Kratos Defense and Security Solutions Inc (KTOS) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense and Security Solutions third 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).

I would now like to introduce Ms. Laura Siegal, Vice President, Corporate Controller. You may begin.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions third quarter earnings conference call. With me today is 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 and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance constitute forward-looking statements. 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 November 3, 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 and expectations or otherwise, for any reason.

This conference call will include a discussion of non-GAAP financial measures as that term is defined in Regulation G. 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 flows. 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 third 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 the call up to your questions.

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

Very good. Thank you, Laura. For the third quarter Kratos' performance was very solid and obviously very difficult, challenging and changing Department of Defense, National Security and overall Federal Government budgetary environment.

During the quarter, Kratos continued the successful integration of Integral Systems, which closed in July. But the progress of the integration process being reflected in our increased EBITDA margins, as duplicative public company costs, corporate related costs and redundant general and administrative costs are either reduced or eliminated.

The progress we have made with the integration of Integral Systems, and the continued improvement in Kratos' profit margins is consistent what we have previously communicated to you. Additionally, all other previous acquisitions have now been substantially integrated with Kratos, the success of which is also reflected in Kratos' improved profit margins and the third quarter cash flow generated we've reported today.

Deanna will discuss the integration progress more in her prepared remarks. Additionally, and very importantly, also contributing to Kratos increased margins in the third quarter was a very favorable contract and program mix. Specifically related to contract mix, we are seeing increased demand for Kratos' cyber security, information assurance related software products and solutions.

Kratos' electronic warfare, electronic attack and intelligence, surveillance and reconnaissance products, our unmanned systems related products and services virtually across the board, and very strong demand for Kratos' satellite communications and related information assurance products, all of which brought higher overall profit margins to the Company.

These areas, and in particular ISR and unmanned systems related equipment, which enable smaller units to monitor and control larger areas, are force multipliers. And with what is currently being debated related to defense budgets, potential cuts and et cetera on a relative basis. We believe that these areas will continue to be solidly funded and priority areas.

We are also seeing strong demand for Kratos' Public Safety and Critical Infrastructure Security solutions here in the United States, which once again saw solid organic growth during the quarter.

Kratos' Critical Infrastructure Security business has been and is expected to play an increasingly important role for Kratos, as we move forward, with this business generating 25% sequential organic growth in the third quarter and now making up approximately 15% of our Company.

In Kratos' Critical Infrastructure Security area, we are seeing demand for comprehensive security deployments in the transportation infrastructure area including at airports, railways, bridges, tunnels, energy generation and power facilities and the related electrical grid transport, pipelines and datacenters for these assets. We're also seeing demand in the advanced surveillance area, which includes infrared and other specialty cameras and intelligent video system deployment where Kratos is very strong.

Additionally, we're focused on CBRN&E; chemical, biological, radiation, nuclear and high explosives detection, sensing and identification, where we manufacture specialized support equipment and provide specialized system integration work.

As you know, the vast majority of Kratos' Critical Infrastructure Security business base is not Federal Government funds driven. And we continue to see some of the strongest organic growth in all of Kratos in this area. Public Safety and Critical Infrastructure Security are opportunity areas for Kratos and we are looking toward this business as being an offsetting and stabilizing factor in these challenging Federal budgetary times.

Kratos' Ballistic Missile Defense related and AEGIS business also generated very solid growth in Q3 and growth in the AEGIS area is expected to continue into the future, primarily as a result of the continuing global proliferation of missile systems, which has been verified recently by multiple intelligence agencies and other parties. I will talk more about this a little later on, as this is also one of the fastest growing business areas in our Company today.

From a programmatic and operational standpoint for the third quarter, representative contributors included electronic warfare and electronic attack products for the EA-18G Growler, which is just now entering full rate production. We believe that advances in EW and radars will continue to drive Kratos' EW and EA business into the future with the need for stand-off systems, active jamming solutions, multi-sensor weapons and improved targeting systems increasing.

Specialized products for the Trident II D5 ballistic missile, which is expected to continue to be the United States primary strategic deterrent for the next [40] years. The Trident ballistic missile submarine fleet, which Kratos supports is the most survivable leg of this country's triad nuclear deterrent.

Specialized mil spec ground equipment for certain ISR platforms, which has recently been seeing increased demand in certain theaters. We are firm believers at Kratos, that intelligence, surveillance and reconnaissance technologies, capabilities and platforms will continue to be strongly funded even in these difficult budgetary times.

Security training system deployments at certain military bases for war fighters and special operations personnel where we are seeing strong demand as the United States war fighter is becoming more specialized and special operations mission focused.

We performed mission module work for the Littoral Combat Ship. With LCS 3, the USS Fort Worth, LCS 4, the USS Coronado, both scheduled for delivery next year. LCS 5 and LCS 6, the USS Milwaukee and USS Jackson currently under construction and LCS 7 and LCS 8, the USS Detroit and USS Montgomery now under contract.

We performed work related to the weaponization of certain unmanned systems platforms, which we will not go into detail on this call. Electronic products and equipment related to the AMRAAM missile with the US Air Force in September ordering the FY '11 production batch of 430 missiles, training systems for the M1 Abrams main battle tank. This program for Kratos is now in full rate production and is expected to remain so into 2013. We are also pursuing certain foreign military sales opportunities in these areas.

We are providing training systems for the CH-47 Chinook helicopter. Boeing is currently, approximately 143 units complete on a 215 Chinook unit order and recently celebrated the 50th anniversary of this platform. The Chinook is the world's premier heavy-lift military helicopter and is in high demand with a growing number of defense forces worldwide. For example, in August, the UK ordered 14 additional Chinooks, which will bring the UK Chinook fleet up to 60 aircraft. Here as well, Kratos is currently looking at certain FMS opportunities.

