helicopter program. All the new ones have basically been cancelled and they've said they're going to extend those airframes out until 2020 or 2030s. We're on the old ones. They get extended out, we do good. The M1A1 and M1A2, the next generation main battle tank isn't going to happen; the Abrams is going to be extended; we're on that. That's kind of how we look at it.

Then you guys had a 2012 revenue estimate out there. Do you still have that number? I know at one point you were kind of in the $770 to $805 million range.

Right. We still have it, but what we've done because of the Integral Systems coming in at the beginning of this year and with what's just happened with all the budgetary things and then on the converse, our public security and safety business doing so well along with our Aegis business; we're going to wait to refresh that out later on this year.

Jonathan Richton, Imperial Capital.

I really only have one question and that was kind of regarding your earlier comments in terms of prioritization of programs in this budgetary environment. I guess that the way I'm interpreting it and please correct me if I'm wrong, is that really you'll have the programs moved forward or at least kept in those times and other potentially less profitable for you guys, programs pushed out to later on date. But doesn't that imply that once those programs run out, the more profitable ones that come sooner than later and you're going to be left to say it's even four or five years down the line, but you'll be left with the lower margin business?

Very candidly, that's if the lower margin business even continues and that's also assuming that some of those new program opportunities and I just mentioned a few of them. There are several that we are pursuing that we don't win any of those and we fully expect to win some of those to backfill those.

So really kind of on the worst case scenario as it appears now, it could be lower revenue but margins will remain intact, depending on what happens, but that's what it could look like.

Right, but as of today, we're reiterating what we said before for our full year 2011, we fully expect to achieve those revenue targets and those profit targets this year as we sit here today. We're fully expecting to do it, based on the backlog and the book of business we see right now.

Then I got on the call a little late, so I apologize if this was already addressed, but looking at leverage kind of coming up over 6 times, what's the acquisition pipeline looking like going forward? Are you expecting to hunker down a little bit, you know, digest what you have and play through with what the environment's going on or are you still actively looking to continue to make acquisitions?

Jonathan, just to correct it from a leverage perspective, it's closer to 5 times. I think what the disconnect may be is because of the acquired companies, we're reporting on a GAAP basis from the date of acquisition going forward, so it does not include the pro forma impact of the acquisitions on an LTM basis. So if we look at the definitions in accordance with the debenture agreement, we're closer to 5 times, right at 5 times.

But still it appears to leave limited room for more acquisitions going forward. I guess back to that, what's your thought kind of where things look now with where the budget's going and what your capital structure looks like?

So with what we're looking at right now, we really believe, considering the environment, which is very challenging, it's very challenging, we have about a good a hand of cards as we could hope to have. And I mean that. We're extremely well diversified, we don't believe we're on any major at-risk programs at all and we think we're in a handful or so of areas that funding is going to maintain to be stable if not increase. So, I don't believe, and as of right now, we have no plans to do anything significant for the balance of this year, nothing at all. That doesn't mean that there might not be a tuck-in opportunity that presents itself that would be at a great multiple or something like that, but nothing substantive.

And as I mentioned on the cash flow side relative to the leverage question, this company generates a ton of cash for a number of reasons. It has to do with the dynamic of the government contracting business. This is a business where DSOs should be somewhere between 80 and 90 days or less. CapEx is very very low and we're looking, as I mentioned, to generate somewhere after interest expense, to generate somewhere between $60 and $70 million a year in free cash flow. So it's a significantly quickly de-levering model and with those $220 million or so of the federal NOLs and only paying $3 million or $4 million a year on cash taxes, it's very helpful for our strategy and will help us de-lever very very quickly.

I show no further questions in the queue and would like to turn the conference back to Mr. Eric DeMarco for closing remarks.

Very good. Thank you very much and we will be chatting with you again at the end of the third quarter. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect at this time.