Kratos Defense and Security Solutions Inc (KTOS) 2012 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Kratos Defense & Security Solutions Second Quarter 2012 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 follow at that time. (Operator Instructions). As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Ms. Laura Siegal, Vice President and Corporate Controller. You nay begin.

Good morning, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Second Quarter Earnings conference call. With me today is Eric DeMarco, Kratos's President and Chief Executive Officer, and Deanna Lund, Kratos's Executive Vice President and Chief Financial Officer.

Before we begin the substance of today's call, I would 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 Kratos corporate web site at www.kratosdefense.com.

Additionally, I would like to remind our listeners that this conference call is open to the media and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the Company's web site 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 risk 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 2, 2012, 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, amortization of purchased intangibles, and excess office space expense using a cash tax rate and using a statutory tax rate of 40%, adjusted cash flow form operations reflecting cash flow from operations excluding transaction-related items, and adjusted free cash flow reflecting cash flow from operations excluding transaction-related items plus capital expenditures 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 web site.

In today's call, Mr. DeMarco will discuss our financial and operational results for the second quarter of 2012. He will then turn the call over to Ms. Lund to discuss the specifics related to your financial results. Mr. DeMarco will then make some concluding remarks about the business and we will then open up the call for your questions.

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

Thank you, Laura.

Kratos's second quarter 2012 results came in pretty much as expected with revenue increasing sequentially over the first quarter with 100% of this growth being organic. The primary reasons for the sequential second quarter 2012 organic growth include Kratos's business today is primarily specialty product-based focused on niche United States national security C5ISR priority areas. Our critical infrastructure security business, which comprises approximately 15% to 20% of the Company, is not funded by DoD budgets and it continues to grow organically sequentially and year over year. And this is being driven by the increasing Homeland-related asymmetric threat profile we're experiencing right now. And also demand for Kratos's ISR, electronic attack, and electronic warfare-related products, including internationally, continue to generate strong organic growth for the Company. Additionally, our legacy traditional government services business, which as you know is in a marketplace that has been commoditizing over the past few years, today comprises only approximately 10% to 12% of the Company's revenue base. And although it is continuing to contract, it's less of a drag on our Corporation's overall growth than it has been in the past few years as obviously it's a much smaller and shrinking piece of our business.

Looking forward to Q2 and Q4 of 2012, based on the significant amount of specialty product orders we have received during the first six months of the year, we continue to expect a significant second half 2012 sequential organic revenue and EBITDA increase as a substantial portion of this business is currently in backlog. It's in the manufacturing process and it's scheduled for second half delivery.

Specific areas where we expect sequential organic growth in the second half of 2012 over the first six months include an ISR, EW/EA, missile systems, cyber products, and certain specialty national security-related programs.

Additionally, Kratos's hypersonic systems business has been performing very well, as is our specialty training systems business. Hypersonics is related to potential anti-axis area denial threat scenarios and hypersonic technologies and systems have the ability to provide the dominance once afforded by Stealth. Hypersonics is a major focus area for Kratos with DARPA and certain other agencies making significant investments in this area. In the future Kratos expected to provide hardware and services for numerous additional future hypersonic tests and launches.

In Q2, Kratos's specialized ground equipment business also performed very well, including in the strategic platform and program areas of missile systems, electronic module enclosures, LCS, and certain other strategic national security program areas. Conversely, this business unit's work related to supporting tactical initiatives that specifically related primarily to certain Army and Marine programs, fell short of our expectations in Q2 with certain expected orders continuing to be delayed and pushed to the right. We believe that certain tactical programs are being directly impacted by the ongoing federal budgetary issues, related procurement delays, and also the ongoing strategic pivot that's hitting the industry right now.

Though we expect our overall specialized ground equipment business to grow compared to last year, including sequential growth in the second half of this year as compared to the first six months, the downward trends in the traditional ground and communications-related support program areas are expected to continue at least until we have a more macro level clarity at the budgetary level.

We also continue to expect Kratos's unmanned systems business and CEI to have a very solid second half of 2012 as we originally expected when we announced the combination of the companies. And Kratos was recently awarded a new next-generation UAS-related contract.

Directly related to our expected second half revenue and EBITDA ramp, Kratos's second quarter book-to-bill ratio was approximate 1.1 to 1. And bookings thus far in Kratos's fiscal third quarter have remained strong.

Representative of thus far continued strong bookings, we have just received customer approval for a new near $70 million contract award where the Kratos team was successful and which we hope to formally announce in the next two week. We also very recently received a sole source near $20 million single award contract from a certain customer related to cyber warfare. And next week we will be formally announcing the expansion of Kratos's RF interference, detection, geo-location, and identification business where Kratos now covers nearly 90% of the world's global fixed satellite services constellation. We believe that Kratos is the only managed solutions provider of RF monitoring, detection, characterization, and geo-location in the industry.

Related to this, Forecast International recently projected that the worldwide commercial SATCOM market to be worth approximately $53 billion from 2012 to 2021 and we believe that Kratos is extremely well-positioned to participate in this growing market.

Kratos's bid pipeline is also currently particularly strong, especially in the specialty national security, cyber, SATCOM, ISR, missile system, EW and EA product areas.

Our second quarter EBITDA, though solid at $24.3 million, was slightly below where we had expected, primarily as a result of a revision to the timeline for the integration of the critical infrastructure business we acquired at the beginning of this year. Additionally, our second quarter IR&D was higher than originally anticipated as we accelerated or pulled in efforts on certain electronic warfare and cyber opportunities based on specific customer programs.