During the third quarter, the US Air Force contracted for two more wideband global satellites. The WGS is a new communication system for the US military. There are currently three WGS satellites in orbit, and with this new order there are now five additional WGS satellites currently in production. Kratos' prime contractor related to certain aspects of commanding, controlling, testing, planning and protecting the US [Space-based] satellite system including the WGS. The military is increasingly dependent on satellite communications for its war fighting, ISR, unmanned systems command and control and ISR requirements and this Kratos contract is one of the largest in our Company today.

Also in the third quarter, the US Navy approved the contracts to finish building the second and third Zumwalt class guided missile destroyers. Kratos is the sole source provider for the electronic modular enclosures for the DDG 1000 and the Navy's recent decision to build out two additional Zumwalts is very good news for our Company.

During the third quarter, Kratos' AEGIS Ballistic Missile Defense business continue to grow, driven by this administration's phased adaptive approach for missile defense, which is a ship-based and AEGIS focused. The importance of the AEGIS BMD system was emphasized once again just this past month with the announcement that four ballistic missile defense war ships will now be four deployed to Naval Station Rota, Spain as part of Navy's plan to shield Europe from nuclear missiles.

The US Navy has restarted the DDG 51 Arleigh Burke destroyer production line to produce more of these AEGIS missile defense platforms with approximately 24 AEGIS BMD ships in fleet today. And the Navy's current target to expand AEGIS BMD capable ships to up to 94 over the next decade.

Conversely, we are now seeing weakness or increased competition in certain of our traditional or legacy services-related business, including certain weapon system sustainment work, support work at the Pentagon and for the Navy and across virtually all information technology related areas, except as related to cyber security or information assurance, where we are providing our proprietary products.

Though these areas represent a small percentage of Kratos' business, these areas where we are seeing weakness or increased competition have historically been more highly revenue concentrated for Kratos, as they are primarily labor-based cost plus fixed fee contract type in nature. And accordingly, they also have typically generated the lower profit margin for us.

We believe that the weakness in these areas will continue for the foreseeable future as the government pushes forward with the increased usage of multiple award and IDIQ contract vehicles, with tasking being recompeted every couple of years. And as this administration continues to strongly push for a larger amount of business in these IT, PM and support areas to be directed to small businesses and other types of set-aside entities.

We are also continuing to see some insourcing of contractor positions to the government in these areas as well. We also believe that the business mix demand change and trending is also occurring to some extent as a result of the federal government budgetary dynamics that we're currently experiencing.

So in summary, from a mix standpoint, we are currently expecting continued strong demand for Kratos' offerings where have proprietary or niche products, technology or solutions, including in the areas of ballistic missile defense, unmanned aerial systems, intelligence, surveillance and reconnaissance, electronic warfare, electronic attack, cyber and critical infrastructure security and weakness in our historically more labor intensive information technology, system support and program management business areas, at least through the existing federal government 2012 continuing resolution period and the ongoing budget debates and super committee deliberations.

Related to the specialized niche product and technology growth or opportunity areas that we see.

With the completion of the Integral Systems merger and our 2012 planning process now beginning, we have begun a product development assessment across the Company, focusing on where strategic investments should be made going forward and what the IR&D spend should be. This assessment is program-by-program and product-by-product, focused on further enhancing our current product offerings or for development of new products to address market opportunities we are seeing and to position Kratos for sustained growth for the future.

We intend on completing the strategic review process by the end of this year and commencing the required IR&D to ensure that Kratos remains and is designed in on current and future mission-critical national security programs, including currently deployed system upgrades.

The specific program platform and product areas currently identified for investment include electronic warfare, electronic attack, space related cyber security, signal monitoring, signal intelligence and certain classified areas. These are all areas where Kratos currently hold either sole source or very limited competition positions.

Completing this review, and making the investment in these highly technical and specialty product areas has added importance as a result of the industry weakness in the traditional services areas I mentioned previously and our intention to continue to transition the business more and more to the specialty products and niche market areas focused on EW, EA, ISR, UAV, cyber and SATCOM.

As we make these investments, we intend to continue to run the business at the 13% to 14% EBITDA margin level rate, meeting our previously communicated cash flow, and generation objectives, reducing our debt and increasing the equity value of the business.

Accordingly, for the fourth quarter, we are forecasting revenues of approximately $230 million to $240 million with EBITDA margins in the 13% to 14% range and we are reaffirming our previous cash flow guidance.

I'll now turn the call over to Deanna.

Thank you, Eric. Good afternoon. We are pleased with our financial performance this quarter, especially in light of the challenging conditions of operating under the Deficit Reduction Act and deficit related super committee uncertainty throughout most of the third quarter. Uncertainty from an expected federal budget year 2012 continuing resolution, which we are now experiencing, as well as a continued lingering impact of the 2011 CRA that resulted in delayed contract awards and funding.

Today we reported third quarter revenues of $211 million and adjusted EBITDA of $29.5 million or 14% of revenues, up sequentially from the second quarter revenues of $171.1 million and adjusted EBITDA of $22.7 million or 13.3% of revenues. Our consolidated quarterly revenues of $211 million compared to third quarter 2010 revenues of $119.9 million reflect the aggregate contributions from the acquisitions made in 2010 of DEI, SCT and Henry Brothers, as well as the more recent acquisitions of Herley and Integral Systems in 2011, which contributed an aggregate of $121.7 million.

