Kratos Defense and Security Solutions Inc (KTOS) 2012 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & security Solutions fourth quarter 2012 earnings 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. As a reminder, this conference call is being recorded.

I would now like to turn the call over to your host, Laura Siegal, VP, Corporate Controller.

Good afternoon, everyone, and thank you for joining us for Kratos Defense & security Solutions fourth quarter and fiscal year end 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 is it available on the Kratos corporate website at www.kratosdefense.com. It is also available on the SEC's website.

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 and the potential impact of sequestration, and the constraints on the federal budget constitute forward-looking statements.

These forward-looking statements are subject to risks and uncertainties including those found in the risk factors section of our annual report on Form 10-K 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 annual report on Form 10-K and any of our other SEC filings for a more complete description of these risks.

All forward-looking statements are qualified in their entirety by this cautionary statement, and we undertake no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date hereof. We filed our annual report on Form 10-K today. 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 impairment of goodwill and intangible assets; acquisition related items which include the contract closeout settlement of an acquired contract; amortization of purchase intangibles and excess office space expense using a cash tax rate and using a statutory tax rate of 40%; adjusted cash flow from operations, reflecting cash flow from operations, excluding transaction related items; and adjusted free cash flow, reflecting cash flow from operations, excluding acquisition related items and less 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 website.

In today's call Mr. DeMarco will discuss our financial and operational results for the fourth quarter and fiscal 2012 and our outlook for fiscal 2013. He will then turn the call over to Ms. Lund to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business, and we will then open up the call to your questions.

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

Thank you, Laura, and good afternoon.

We believe that Kratos' fourth quarter and full year 2012 results are representative of the unique and differentiated specialized product and IP-based national security business we have built and that the expected future defense budgetary environment, though challenging, will provide us an opportunity to continue to demonstrate our differentiation. We believe that companies like Kratos that have positioned themselves to address unavoidable threats including rogue nation ballistic missiles and cyber warfare and that address anti-access area denial, clearly will have opportunities, and we are seeing these opportunities now. ,

We also believe that the majority of the US national security programs that Kratos supports are related to what are known as foundational security capabilities including strategic satellite ISR, C2 and RFI, BMD, threat representation and UCAS, all Kratos strength areas and that foundational security related programs will remain priority funding areas. Directly related to Kratos' positioning, our book-to-bill ratio in the fourth quarter was 1.1 to 1, which represents three straight sequential quarters of a book-to-bill greater than 1.0 to 1 and we have received some important bookings thus far in Q1 of 2013. In Q4 Kratos generated $15 million of adjusted free cash flow, and we generated $41 million of full year 2012 adjusted free cash flow and $52 million of 2012 cash flow from ops, demonstrating the cash generation capability of the Company.

We finished 2012 with approximately $50 million in cash on Kratos' balance sheet, and our 2013 free cash flow target is to generate an additional $50 million of cash, which would put us right around $100 million in cash on Kratos' balance sheet at the end of this year. Our 2012 cash flow generation provides us confidence in our 2013 FCF objective, and we will remain laser-focused on continuing to build the Company's cash balance sheet position as we move forward, paying down our debt and creating equity value. Deanna will discuss this in detail later on in her remarks.

Also related to our confidence for '13, since the end of Q3, Kratos has successfully won some of the largest recompetes and production follow-on awards in our Company, including in the satellite communications, aerial drone, electronic warfare, missile system and ISR areas. Additionally, Kratos' critical infrastructure security business is continuing to recover from the work stoppage and delays we experienced in Q4 from Hurricane Sandy, and this business has one of the strongest backlogs and bid pipelines in its history as we begin 2013.

We expect our Critical Infrastructure Security business, which primarily is commercial funded and non-US Federal Government funded, to renew its growth trajectory in mid 2013. Also related to the '13 forecast, approximately 30% of Kratos' overall business is non-DoD or US Federal Government funded, with these customers being either international or commercial security funding sourced and which are not impacted by US federal budgetary issues. Accordingly, as we begin the new year, a significant portion of our 2013 forecasted business is either currently under contract, we have visibility into it, or it's with a commercial international customer.