For PSS, we have revived the business integration timeline, pushing out the planned substantial completion of this integration effort into the first quarter of 2013 rather than the previously expected later this year in order to ensure a successful completion of certain security system integration projects we are currently executing on to ensure customer satisfaction and very importantly to ensure the timely collection of the security programs-related accounts receivables, which we expect to receive in the second half of 2012.

Accordingly, even though Kratos' public security business EBITDA margins increased sequentially over 60% in Q2 above Q1 and we expect them to continue to sequentially increase even more over the balance of 2012, the change in the integration plan timeline did reduce our first half expected margins.

We also expect sequential EBITDA expansion in the second half of 2012 for all of Kratos driven by PSS and by the scheduled national security program product deliveries I mentioned previously and by the expected delivery of certain large situational awareness and cyber security-related software product orders, of which we had very few in the first half of the year, but the second half pipeline currently looks very solid.

Major programs we can discuss and which we expect to contribute to Kratos's second half include Trident, EA-18G, P8, Patriot, Arrow, Sling of David, Iron Dome, Blackhawk, Chinook, MALD, Aegis, Raiders, and AMRAM.

During the second quarter, we completed our review of certain of the Integral Systems businesses or product lines and we have now made the decision to divest certain of these, which are not core to Kratos or our strategic plan. We've already commenced the process of disposing of these businesses, which were originally expected to generate approximately $35 million in revenue for 2012 and we currently expect to complete the dispositions by the end of this year.

Related to the decision to divest these noncore businesses, Kratos only has a limited amount of IR&D, B&P, and obviously financial resources for investment. And with the disposition here, we will be allocating our resources to our strategic focus areas, including unmanned systems, electronic warfare, ISR, and satellite communications, where we have some promising near-term opportunities.

With the end of the second quarter and the closing of the acquisition of CEI, we announced a new Kratos organizational structure to better align the business with our strategic plan and our focus areas.

Kratos's organization now has two sectors or segments -- C5ISR and critical infrastructure security -- under which there are five divisions, which are focused on unmanned drones, aerial targets and unmanned systems, electronic products/systems, warfare, attack, and ISR, rocket support, hypersonic and BMD product solutions and services, SATCOM/cyber technology and training, and finally critical infrastructure and strategic and asset security.

Related to structure, as I mentioned before, Kratos's traditional government service business is contracting and we have been reducing this business's cost profile to address the current low-cost environment.

Accordingly, we are consolidating certain facilities and are now in the process of subleasing certain excess space that we have and in Q2 we took an approximate $1 million noncash facilities charge related to the situation.

So in summary, Kratos's business is organically growing and we expect that organic growth to continue sequentially into the second half of this year. We expect our profitability, EBITDA, and cash flow to also continue to organically grow and expand sequentially for the second half of 2012 as compared to Q1 and Q2.

We believe that the vast majority of Kratos's business today is focused on the clear national security priorities of this country and that we are well-positioned for the DoD's strategic path forward and the formally-announced strategic pivot.

We believe that we're designed in the products and technology on major, established, and entrenched national security programs, which forms a significant competitive barrier to entry, especially in the existing budgetary environment.

And now I'll turn the call over to Deanna for the financials.

Thank you, Eric. Good afternoon. As a reminder, all financial performance data discussed and presented today reflects the Integral Systems noncore businesses that we decided to divest as discontinued operations. Accordingly, all prior-quarter and prior-year data has been similarly classified to present the discontinued operations in a comparative format.

The second quarter financial performance remained solid in what continued to be a very difficult, challenging, and changing Department of Defense, national security, and overall federal government budgetary environment.

Our revenues of $219.8 million were up sequentially approximately 4.9% from the first quarter of 2012 revenues of $209.5 million, primarily reflecting sequential organic growth in our critical infrastructure business of 8.4%, as well as in our electronic attack and electronic warfare products business and our satellite communications business, which both grew 2.7% sequentially from the first quarter.

On a year-over-year basis, our revenues increased $48.7 million from $171.1 million in the second quarter of 2011 to $219.8 million in 2012. Approximately $71.5 million of this increase was generated by the acquired businesses of Integral Systems, SecureInfo, and the acquired critical infrastructure business. This growth was offset by a reduction of approximately $12.4 million in traditional services revenues that continued to be compressed as Eric discussed earlier, as well as a reduction of $10 million in shipments of our ground equipment business and other legacy weapons systems due to delays in shipment Eric touched on earlier as well. As Eric had mentioned, our traditional services business was greater than $250 million in annual revenues in 2009 and has contracted 22% to 32% each year since that time. For 2012 it is down to an annual run rate of approximately $100 million. Fortunately this business now comprises a much smaller portion of our overall revenues, down from over 75% of our total revenue several years ago to 10% to 12% this year. Although this business continues to contract, the overall relative impact to Kratos's consolidated operating results have become less significant due to our diversification over the past several years into more niche products.

Our adjusted EBITDA of $24.3 million for the second quarter of 2012 is from continuing operations, excludes merger and acquisition expenses of $1.5 million, stock compensation of $1.2 million, and $1.4 million of unused office space expense and other expense.

The EBITDA for the second quarter was down significantly from $25.1 million in the first quarter due in part to the mix of revenues in the current quarter with less of the typically higher-margin products in this quarter, as well as due to an increase in internally-funded research and development of $1.2 million that we are making a select satellite communications and electronic warfare/electronic attack products. As we have stated previously, our revenues and associated margins can be choppy at times based upon the mix of products shipped in any given quarter.