In addition, organic growth in our AEGIS target and Public Safety businesses were offset by the impact of continued government insourcing and the impact of increased weakness and/or competition in certain of our legacy services businesses.

Our Government Solutions business revenues increased year-over-year from $110.2 million to $178.6 million reflecting the contributions from the acquired companies made in our Government Solutions business of $98.2 million and organic growth in certain AEGIS target businesses offset by the aggregate net reductions I mentioned previously.

Our Public Safety business revenue have continued to grow organically and on a pro forma basis reflecting Henry Brothers as if acquired at the beginning of 2010, growing sequentially $6.6 million or 25.6% from the second quarter 2011 revenues of $25.8 million to $32.4 million and year-over-year on a pro forma basis $11.7 million. Approximately $23.5 million of the revenues in the third quarter of 2011 were generated by Henry Brothers.

Our gross margins increased from 20.4% in the third quarter of 2010 to 28.5% in the third quarter of 2011 and sequentially up from 26.5% in the second quarter of 2011 reflecting the favorable mix of revenues. Our mix of revenues for the third quarter is 54% products and 46% services, up from the third quarter 2010 mix of 37% products and 63% services.

From an operating segment standpoint, our Government Solutions segment generated $10.8 million of operating income in the third quarter of '11, up from $7.1 million compared to the same quarter last year. Our Public Safety and Security segment generated $3.7 million of operating income in the third quarter of '11, up from $700,000 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 cost reduction actions we have taken. From an operational adjusted EBITDA metric, our Government Solutions segment generated $25.1 million of adjusted EBITDA or 14.1% of revenues and our PSS segment generated adjusted EBITDA of $4.4 million or 13.6% of revenues in the third quarter.

On a consolidated basis, our adjusted EBITDA for the quarter was $29.5 million or 14% of revenues, up year-over-year from adjusted EBITDA of $11.7 million or 9.8% of revenues in the third quarter of 2010 and up sequentially from $22.7 million or 13.3% of revenues in the second quarter of '11.

Our adjusted EBITDA excludes the impact of approximately $3.7 million of acquisition related expenses and stock compensation expense of $900,000.

On a GAAP basis, net loss for the third quarter was $6.9 million, which included the $3.7 million of acquisition related expenses, $11.9 million of expense related to amortization of intangible assets, as well as a $1.6 million income tax provision recorded against a pre-tax loss of $5.3 million.

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 provisions, which may be subject to variations on a period-by-period basis. For instance, our third quarter GAAP net income reflects a net $1.6 million income tax provision, which is primarily related to the amortization of purchase intangibles of $11.9 million, which is substantially not deductible for income tax purposes.

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 million to $4 million per year. This reflects our estimate of our ability to utilize our approximate $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 currently utilize up to $28 million of federal NOLs per year for the next five years, commencing with 2010 with a carryover into the next year, if not utilized, and thereafter, we can utilize up to $11 million per year of federal NOLs until all NOLs have been utilized throughout the expiration date. We believe, we will utilize all of our NOLs prior to the expiration date.

In addition, as we have stated before, we think it is important to note 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 third quarter GAAP operating income, includes an amortization charge for purchased intangibles of $11.9 million, which is equivalent to approximately $0.39 per share as majority of the purchased intangibles are not deductible for tax purposes.

As we have previously stated, we expect the amortization charges to increase for the balance of 2011 and 2012 to reflect the Integral acquisition. 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 $13.2 million for the fourth quarter of 2011, and to be approximately $32.3 million in 2012.

On a pro forma basis, EPS from continuing operations utilizing an expected average cash pay income tax provision of approximately $700,000 was $0.31 per share. This was computed by excluding the acquisition related expenses of $3.7 million and the amortization of intangibles of $11.9 million, from the loss from continuing operations of $5.3 million, or a pre-tax pro forma income from continuing operations of $10.3 million less a cash tax pay provision of $700,000 or $9.6 million income after cash taxes.

Moving on to the integration of Integral Systems. The scheduled integration activities related to Integral remain on track according to our previously communicated plans. As we discussed earlier, we expect that the integration of the back office functions should be substantially completed in the first quarter of 2012.

Now moving to the balance sheet and liquidity. Our cash balance was $109.4 million at September 25 plus $1 million in restricted cash. This cash balance does not reflect approximately $9 million to $10 million of remaining transaction payments due related to the previous transactions. In addition, as a reminder, we currently have an undrawn revolving line of credit of $65 million with approximately $21 million of letters of credit outstanding.

As a result of the payment of merger related expenses and other related costs of approximately $7 million in the third quarter, our cash generated from operations was $17.8 million. Excluding the payment of the merger expense our cash generated from operations was $24.8 million.

Our DSOs have increased from the second quarter of 2011 from 87 days to approximately 100 days, adjusted for the impact of the Integral acquisition, which reflects a result of the residual effect of 2001 continuing resolution, which impacted the timing of contract funding and awards as well as the Integral acquisition. The DSOs for Integral are higher than our typical DSOs due in part to the mix of milestone related payment billing terms and other related terms. We believe that as these milestone related payment billing terms are met, we will be able to reduce the Integral DSOs over time.

We continue to expect to generate an aggregate of approximately $20 million to $25 million in cash flow from operations for the second half of 2011 excluding the payment of transaction related expenses.

Other key balance sheet and capital structure elements at September 25 are as follows. Accounts receivable, a majority of which are due from the US Government and other agencies in contracts for which the US Government is the ultimate end customer was $248.7 million. Debt under our outstanding notes at September 25 was $625 million plus the issuance premium of $23.9 million.