On a year-over-year basis, our adjusted EBITDA has increased from $22.7 million in the second quarter of 2011 to the $24.3 million in the current quarter.

From an operational segment perspective, our Government Solutions segment generated $175.8 million in revenues and $20.6 million in adjusted EBITDA or an 11.7% adjusted EBITDA margin. This was up from revenues of $145.3 million and $20.5 million in adjusted EBITDA or a 14.1% adjusted EBITDA margin for the comparable second quarter of '11. As stated previously, operating margins during the current quarter were impacted by a less favorable product mix as well as the increase in investments in research and development, which increased $3.6 million from $1.2 million in the second quarter of 2011 to $4.8 million in the current quarter.

Our Public Safety & Security segment financial performance for the second quarter improved sequentially from first quarter revenues of $40.6 million and adjusted EBITDA of $2 million or a 4.9% adjusted EBITDA margin to revenues of $44 million and adjusted EBITDA of $3.7 million or an 8.4% adjusted EBITDA margin.

The performance reflects the sequential organic revenue growth as well as the impact of certain of the integration actions we took during the second quarter, which included a gross profit improvement from 25.6% in the first quarter to 27.7% in the second quarter. Although the operating margin improvement is not what we had originally expected to achieve in the second quarter due to the revised overall timeline of the integration of the acquired critical infrastructure business, the adjusted EBITDA margin rate for the current quarter is fairly consistent with the adjusted EBITDA margin rate of 8.5% or adjusted EBITDA of $2.2 million on revenues of $25.8 million in the comparable second quarter of 2011.

As we continue to integrate the acquired business into our public safety business for the balance of 2012 and into early 2013, we expect to continue to see the EBITDA margins expand, however, at a reduced acceleration rate than originally expected for the reasons Eric highlighted earlier.

Our gross margins decreased slightly from 26.5% in the second quarter of '11 to 26.3% in the current quarter, down on a sequential basis from 27.4% in the first quarter of 2012 as a result of the product mix in the current quarter.

Our mix of revenues for the second quarter is 49% products and 51% services compared to the prior-year second quarter mix of 56% product and 44% services.

On a GAAP basis, net loss for the second quarter was $17.2 million, which included a loss from discontinued operations of $2.3 million, the $1.5 million of acquisition-related expenses, $8.9 of expense related to amortization of intangible assets, as well as a $6.6 million income tax provision primarily related to the impact of tax liabilities in an individual state and foreign jurisdictions, for which we do not have NOL offsets.

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 similar to what we experienced this quarter. We continue to believe it is meaningful to provide the average quarterly estimated cash tax payments of approximately $1.2 million for the second quarter and approximately $5 million for the year.

As an update, we now have over $300 million of net operating losses, which we can carry forward to reduce taxable income going forward, up from approximately $260 million in the first quarter. The increase is due to a successful tax planning strategy that resulted in additional net operating loss carry-forwards of $40 million.

We continue to believe it is also meaningful to provide our earnings per share excluding the amortization expenses, acquisition-related expenses, and the excess office expense accrual and reflecting a cash-pay income tax.

On a pro-forma basis, EPS from continuing operations excluding amortization, merger expenses, and the excess office accrual and utilizing an expected quarterly cash-pay income tax provision of approximately $1.2 million was $0.06 per share for the quarter.

Moving to the balance sheet and liquidity, our cash balance was $145.7 million at June 24 plus $800,000 in restricted cash. This cash balance reflects the net proceeds of $97 million from the equity offering we completed in May to find the CEI transaction, which closed after quarter-end on July 2. The cash balance also reflects the biannual interest payment on the senior notes that we made for $32 million in May, which also impacted our cash flow from operations for the quarter. For the second quarter of 2012, we utilized $14.6 million in cash from operating activities excluding the payment of $600,000 of acquisition-related expenses. The use of cash reflects the biannual interest payment, an increase in inventory of $2.5 million for the quarter, and $9.6 in inventory for the first half that we do not expect to recur in the second half of 2012. For the first half of 2012, we have generated $12.6 million of cash from operations excluding the payment of acquisition-related expenses of $2.9 million.

Cash on hand as of today is approximately $50 million with approximately $25 million drawn on our revolving line of credit, down from the $40 million line draw that we made to fund the cash portion of the CEI transaction, which closed on July 2.

We currently have a revolving line of credit of $110 million, with approximately $12.7 million of letters of credit outstanding and the $25 million draw outstanding that we took to fund the CEI transaction. Our total available liquidity today is approximately $120 million.

Our DSOs for the second quarter are at 106 days, down sequentially from 111 days in the first quarter, which is above our target DSO of approximately 90 days. As expected, our DSOs have been impacted by Integral's DSOs, which are higher than our typical DSOs due in part to the mix of milestone-related payment/billing terms and other related terms. In addition, as expected, the recent acquisition of the critical infrastructure business, which has approximately $25 million of accounts receivable, has impacted our DSOs by approximately two to three days.

We continue to expect that as milestone-related contractual payment/billing terms are met due to the Integral contracts and as we continue our newly-implemented, more rigorous billing processes and procedures for the newly-acquired critical infrastructure business that we will be able to continue to reduce the overall DSOs and generate additional operating cash flow.

In total, we view these excess receivables as an opportunity to generate additional operating cash flows as we achieve the contractual billing milestones and as we implement our rigorous billing processes and procedures. For instance, at our currently quarter run rate, a four-day reduction in DSOs similar to the reduction we were able to achieve in the second quarter, it's equivalent to a cash flow generation $10 million.

Debt under our outstanding notes at June 24 was $625 million plus the issuance premium of $20.8 million. Total net debt today included in $25 million outstanding on the revolver net of the $50 million, unrestricted cash and the issuance premium of $20.8 (sic) million is $607 million.

Our contract mix for the second quarter was 74% generated from fixed-price contracts, 15% on cost-plus fixed-fee contracts, and 11% on time and material contracts. Revenues generated from contracts with the federal government were approximately 64%, including revenues generated with the DoD of 58% and revenue on contracts with non-DoD federal government agencies of 6%. We also generated 5% of our revenues from state and local governments, 22% from commercial customers, and 9% from foreign customers.

Backlog at quarter-end was $1.1 billion with $546 million funded.

Moving on to the guidance for 2012, consistent with prior years, we provide annual guidance and not quarterly guidance due to the choppiness on a quarter-over-quarter basis consistent with the heavy product mix business. We are updating our estimated fiscal 2012 revenues to be $950 million to $1 billion and adjusted EBITDA of $120 million to $125 million. We expect amortization expense to be approximately $42 million for 2012 with $12 million in Q3 and $11 million in Q4.

The updated guidance was derived by taking the midpoint of our previous guidance of $975 million less the impact of the discontinued Integral businesses, which were originally expected to generate $35 million in annual revenues and the elimination of our sales to CEI of approximately $5 million for the balance of 2012 plus the estimated revenues for CEI of approximately $60 million or a total of $995 million.

The updated adjusted EBITDA guidance was derived by taking the previous low end of the range of $120 million less approximately $5 million for the impact of the timeline change of the integration of the acquired critical infrastructure business whereby cost reductions have not been achieved as quickly as originally anticipated due to the reasons Eric discussed earlier plus approximately $8 million to $10 million for the contribution expected from CEI for a total of $123 million to $125 million. For conservatism, we have provided a range of $120 million to $125 million.

We are also updating our estimated pro-forma EPS for 2012 using an estimated weighted average shares outstanding for the year of approximately 47 million, which reflects the equity offering of $20 million shares to fund CEI acquisition on a weighted average basis and excluding the amortization, acquisition expenses, excess office space expense, and using an estimated cash-pay income tax provision of approximately $5 million, which are estimated at $0.63 to $0.73. Using a full statutory 40% tax rate, excluding the amortization expense and acquisition expenses, we estimate pro-forma EPS to be in the range of $0.45 to $0.55.

In addition, we have updated our free cash flow guidance from continuing operations excluding acquisition-related items after interest payments and capital expenditures of $50 million to $60 million. This is derived by the $120 million to $125 million of adjusted EBITDA less annual cash interest payments of approximately $63 million, annual capital expenditures of $12 million to $16 million, and annual cash tax payments of approximately $5 million and a working capital source from the reduction of DSOs previously discussed of approximately $10 million to $20 million, which reflects an approximately additional reduction of four to eight days.

As a reminder, our semiannual interest payments of approximately $32 million on the senior notes are paid in June and December. Therefore we expect our free cash flow for the first and third quarters to be the strong cash generation quarters as the interest expense is accrued in those quarters and not paid until the second and fourth quarters of the year. We expect to pay down the outstanding borrowings on the revolver to zero in the second half of the year.

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

Great. Thank you, Deanna. And quickly in closing, in the current environment that we are operating in, forecasting precisely is obviously extremely difficult, but overall trajectory is what we believe is very important.

Kratos's current trajectory as demonstrated by our Q1, Q2, and overall first half of 2012 results is clearly that of an increasing organic growth and overall growth trajectory. As Deanna and I referred to several times in our prepared remarks, we believe that Kratos today is well-positioned in these challenging times strategically, operationally, and financial.

The second half of 2012 is currently shaping up for Kratos to be significantly stronger than the first half with increased year-over-year and sequentially revenue, EBITDA, and cash flow growth organically, which the management team obviously is committed to.

We'll now turn the call over to the moderator for questions.

Operator: Thank you. (Operator Instructions). Our first question comes from the line of Mike Crawford with B. Riley. Your line is open.

Thank you. Eric, just broad picture, in the current environment, where are you seeing the most demand for your programs and where is that visibility the least and what's getting funded, is more likely to be funded in a CR-type environment versus what are the things that are more likely to be cut?

Right. What we've been seeing and what we think we're going to continue to see ties directly into the strategic update the Pentagon put out in January of this year. And it has to do with the strategic pivot, which is tying in the strategic platforms. We are seeing weakness primarily in the Army area, in the Marine area, on tactical systems. We are seeing strength on strategic platforms that have to do with anti-access and area denial, Air Force systems, Navy systems, and space-based systems. Programmatically we're seeing strength right now and it looks like it's going to continue on some of the ones I mentioned -- Trident, EA-G18, Patriot, AMRAM, internationally with Iron Dome, Arrow, and Sling of David, and several satellite communications areas and programs -- one I can mention is Raiders. I can't get into the other ones -- and in certain unmanned systems areas.

Mike Crawford. Okay, thank you. And then relative to Composite Engineering, I believe you're expecting a step-up in revenue with the Navy in the back half of this year or at least you had been with the more significant increase next year. I'm wondering if that timetable has changed at all and then anything you can say regarding the prospects of winning business with the Army?

Okay, we continue to expect a significant step-up in overall CEI revenue in the second half and we continue to expect a significant step-up in 2013. The second half of this year is being driven by MALD, two Air Force contracts, and three international contracts. The second half of next year it'll include what I just mentioned and in addition to Navy when it should become more meaningful.