Total net debt, net of the $109.4 million unrestricted cash at September 25 and net of the issuance premium of $23.9 million was $524 million. Our contract mix for the third quarter was 66% of revenues generated from fixed price contracts, 12% of our revenues from CPFF contracts and 22% from time and materials contracts.

Revenues generated from contracts with the Federal Government were approximately 75% including revenues generated from contracts with the DoD of 69% and revenues generated from contracts with non-DoD Federal Government agencies of 6%. We also generated 7% of our revenues from state and local governments, 11% from commercial customers and 7% from foreign customers. Backlog at quarter end was $1 billion with $548 million funded.

Moving on to fourth quarter guidance for 2011, we estimate fourth quarter revenues to be $230 million to $240 million and adjusted EBITDA of $29 million to $31 million. Pro forma EPS for the fourth quarter of '11 excluding amortization, acquisition expenses and the using an expected cash pay tax provision of approximately $700,000 are estimated at $0.21 to $0.27 per share.

Using the full statutory 40% tax rate, excluding the amortization and acquisition expenses, we estimate pro forma EPS to be $0.14 to $0.18. We currently estimate the annual amortization expense for purchase intangibles for the fourth quarter to be approximately $13.2 million reflecting the impact of the acquired companies. As we have mentioned previously, this 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 the amortization along with GAAP EPS.

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

Great. Thanks, Deanna. Obviously, the world continues to be an unstable and dangerous place. With missile development programs in Iran and North Korea, Russia rearming with new weapon systems and technologies and the increasing militarization of China.

With just last week, it being publicly disclosed for the first time that China has suspected in the interference of US Government satellite communications on multiple locations. And also that Iran has developed a technology to jam it's enemy's military GPS and spy satellites and additionally, that Iran has developed an excellent capability in electronic warfare and electronic attack.

We are seeing potential destabilization in Pakistan, Africa, Syria, across the Middle East and now in Central and South America along with continued and potentially expanding threat of Al Qaeda and other international terrorist organizations. Cyber warfare and cyber terrorism is growing exponentially on a global scale, including attacks on critical infrastructure, power grids, water systems, transportation systems, industry, and of course, Department of Defense and other national security and related government agencies.

We currently believe that the coming and expected future budget cuts will fall primarily on conventional and exclusive platforms like the F-35, Ground Combat Vehicle, the JLTV, MEADS, EFV, none of which Kratos is involved with in any material way. And additionally less than approximately 1% or 2% of Kratos' business has been historically tied to the overseas contingency operations budgets. So the draw down in Iraq and a decreasing optempo in Afghanistan is not expected to materially impact us.

From a strategic positioning standpoint, as I've mentioned before, we believe that there will be a continued demand for specialty, mil spec, microelectronics, electronic warfare and attack related products, ISR systems, unmanned system platforms, cyber security offerings and security satellite communication systems. As all of these are force multipliers and each of these areas is where Kratos has a strong presence today. And a substantial amount of the work that we do in these areas is sole or single source and has limited competition. Also as I mentioned before, approximately 15% of Kratos' business is in the non-DoD and non-federal government funded Critical Infrastructure Security and Public Safety System deployment areas.

Additionally, Kratos' business is extremely well diversified, with no one contract customer or program last year making up greater than approximately 3% of Kratos' revenues and the vast majority of the contracts that Kratos receives are single award contracts, they're not MACS and they're not IDIQ contract vehicles.

In summary, we believe that Kratos is relatively well-positioned for the current environment. So as I mentioned before, in concluding, as we move forward, we're going to focus on execution, specifically targeted IR&D efforts, cash flow generation, the reduction of Kratos' net debt position and de-levering.

And with that, we'll turn it over for questions.

(Operator Instructions). Mark Jordan, Noble Financial.

Good afternoon. Eric, a question relative to just sort of the absolute size, it seems like from the prior guidance that you're still adamantly arguing that the Company is going to be able to deliver the improvement in EBITDA and for the 13% to 14% range for next year. Could you give us -- looking at that fourth quarter run rate is -- would you look at that as a sort of minimum expectation for average quarterly revenue in the 2012?

It's a hard one, Mark, because of continuing Resolution 12, that obviously we're in the middle of. The super duper committee is going to make their recommendation one way or the other by the 23rd and what those will -- what type of impacts those will have on customers and funding decisions by the customers. That's why we're trying to be cautious here and as realistic as possible.

We feel pretty good about the $230 million or $240 million in Q4, and a lot of that work is -- and obviously, we're well into the quarter, a lot of that work, we have very, very good visibility on, and it's absolutely mission-critical to the national security of this country considering the threat, some of the threats I went through.

So it's hard to say, I believe when we report Q4 in -- early in calendar Q1 of '12, hopefully, the Committee will have made a decision one way or another. We'll have some clarity on the CRA and we'll be able to give you a better picture of quarter-to-quarter flow.

Okay. Let me rephrase it a little bit, just saying, assuming there are not -- there's not an additional large incremental cut to the 10 year DoD budget beyond the $450 million on the table. And that, we get a '12 budget somewhere around year-end. Would you feel that you are in a -- you should be positioned well enough to sort of be at that kind of run rate through the yields given that scenario?

Well, assuming that we have $450 million that's in the Deficit Reduction Act and we get a continuing resolution at or near year-end, all right. As you know historically, there have been a significant spiking in funds around the federal fiscal year-end, which is September 30, which we saw some of this year and that is contributing to what we're going to see in Q4. So, based on what you just said, I don't want to go on a run rate quarter-to-quarter, because of the funding characteristics around the federal fiscal year. But if you have annualized it, based everything we're seeing right now, that's in the ballpark.