And prospects for the Army?

The Army, I don't want to get ahead of myself, but they are on the original expectation timeline. Nothing has changed there.

Okay, thank you.

Thank you, sir.

Thank you. Our next question comes from the line of Michael Ciarmoli with KeyBanc Capital Markets. Your line is open.

Hey, good afternoon, guys, nice quarter. I guess, Deanna, maybe just for clarity, what is the expected revenue for CEI for the second half of the year here?

Yes, that was the $60 million that I had denoted in my long comments, so it probably got lost in there, but it's $60 million, yes.

6-0, $60 million?

Correct.

Okay. And then one other housekeeping, just the pro-forma EPS of $0.63 to $0.73, were there any other changes in that from the $0.95 to $1.25 besides just the higher share count for the remainder of the year.

Obviously with the change in the range on the EBITDA, so the tightening of that to $120 million to $125 million, that's the other driver.

Okay. And then just as we look at obviously there's a lot of moving parts and uncertainty here, but I think, Eric, you said the portfolio's now complete with the addition of CEI. Can you give us a sense of what we can expect on a go-forward basis here in terms of a target model? Certainly it looks like the second half of '12 your EBITDA margins should be at the 14% range. I know we've got sequestration hanging out there, but is that the right level to think about going into next year in the absence of a sequestration trigger? Or is there further upside that we could see in terms of the margin profile?

Okay, that's a very good question. It absolutely, absolutely should be 13% to 14%, 13%-plus. Absolutely. The upside potential that we have is primarily in three areas. And God willing we'll see some of this in the second half because we expect to. Our cyber business, a substantial portion of that is products, software products. And as I mentioned in the prepared remarks, it comes in ebbs and flows. The first half we had some, wasn't significant. The second half is shaping up right now, it could be very significant. We are putting a significant amount of money in this area, especially in a new type of cyber product, which we announced a couple of months ago. We're not making a big deal out of this, but these are cyber products relative to MILSATCOM where we have the customer, we know what the issues are, and in 2013 if we just get a little bit of that, because of the profit margins on software, that could be a driver for us. So there are those areas.

Additionally, it's certain of the international weapons systems areas, particularly in EW/EA and missile systems. I talked about some of those in the prepared remarks. That is an area, if those come to fruition in blocks so we get leverage on the G&A, that could drive it as well.

Okay. On those cyber, those software sales, anything different with those actual sales in terms of revenue recognition? Are those typical of commercial sales where we've got sort of licensing revenue and is there a benefit there to cash flows?

It's twofold, Michael, so as we ship the product then there's the revenue recognition as the product is shipped, and then there typically is a maintenance stream of the following 12 months as well.

Michael, one other thing I should mention is in our critical infrastructure and strategic asset security business, today approximately 15% of that is the service. We are awarded a contract, we design the system, we deploy it, we integrate it into a command-and-control system. That's the deployment pierce. Then we typically get a contract to run it or maintain it. Those annuity stream-type contracts could be much more profitable than the deployment. So obviously if we're building up this business, if that grows along with it, that can help the margins as well.

Okay. And then just last question, if we think about it, I guess it looks like Washington, Congress, they're making pretty good progress on a continuing resolution here for six months. Is there anything that could happen between now, end of year with either the CR, election noise that introduces more risk to you guys achieving your kind of financial objectives for the remainder of '12? Or is it going to be more 2013 of an impact?

Thinking.

Michael, I would say Q3 I feel pretty good about. Obviously calendar Q4 is the beginning of federal fiscal '13.

Right.

Obviously as you have, I've seen that supposedly the Congress, the House, Boehner, Reid, and Obama have come to some type of an agreement for a six-month extension. I see that, but you know it's very, very fluid. So I would say fingers crossed. We're trying to be conservative for the next six months, but we're obviously in uncharted waters here.

All right, fair enough. Thank you very much, guys.

Thank you, sir.

Thank you.

Thank you. Our next question comes from the line of Mark Jordan with Noble Financial. Your line is open.

Hi. This is Eric in for Mark Jordan. Two questions -- first, for each of the business segments, I was wondering if you could just talk briefly about the levels of effective competition you're seeing for each of the businesses.

I'll give you some of the business lines so you can get a feel for it. In the critical infrastructure area, the two primary competitors that we had had for several years, they had some major issues and they kind of went away last year. And so our two primary competitors have exited the field for all practical purposes. There is one primary large guy left. These are system integrators. And then from time to time the product guys will show up to try to push their products and integrate their products.

In the electronic products, the EW, the EA, and the missile system electronic areas, there are two primary players. We are one of them. And then there's another guy and then from time to time smaller peripheral players show up. And so that approximate $200 piece of business, the first piece was $200 million. And that approximate $200 million piece of business, it's us and one other guy for all practical purposes with a couple of other smaller guys that show up from time to time.

In the MILSATCOM, in the satellite communication area, again, I'm rounding here, another couple hundred million, it's typically us and one other guy, one other guy. And from time to time one or two small guys show up, but it's really typically a two-horse race.

And what is driving this is what's happening budgetarily. And the funded R&D dollars are drying up. And so if you are designed in today, you're in. And it's very difficult, if not impossible for somebody to come and compete with you unless they're going to try to acquire somebody and exploit it.

In the cyber business, in the product area, it's us and like three other guys. In the cyber services area, it is a mess. And there are lots and lots of people in the cyber services area. And in that area, there right now is a significant supply/demand imbalance where there is a huge demand for services, but there Is not a supply of people that we can hire or anybody can hire. There aren't enough people to do the work right now and so it's very hard to get any traction in that area to grow. And in our services business, which I had previously said I thought was around $80 million, Deanna scrubbed it. It's about $100 million and it's shrinking. It's a freefall. And any of these traditional services contractors, when a contract comes out, 100 people show up. And then if it's a MAC, 100 people show up and then 20 people are awarded the contract and then you get to bid against 20 of your best friends.

So that's kind of the lay of the land right now.

Got it, thanks. And one more question, just relative, again, to each of the business segments. How is the visibility of demand looking longer term out to 2013, 2014?

So it's very, very program-specific. Let me give you an example. So one of the largest programs in the Company that we are on is the EA-G18 team. The visibility on that as we sit here today is fantastic through 2015/2016 because of what's happening with the F-35, what the build is on the F-18. You can take a look at Boeing and you can see it. It's just fantastic.

One of the next biggest contracts in our Company is the Trident II D-5. Its successor was canceled. It's gotten a CLEP, and SLEP, a service life extension program through 2052. We're sole-source. It's fantastic.

I'll give you one more fantastic one and then I'll talk about the not-so-fantastic ones. P-8 Poseidon, it's coming out of LRIP, it's going to full-rate production. I think there's between around 115 that are going to be procured by the Navy to replace the P-3. It looks like India's going to buy 20 or so, Australia is going to. It's fantastic for us. I mean, it's just fantastic. You can see way out.

So now let's go to the not-so-fantastic. Command Post Platform, it's a [comm] platform for the Army. We built specialty products that have high altitude electromagnetic plus protection for this. It's clear as mud right now. We thought we were going to get some big orders in the first half. We didn't. I don't know if we're going to get them in the second half. I would say right now we're not. And I don't think we're going to have any clarity on that until maybe mid next year. There's a lot of discussion going on, not just budgetarily. And with the strategic shift, but also what was going on with the JLTV and the Hummer recap, which ties into the Command Post Platform. And so it's program-specific. Some a really good, some are real murky.

And the critical infrastructure side is very clear right now because there's so much demand because of the asymmetric threat profile that's happening in this country relative to strategic assets.

Thank you. Our next question comes from the line of Matthew Pavani with CK Cooper & Company. Your line is open.

Hi Eric, hi Deanna.

Hi.

Hi Bhakti.

Hi. I had a question. I think I misunderstood the information. The $35 million in revenues that is going to come from the divested business and the revised revenue guidance is $950 million to $1 billion, so does that $35 million is included in that or it's additional? I'm sorry, I don't get that.

No, that is excluded, Bhakti. When we discontinued operations the revenues come out of, for those businesses that are discontinued, they come out of the revenue line and out of everything on the income statement except for on the line discontinued operations, so that is excluded from that guidance because it will no longer be counted for in revenue.

Okay. So after excluding that $35 million, the new guidance is $950 million to $1 billion?

That's correct.

Okay. Also there was a significant increase in the -- I mean, comparatively increase in the R&D. Would that be a fair run rate to expect going forward in Q3 and Q4, the R&D expense, or is that going to pick up in Q3 and Q4.

We think it'll probably be around that same level and probably drop a little bit by the end of the year as we complete some of the investment efforts.

Okay. My next question was really related to the M&A and integration expenses. How much of the integration expenses are expected to be accounted going forward in Q3 and Q4?

So for the mergers and acquisition expenses, it should be the final transaction expenses for the CEI transaction, which closed in our third quarter. And that will be probably around $2 million, $1.5 to $2 million.

Okay. I also had a question on the amortization. Now that the acquisition of CEI is completed, what should we be expected amortization expense to be assumed going forward?

Yes, so that was what I have in my prepared remarks. So the total amortization, which includes the CEI transportation, is estimated at $42 million for the full year with $12 million in Q3 and with $11 million in Q4. So that already includes the anticipated impact of CEI.

Oh, okay. I'm sorry, I missed that.

No problem. I had a lot of numbers in my prepared remarks, so.

Yes. I was also confused about the numbers that you gave out that was $43 million for Q3 and $44 million for Q4. I'm sorry, I did not get that. What exactly that was? While you were giving out the guidance?

I'm trying to think? Yes, the guidance I gave was for the full year of $950 million to $1 billion in revenue and $120 million to $125 in adjusted EBITDA, so I'm not quite sure what you're referring to as far as the --

Three for Q3 and $44 million for Q4, yes, I couldn't jot that down.

Yes, what I gave around that range was the $42 million anticipated for the full year of amortization expense. So that might be what that jumble.

Yes, maybe I am missing that then. Okay. Oh, yes, my last question was regarding to the tax payment. And if I understood correctly, the tax payments are expected to be $5 million for the second half of the year?

No, for the full year.

Oh, for the full year?

Yes. So approximately on an average basis by quarter about a $1.2 million.

Okay. Yes, that's it. Thank you very much.

Thank you.

Thank you. Our next question comes from the line of David Sagalov with Jefferies. Your line is open.

Hi guys. Thanks for taking the questions.

Hi.

Hi David.

Hey. Can you just comment, there was a contract last quarter that was pushed out. It was protested. The protest was finally dismissed and just can you comment if that revenue has come in?

There's very, very good news on this. The contract has been awarded and we've got it. We're building it. We're getting ready to ship it. And knock on wood it looks like it's been doubled.

And when would that impact or come into the results?

Late this year, Q1 '13.

Great.

Thank you for asking.

And regarding the discontinued operations, can you tell us what the EBITDA contribution would've been from those operations if there are any?