Okay. Looking at the foreign military sales area, you mentioned it in your presentation that you had some things that you were bidding on. Could you say what -- since the large, I guess, Egyptian or missile deal hasn't done anything on the table. What do you have in the pipeline on that front?

Right. So we have a number of things in the pipeline. They are primarily surface-to-air missile system in nature, with one being related to equipment that supports radars and fire control systems, a separate one. There is obvious -- our Egyptian business was not materially impacted by the Arab Spring and what happened in Egypt. And we -- these FMS cases, they take time, and they're still out there, we're tracking them, but they take time. And also, Mark, we're also pursuing some in the Pacific Rim area that are also surface-to-air missile related as well.

Okay. You got a $109 million in cash, obviously the bank line to support your letters of credit needs. What's your strategy for cash, obviously you'll be generating cash through 2012. What you are planning on doing with that over the next 12 to 18 months?

Well, Mark, as you know on our notes there's no call on that through 2014. So, our plan, as we have stated previously, is to continue [deep] to de-lever by reducing our net debt position and that is what we continue to plan to do.

Okay. So, basically you're going to be building up your cash position towards 2014?

That's the plan right now.

Okay. Thank you very much.

Okay.

Mike Crawford, B. Riley & Company.

Thanks. Good afternoon. Eric, maybe just to go a bit further into kind of a what-if scenario for next year. Let's say, we have a continuing resolution like in 2011, where we didn't get a budget till halfway through the year, what might happen there or what if we didn't even get a budget for the whole year, like what might in an environment of most uncertainty, what might a revenue picture be and margin picture for that matter?

Right. And so, obviously, this is all crystal ball stuff, but our job is to try to look at crystal balls and make decisions on them. If we have a dawn of a 2012 budget and we have a full year continuing resolution, that will absolutely and unequivocally adversely impact our DoD business. To what extent? I don't know. The majority of the work that we do is under long-term funded contracts. And as you know our continuing resolution, that's the funding levels of 2011. So you would expect those, right now, to remain funded at the 2011, so they would be flat. The ISR stuff and the UAV stuff we are doing is mission-critical, so my brain tells me that type of stuff even though there would be new "purchase orders or contracts," those would be funded somehow. However, some of the other product work that is PO driven those are under "new contracts", new contract vehicles that would require federal '12 budget. And we saw what happened to those in '11, they got pushed out until we got a budget and now we've been trying to catch up.

So, the DoD business would definitely be impacted, I'm going to say flat to maybe down 4% or 5%, I don't know. Offsetting that of course, we're very fortunate that the critical infrastructure business is just doing great, it's not federal funded, it's been growing 20% or 30% organically, sequentially. The book of business there looks really, really good and hopefully, that would offset that 5% downward if it were to happen. And so maybe net-net we're flat. That's kind of a tolerance around that of a couple of percentage points either way. That's kind of how we're looking at it.

On a margin rate standpoint, I believe assuming things stay the way they are and they were last year, even in that type of environment, we'll be in the 13% to 14% range even with the investments we're going to make on some of the specialized equipment where we've got opportunity with the customers.

Okay. Thank you, so (inaudible), it looks like you would still expect to generate at least $1.15 in free cash flow even if the environment was about as bad as it could be next year?

Yes.

Okay. Thanks. And in that regard, Deanna, you'd -- I'd say, unless I misheard your comments, I thought you said, you are sticking to $20 million to $25 million of cash flow from operations in the second half of 2011, but you already did that in Q3, so did I mishear something there?

You did not mishear me. Just to remind our semi-annual payment for interest on the notes is due in the fourth quarter of $32 million. So that's taking that into consideration in that second half guidance.

Okay.

So hypothetically, if we generate [$33 million] in cash flow before debt service, that quarter we pay the interest, and so it would be -- it would be net from cash flow of zero [using that].

Okay. Great. Thank you. And then -- and last question relates to the Integral business. So between [Epoch and Monics] is one stronger than the other or is it about equal demand and need for each?

They are both fantastic. They are equally strong and they are both doing great and are expected to do greater.

Okay. Okay. Thank you.

You're welcome.

Josephine Millward, The Benchmark Company.

Good afternoon.

Good afternoon.

Good afternoon.

Eric and Deanna, can you give us a sense of book-to-bill during the quarter? what were bookings like?

Bookings, I think in the second quarter we were like 1.5 or 1.6 to 1 something like that. This quarter we were 0.6 or 0.7 to 1 something like that for this quarter. And now with us being 65% or 70% products, it's lumpy. It's quarter-to-quarter, it's lumpy. And so we're targeting on an annual basis to be over [1.05 to 1] for -- take it our target growth rate right now.

Okay. So you didn't really see -- you didn't really experience any spending flush at the government's fiscal year-end?

Spending flush. We experienced an order flush. We got some orders and we have some commitments that we've started to build on that we saw right up until on September 30 and we've continued to see it a little bit now into the first part of October.

So, Eric, now that we are -- the government is operating under a CR, do you think bookings could be better in Q4, or do you think it's more likely going to be the book-to-bill will likely to be under one?

I think it's not. Right now, I don't believe it's related to the CR. I think right now it's related to uncertainty that customers have relative to the super committee November 23rd date, where customers don't know what's going to happen there. They don't know where that's going to fall out. Now we all know that that doesn't impact until [February 13], but there is a lot of cautiousness because of the uncertainty with the customers right now. And I think it's a combination of the CR but I think it's probably more so with what they are going to be looking at with the super committee.