And that's a very good question. Let me explain to you why that's a question, a very good question, because this business was embedded in some business that's continuing. And so it's in some of the same facilities, which shared SCIFs, secure compartmentalized information facilities, and shared cost structures, et cetera, okay? I can tell you the contribution margin, and I'm not trying to be cute, but I'm giving you the contribution margin of this business is around 20% to 25%. And I'm telling you that because depending on who the buyer is, whether it's a strategic or a financial buyer, then it just depends on what type of G&A infrastructure they have because it's embedded and some of the contracts are cost-plus, fixed-fee, that absorb the cost, so it's not an easy answer. Do you see what I mean? It depends. But the contribution margin, 20% to 25%.

Got it. And regarding the second half, any commentary as far as where the weighting would be, more of a third quarter, fourth quarter, pretty even between the two?

Yes. As Deanna routinely says in her prepared remarks and as she routinely tells me not to get too precise, we have delivery schedules. We know what those delivery schedules say. So we know what we think that is. But we have learned that we can have something that's ready to go on September 25 and the customer will say ship it on October 5. And so we're just going to go with our annual guidance and we're very comfortable with what the second half looks like.

Got it. And lastly just I've got one more. Regarding the critical information and the public safety division, so I think I heard you guys say 0% from the federal government. Did you ever break down how much is from municipals and just state and local governments?

We don't in detail.

We don't in detail. What I did in my contract mix or the customer mix, David, was I believe it was 5%, which is state and local. And that can be either on the critical infrastructure side or on the government business side. So that's the total percentage for our consolidated revenues for the quarter.

The big drivers of that business right now are commercial, oil companies, petrochemical companies, power transmission lines, energy generation platforms, data networks, that's switching networks, transportation, including rail, underground, ports. One of the largest and maybe the largest program in there right now, it's several tens of millions, has to do with a skyscraper complex somewhere.

Got it. Great. Thank you very much.

Thank you. Our next question comes from the line of Josephine Millward with Benchmark. Your line is open.

Hi Eric, hi Deanna.

Hi Josephine.

Can you give us an update on the two major public safety bids that you submitted earlier this year? Are you still anticipating awards before year-end?

We are absolutely anticipating submitting the bids in Q3 and we just got updated on that, so it's tracking. The bids are going to be submitted in Q3 and the current plan is late this year, very early next year, but both of them are still very active.

That's great. Eric, can you also give us an update on your -- I don't know if you have updated growth assumptions on the different parts of your businesses. Previously I think you talked about a growth rate of north of 10% for public safety. And if you can just give us an update on what you're assuming for the updated guidance?

Yes, so big picture, public safety definitely 10%-plus, all right, cyber 5% to 10% growth, EW and EA flat, SATCOM 0% to 5%, traditional services minus big time, big, big, big time, and those are the big pieces. The rest of it -- oh, BMD, Aegis, going to continue to grow, hypersonics, significant growth, north of 10%.

What about weapons sustainment? Is that roughly flat?

Down, down, down, 0% to 5% down, sorry. I forgot, 0% to 5% down.

Okay, that's helpful. Do you have a target EBITDA margin for the critical infrastructure business and can you talk about how you would get there?

Well, I'll tell you how we'll get there and then Deanna will help me with the target. This business if you look back last year and the year before has traditionally been one of the strongest profit-generators in the Company. As you know, we made a strategic decision at the end of last year to acquire that critical infrastructure business because we paid in our opinion virtually nothing for it, but we knew we had some integration to do. That integration process, we're in the middle of it and we made the absolute right decision pushing out the plan. It's easy to buy companies. It's easy. Integrating them is the heart. And we had a plan where we were going to reduce certain people, et cetera, on a timeline. And we could've done it in the near term. Our margins would've been up and life would've been great. But it would've impacted some long-term programs and certain key customer relationships and the collection of those receivables. So as we talked about it, we made the decision to push it out a quarter or two, which was, again, one of the smartest things we could've done because it's all coming together and the bookings there are showing that. And so by integrating that business over the next nine months, we are extremely confident because we can control this that those margins are going to continue to significantly go up to where they used to be where Deanna is roughly --

In the past it's been in that 12% to 14% range, Josephine, so that would be where our target would be, to get back there. The progress we made in the second quarter, we are at 8.5%, so we've made some great strides since the first quarter of 4.9% EBITDA. And we're about on par with where we were at this time last year, so we're expecting to continue to see that margin expansion in the second half, just not at the accelerated rate that we had originally anticipated.

Got it, that's helpful, thank you very much.

Sure.

Thank you.

Thank you. Our next question comes from the line of Yair Reiner with Oppenheimer. Your line is open.

Hi, good morning. This is [Wang Wei] for Yair.

Good morning.

Good morning.

Not good morning, good evening. Just looking in terms of the PSS margins, okay, you mentioned that it's going to be 10%-plus, but at the same time it's going to be lower than you previously guided. Are we still going to see the step function occur in the back half of the year or is it going to be more gradual?

You will absolutely see a significant ramp in the back half of the year, absolutely. All we basically did, what we did by making the decision not to eliminate some costs on the initial plan is we reduced the margin in Q2. The margins are going to continue to go up because we pushed out the cost reduction plan.

Right. And then can you just quantify what that cost reduction had? When was it in the second quarter and then for the back half of the year?

Well, for the first half it was about $5 million, but as we talked about in the prepared remarks, so in the first we took out a significant amount of cost, but we left in the first half $4 million to $5 million on the table that we did not take out that is going to come out in the next nine months.