As you know, the OMB, a month or two ago for the next year's fiscal plan, went to the DoD agencies. And they said, we want basically three budgets. We want a budget at [$450 billion], over 10 years. We want a budget down 5% and we want a budget down 10%. And so, that's the type of uncertainty that the customers are seeing right now across the industry. And that's why it's just hard to say. My brain tells me if the super committee came out and they said that they failed and there was going to be $1.3 trillion in cuts and $650 billion more to DoD or National Security accounts over 10 years, I think that would be a good thing, because now there is clarity and the customers can make some decisions.

Well, then I think they will spend the next year trying to repeal that.

Yes, you are probably right.

But, can you give us a breakout of Herley and Integral during the quarter? And if you -- and based on what you've seen so far, do you think these two acquisitions can still sustain the run rates, you had discussed before I believe, it's around $200 million for Herley and $175 million for Integral?

Yes. And the answer to that is absolutely correct, and yes, and they are doing exactly what we expected, and we expect them to continue to do that next year, exactly. So, everything is -- they're performing as we've communicated before, on track, and they're expected to do so next year.

And you're still comfortable with your 20% EBITDA -- adjusted EBITDA margin targets for these two businesses?

Well, Herley is actually been doing it already.

Okay.

And so we're very, very comfortable there. I talked a little bit about IR&D. And so most of the IR&D is going to be in those areas and there's going to be some in the cyber area. So there may be some trade-offs, where maybe one will do a little bit better and the other one will do not as well, because we're going to make some investments for some future products in 2013. But net-net across them all, yes.

Great. Eric, you highlighted some areas of your business that's doing well and some areas of weakness. I was wondering if you can give us a breakdown in terms of what portion of your revenue mix is growing and at what rate, and what portion of your revenue mix is -- where you're seeing contraction, if you can break that out for us, please?

I'll -- well, I will try. I'll give you ballpark on it. So, obviously our Public Safety and Security in our Critical Infrastructure Security business, which is on a run rate of over $100 million, somewhere between $100 million to $120 million of our business has been growing 20% or so.

The electronic warfare and electronic attack business is a very stable, roughly $200 million business. The Integral Systems business, just [as use] round numbers, I know you just mentioned that $175 million, we'll use round numbers, $175 million to $200 million, that's expected to grow a little bit, okay.

We don't disclose in detail the cyber product business, but I think less than $20 million of that is growing expediently. The ballistic missile target business, I think somewhere $20 million or less, that is growing expediently. The balance of the DoD business other than these pieces, I'm going to give you. We have about -- I'm going to say, about $80 million to $100 million business that is feeling the pressure that we were talking about, where it's a -- we're seeing some in-sourcing. And it's a IT or program management focused, where the government is -- they're going to -- the types of vehicles that we're trying to stay away from now, the MACS and the IDIQs, where they're re-competing task orders every year or two under those to further drive prices down. You can see this if you take a look at what NCIT reported yesterday. You can see it what's happening there. So that $100 million is going the other way on us, and the rest of it's about flat.

That's very helpful. Thank you.

Sure.

Kevin Ciabattoni, KeyBanc Capital.

Hey, good afternoon, Eric and Deanna.

Hi.

Hi.

It sounds like you have taken care most of the low hanging fruit at Integral. What's next to do there in terms of integration and synergies?

Sure, Kevin. So, as we have previously described our integration plan, there was some initial cuts immediately after that transaction, primarily related to public company costs and corporate infrastructure costs such as board costs, certain executive positions, D&O insurance, et cetera, audit fees. Those were truncated almost immediately from day one. There is the back office support which we are in the process of moving the back office to San Diego, which is why I mentioned previously, we expect that to occur in the first quarter of 2012.

So, we do still have some of those costs in the infrastructure of what we're reporting, and we'll continue to include those costs in our infrastructure in the fourth quarter, until those costs are eliminated.

In addition, we're looking at some of the underperforming businesses to see if there's any rationalization that needs to occur in those areas as well, which we will be looking at very closely in the fourth quarter.

On the operational side, we've already begun having the technical exchanges with the entire Company, with Integral Systems. I have attended one of those, which was an all-day affair. There have been several others, there were several others scheduled. And as you know, there was a convergence occurring in the electronic warfare, electronic attack and space segment with the electromagnetic spectrum. And this is an area that we -- from a business development and a technical/product standpoint, we intend on exploiting beginning in 2012 and then accelerating in 2013. Now that we have both sides in that covered.

Okay. Great. And then you talked about this a little bit. Are you generally assuming a full year CR for 2012?

We -- the way we've wrapped up our initial plan for next year is a six monther.

Okay.

Because we have experience with a six monther, so we know what that is. Beyond that, as I was trying to explain before to Mark, it's just -- it's a crystal ball, which is very difficult to envision what would happen there.

Fair enough. And then last, in terms of LCS. Is that what's been fairly steady, I mean, kind of in line with the build rates for the ships or is it front-end loaded, what's kind of the ramp there?

It's been choppy. And I believe the reason it's been choppy is because there are modifications to the mission modules. As you know, right now there are three basic mission modules. There is an undersea warfare, there is a surface warfare and there is a mine identification. There were additional packages that are being discussed. There is an expeditionary mission module package being discussed.

Now there's a special operations, mission module package being discussed. And I think because it's -- because we're looking at cutting other shifts and they are looking at cutting other platforms. They're looking at the LCS to potentially replace those capabilities. They are relooking at these modules. So it's been choppy. I can't tell you that's tracking with the ships, I can't tell you it's ahead or behind. It's been in -- it's kind of been in fits and starts so far.

Okay, great. Thanks.

Yes.

Jonathan Richton, Imperial Capital.

Hi, good afternoon.

Good afternoon.

Good afternoon.

On the investments that you mentioned earlier in terms of specialized equipment and I was just wondering this is not going to impact margins, so just (inaudible) your comments. I'm just wondering if you can give us a little more clarity on those dynamics. Are you using cash to fund that -- those purchases, are you increasing CapEx or hiring more people kind of what's going on there?

Yes, Jonathan, it's actually IR&D or internal research and developments. So you will see that actually in the research and development line on the P&L. So that is going to be funded with cash. There is a substantial portion of our R&D that is funded directly by our customer or the government, but there is a piece that we are evaluating as far as how much internally we will invest in.

And all of that is assumed in the margin rates that we're talking about. And it's going to be on an annual basis, because as you saw this quarter, mix is very important to our profitability here. It can be, depending on what we're shipping, it can be higher one quarter than next quarter, depending on what we ship.

Alright. Okay, great. Thank you. And then -- on the last call, I think, we've spoken about how in the worst case scenario with the cuts on super committee that you would see potentially lower revenues and higher margins, kind of longer term, but it seems like it's happening a little bit sooner than maybe previously expected. So you think these are kind of a more accurate level what we could see going forward over the next, say, a year to two years or do you think -- I know you can't really predict [one on], but it just seems like it happens faster than we're originally expecting?

Yes, we -- the integration team here is just doing a phenomenal job. And as you know, it's the same team from the Titan Corporation and their experts in integration. That's A. B, the mix in the quarter in certain programs including in some classified programs was better than we had forecast -- better than we thought and it was primarily in the product area. So it's just hard -- it's hard to say. And also in the -- our cyber products, that cyber security space, and I know you hear this from everyone. I will tell you, this is an area that is going to absolutely out of necessity see significant opportunity for contractors.

Okay. Because, we were kind of thinking about it as, the margin slowly kind of returned to normalized level on the product side and it seems like that might [snip], like we know that's not the case, I think more necessarily. Is that kind of a fair way to looking at it for now?

It's hard, yes. It's hard, it's just -- because of all the different dynamics right now that are inhibiting clarity, it's just difficult to say right now. But the bottom line is, we believe with the investments et cetera, depending on mix, taking all that into consideration, on an annual basis, we're going to continue to do 13%, up to 14% margins.

Any way you can give us an idea of what that R&D spend is going to look like?

No, not yet. As I said, we're going program-by-program and contract-by-contract. So we'll talk when we announce Q4, we'll have that in place, we'll be able to talk about it.

Okay. Great. Thank you for taking my questions.

You are welcome.

John Nelson, State of Wisconsin Investment.

Hello. Good job on dealing with the current very uncertain environment in defense, Eric and Deanna and your team. My question was related to R&D and whether, I mean, it was -- it's been, you've answered that in part. It was related to, I know, it was about 1.6% of revenues in the latest quarter and since your focus has become more hi-tech, could we expect that to grow significantly over the next year or two?

No, not significantly. The vast majority of Kratos' R&D remains government funded. And it will continue to be government funded. So it's in our revenue and it's in our cost of sales, the vast, vast majority. I would, I do expect IR&D to increase a little bit next year, because of some of the things we're going to go after, because very candidly we have customer interest and they've indicated if you build it, we will come. And so that's kind of what we're going to do but it should not be significant.

Okay. Thanks very much.

Thanks, John.

Tyler Hojo, Sidoti & Company.

Yes. Hi, good evening. Just a little bit confused here. Just in regards to the guidance. So if I look at your fourth quarter guidance and basically just add it to what was reported, it looks like you're about $30 million below what you guided for the year last quarter. What's going on there?

The biggest piece of that is what I talked about is this mix shift that we're seeing in that services space. There is a --

It has gotten incrementally -- it's gotten that incrementally worse over the last, call it, three months since we've last talked?

[Tyler], if you take a look at some of the pure services providers, they are actively talking about, you win a contract, it's protested. That has been happening to us. When a contract is protested, contract recompetes are being stretched out. We have won a contract earlier this year, $126 million contract over five years, it was previously a $50 million contract, $76 million in scope increase.

We expected that to start being incrementally funded up to the $126 million. It has not happened, because of what's going on in the budgeting environment, just hasn't happened or still being funded at $10 million a year, we're not being funded at $23 million, $24 million a year.

In the products area, in addition to some of the high-tech products that we build, we build some other products that are in the weapon system support area, okay. As I mentioned in the prepared comments, we have seen some softness in that area right now and I believe that's just prioritization of customers and that's happening because of the Deficit Reduction Act. Because the Deficit Reduction Act happened and that stuck out there [at $450], and then the President's budget request was not approved. And so, that's kind of the dynamics we are seeing there which is what caused that.

Okay. So, I think you mentioned this in a previous question. But this piece of the business that's being impacted is, would you say it's about $80 million to $100 million business today, is that accurate?

Rough numbers, correct.

Okay.

That's what we've seen in the last quarter.

Okay. Where could that go over the next say a year? I mean, could that be like a $30 million, $40 million, $50 million business in a year, or what's your expectation?

Yes. So let's say that it's (inaudible) and let's say that it's $90 million now. I think it could go to $80 million. I think it might go to $75 million. It's possible.

Okay. All right. Okay. So you think kind of the bulk of the impact is kind of behind you now?