Okay. Great. And then just a housekeeping question, in terms of the R&D expense, if I heard correctly, you expect it to ramp up and then to start trending back down, I'm assuming around fourth quarter of the year. Are you still looking for R&D expense to be around $20 million for the full year or is it going to be a bit lower than that now?

We are expecting the ramp-up and that ramp-up would include the acquisition of CEI, which there are some select investments we are making related to that business as well, so our R&D for $20 million for the year is probably on the high side since we were at $4.7 million this quarter and year-to-date closer to just under $8 million. We're a little over $8 million, $8.3 million, so I would say that the second quarter run rate is about where we'll be at or slightly a little give or take a little plus or minus from that range.

And also I want to add, I know you know this, but I want to make sure we're clear. We have a significant amount of funded R&D. It's significant. But it's not in a --

A customer funding or anything.

-- a customer-funded. It's not in IR&D. It's in revenue. But that's a fairly sizeable number in this Company.

Right, no, I'm just trying to look at the possible puts and takes, to get back to the adjusted EBITDA. And then just one final thing -- in terms of the share count, is there a number that you could guide us toward? I'm looking at in terms of your 10-Q filing for the first half of the year ends at 52.5 million, but then after July 27 it was 57 million. I just want to make sure at least I get that number correct.

Yes, it's closer to that 52 and change. I would say to be safe about 53 million.

Okay, perfect, thanks again, guys.

Okay, thanks.

Thank you. And our next question is a follow-up from the line of David Sagalov with Jefferies. Your line is open.

Hi, sorry, quickly just, Eric, when you were giving the broad commentary on growth expectations, was CEI baked into that anywhere or is that going to be separate from those broader categories that you mentioned?

Well, the way I was talking, it was excluding CEI.

Okay, great.

I was trying to give an apple-to-apple. That was just excluding CEI.

Okay. Going forward, where would CEI pretty much be baked into?

As I've talked about before and Deanna mentioned, historically, recently, the Company has been generating a 20% year-over-year organic growth rate. We expect that from '11 to '12 and we expect that to continue '12 to '13.

Great. And lastly, on just the services business, you previously you said down 15% to 20%, so it sounds like now you're expecting worse than that?

You mean on which piece, I'm sorry?

The IT or the commoditized military services.

No, I'm expect it to be down around 10% to 15%.

Oh, okay, so it's not worse than previous?

No, it's just still terrible. It's terrible. It's very difficult to win a recomplete in this environment. I mean, lowest cost, lowest cost, technically acceptable, is ruling the day. It's ruling the day today.

And as I said in the prepared remarks, David, the pure government services businesses over the last several years has been declining at an annual rate of 22% to 32% from 2009, 2010, 2011, and into 2012, so we believe that it'll be less than that 22% to 32%, but probably closer to the low end of that reduction rate.

Got it. Thank you.

Sure.

Thank you. Our next question comes from the line of [Amir Wacht] with [Sykes]. Your line is open.

Hi. Just a housekeeping question, Deanna, do you have the LTM pro-forma EBITDA by chance --

I actually do not have that with me and I usually do.

That's okay. And then I wanted to follow up on the $10 million delay in shipments this quarter for revenues. I'm sorry, maybe I missed the color behind it. What was it and will this impact next quarter?

Are you referring to what we had discussed last quarter or in my prepared remarks where I discussed --

Your prepared remarks this quarter.

Yes, what I was actually walking through was on a year-over-year basis. That's what I was referring to. So it was a reduction year over year in shipments related to certain ground equipment and related to certain weapons systems.

Yes, so that's the first Q impact, okay. Got it.

Yes.

I didn't know if that was something additional this quarter. And then --

No.

-- on the discontinued operations, I know that the EBITDA is difficult for you to isolate, but what was the revenue? Is it the $1.8 million?

The revenue that was originally expected for this year was $35 million.

-- and based on what it looks like for second half shipments and backlog, revenue in that business we're discontinuing and selling is going to be particularly strong in the second half.

In the second half, got you.

Oh, yes, the backlog. It's ironic. It's ironic. It's good for the process we're going through, but Q3 and Q4 right now the backlog and bookings are really strong in that DISCO business.

And what was it for the second Q? Do you know? So the $35 million is for the year, what was it for the second Q? Do you know?

That was what we had discussed in our press release. It was $1.8 million for the second quarter.

$1.8 million, okay.

Correct. Correct.

Got you. And then do you expect, I mean, is there a pipeline of buyers? Do you expect this to close sometime this year or difficult to say at this point?

There is a target list of buyers. We have already engaged with buyers. And as I said in the prepared remarks, the plan is to have it disposed of by the end of this calendar year.

Okay. Sounds good. And you said that the revolver draw that should be paid down by quarter-end, right? Did I understand?

You're right.

In the second half.

Second half, great, thank you so much. That's all I have.

Thank you.

Thank you. Our next question comes from the line of Michael Ciarmoli with KeyBanc Capital Markets. Your line is open.

Yes, thanks. Yes, just a quick follow-up. I missed it on the share count. What should we be using for an average share count for this year? And I think you've commented on next year as well?

Yeah, I just commented for this year. It's 47 million for the year weighted average.

Got you. Perfect. Thank you.

Thank you.

(Operator Instructions). And I'm not showing any additional questions in the queue at this time. I would like to turn the call back over to management for closing remarks.

Great. Thank you all for joining us this afternoon. And our next scheduled communication with the group will be when we report Q3. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does concludes the program and you may all disconnect. Everyone, have a great day.