I think it's, a) kind of behind us, but, b) over the next year, let's say it goes down another $15 million. Let's say it goes from $90 million to $75 million or so. If our -- what we're seeing right now, hopefully, some -- what we're seeing in the critical infrastructure business and some of the other areas are going to continue to offset it.

Okay. All right. Very helpful. And just a couple of cleanup items. Are you able to break out what Integral added to the backlog in the quarter?

I don't know. Let us circle back with us on that. I want to make sure that we don't breach any of the rules on that. If we -- if we can give it to you, we'll absolutely give to you (inaudible). So --

Okay. So --

Circle back with Deanna on that one.

I'll look back on that one. And then the last question --

If we can, we will absolutely give it to you.

Okay. Understood. I appreciate that. And then last one, just on the share count. What do you expect the share count to be in the fourth quarter?

Tyler, it should be about 34.4 million.

Okay. Perfect. That's all I have. Thanks a lot.

Thank you.

Ania Wacht, Seix.

Hi. This is Ania Wacht from Seix Advisors. So your focus is on deleveraging the business pretty much accumulating the cash. Should I take it as there are no large acquisitions on the plate currently?

That's a great question. We -- there are absolutely no large acquisitions on the plate currently. And we -- as I mentioned before, if there are small tuck-ins that are in spaces that we're exactly in today that are growing, we might look at them, small, but nothing -- our current plan is right now nothing significant. We want to get integrated and we want to print the numbers.

Sounds great. Glad to hear that. And another question on the -- and this is following to the previous question about the organic growth versus acquisitions for the quarter. Is there any way that you could ballpark it for me, how much of EBITDA was organically grown versus last year?

Oh, boy. We've, like Henry Brothers is completely integrated with PSS, [its health] side is completely integrated with Gichner. Herley has now completed it, completely integrated with our weapon systems business. It's -- the longer it goes, it gets very, very difficult to do that because we integrate from a business development standpoint, a cost pool standpoint, a cost allocation standpoint for our rates. It's just hard to do that.

Yes. So I have actually that -- the acquisition that would impact the comparability for the quarter, I had the Herley and then Integral, obviously Integral for only part of the quarter. So, I kind of ballpark that about $17 million, $18 million from the acquisitions. Would that be very wrong, close or I should not be even (multiple speakers)?

Yes, that's -- it's in the ballpark.

Okay.

But I won't. But keep in mind, like our Herley, we'll use them because they've been -- we've had them for a time now, they're printing numbers. Our Herley is generating roughly before part of our divisional weapon systems cost structure, $50 million in revenue, around $10 million of EBITDA, round numbers, right?

Yes, yes --

But within that cost structure, it get allocated some costs. It -- that make -- you just have to do for the rules. It gets allocated some costs. That means some of the other businesses look a little bit better. And that's what I mean it's just hard because it gets [blurred] the way cost allocations work.

Yes. So, but you definitely lost revenue for the existing business, I mean, so the organic growth -- there was no organic growth essentially. Or it was negative, right, on the revenue front?

In the traditional services areas, like information -- like IT and program management work and some of the sustainment work on some of the legacy systems. Absolutely year-over-year it was negative, absolutely, okay. Organically, year-over-year, okay, as I mentioned our AEGIS Ballistic Missile Defense business is growing very, very strongly, it's near 20%. Our cyber products business is growing, I'm going to say, 15% or 20%. But again they're blended together, so it's hard to pull it all apart.

Yes. Deanna, I think you mentioned out and I apologize you were going over this very quickly, but I think you said something like $121 million of revenue from acquisitions, did I catch that correctly?

Yes, that's correct, Ania, yes.

Okay. So, I got that one. All right. Great. So that's all I had. Thank you so much.

Thank you.

Thank you.

Jerome Lande, MMI Investments.

Hi. I have a follow-up from I think it was Mark Jordan's question about the de-levering. So, you're going to build cash -- cash flow continues to be strong, but during this last quarter, your bonds got crushed even though (inaudible) in the world, going down, but even going down below par. Wouldn't it make sense just maybe to have an authorization out there to be able to buy those back, because it's kind of expensive, it's de-leveraging true, but that's only true on a liquidation basis, on a realistic basis, you're not -- you don't have a call date as you said Deanna, until, I think, it's 14. So, it seems like a great way to pick up some cheap earnings by being able to buy back some of those, because they are expensive?

No. You're right. And you're absolutely right, Jerome, for one day, they dipped under par and our radar went up and everything as you know today, they're back at [106 and 107]. We are absolutely attuned to that financial opportunity if it presents itself. Absolutely -- we absolutely agree.

Okay. That's great. I mean, for what it's worth, I'd suggest that it just seems like, I don't know anybody who's [rationale person doesn't -- who thinks] we're totally out of woods here, we're going to get more weird spiky events. And the reason I'm raising it is, I think you need a public statement about an authorization in order to be able to do it. And that could be wrong, I'm sure, you're getting it by some counsel, but it would be pretty sweet to be positioned in case it does happen because I mean, who doesn't think it's going to happen, right?

Right, there are -- that is correct. Well, it may happen, it may not, but you are correct on being positioned, we're on it. There are some other dynamics related to it that aren't bad or good. There were just some other dynamics but our intention is to be positioned to make sure that if we can do it, we do it.

Alright. That's great, thank you.

You're welcome.

Thank you. I would now like to turn the conference over to the speakers for any additional comments.

Very good. Thank you for joining us this afternoon and are -- we'll be circling back up with you in calendar Q1 for Q4. Thank you.

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