Importantly, the potential impact of an extended sequestration event as currently written with an approximate 10% across the budget line item reduction, with no discretion as to how cuts would fall, has not been assumed in our 2013 guidance. Despite the current sequestration, Kratos' guidance assumes and we believe that the Pentagon will ultimately be provided the discretion to protect the funding for its priority programs and its priority initiatives. In closing, we believe that Kratos supports many priority programs, and the spending bill passed by the House last week calls for such spending priority flexibility for the Pentagon.

Deanna?

Thank you, Eric. Good afternoon.

The fourth quarter financial performance was favorably impacted by strong demand and performance in our electronic warfare and satellite communications businesses. Our revenues of $263.6 million were down 4.6% sequentially from the third quarter as expected, due to the impact of Hurricane Sandy on our PSS business, as well as due to coming off of a very strong third quarter in which we saw an acceleration of orders and shipments in certain of our DoD business as certain customers were spending funds before the government fiscal year end of September 30 in anticipation of the six month continuing resolution. The fourth quarter's revenues were up 24% from Q4 '11 revenues of $213.4 million. On a pro forma basis Kratos' 2012 revenues grew organically 1.3% over 2011, including the revenues from the acquired companies of CEI and the acquired critical infrastructure business were -- as if included in both years on an apples-to-apples basis.

This organic growth was generated despite a 21.6% reduction in our traditional government services revenues, which are now at about $100 million in annual revenues. Excluding the impact of the reduction in our legacy services revenues, Kratos' organic growth was approximately 3.8% on a pro forma basis. During the fourth quarter we performed our annual test for impairment of goodwill and intangible assets.

The impairment test was primarily impacted by the recent softness in the equity markets resulting from the uncertainty surrounding DoD budget and the assumed potential impact of sequestration. The impairment charge of $96.6 million that we recorded in the fourth quarter is a non-cash, non-operational charge and does not impact any of our debt covenants under our senior notes or our revolving line of credit. The charge was primarily related to acquisitions we had made several years ago, prior to 2009, in the legacy defense services space which has continued to commoditize.

As we have been discussing with you over the past several quarters, our Legacy Services business has declined over 60% over the past three years from revenues of approximately $250 million in 2009 to approximately $100 million in 2012. The $96.6 million charge was comprised of an $82 million charge for goodwill and a $14.6 million charge related to intangible assets related to the use of acquired trade names. Our adjusted EBITDA of $31.6 million for the fourth quarter of 2012 is from Continuing Operations and excludes the impairment of goodwill, excludes acquisition related items aggregating to a total of $2.2 million in net credit and stock compensation of $2 million.

The $2.2 million in net acquisition related credits are comprised of the following items. There is a reduction of $3.3 million litigation accrual related to the Integral acquisition, a $1 million reduction of the estimated earn-out related to a previous acquisition, a $1.1 million favorable settlement of an acquisition related item, all net of a $3.2 million closeout settlement of a contract acquired in a previous acquisition.

From an operational segment perspective, our Government Solutions segment generated $215 million in revenues and $27.6 million in adjusted EBITDA, or a 12.8% EBITDA -- adjusted EBITDA margin. Our Public Safety and security segment generated $48.6 million in revenues and $4 million in adjusted EBITDA, or 8.2% adjusted EBITDA margin.

While we are substantially back up and running in the first quarter of 2013 in the Northeast region, there are still areas in the region that are not back up completely to the pre-Sandy operating levels. We anticipate that the overall growth trajectory and margin expansion will slowly pick up in the first and second quarters in 2013 with more to action in the second half of 2013.

Our mix of revenues has continued to expand on the product side with 58% products and 42% services, up sequentially from 55% products and 45% services in the third quarter. However, a significant portion of our Services business encompasses services wrapped around Kratos products or customer products and, therefore, could be considered product-centric.

On a GAAP basis, net loss for the fourth quarter was $90 million, which included the impairment of goodwill and intangible assets of $96.6 million, income from Discontinued Operations of $1.1 million, a net credit of $2.2 million of acquisition related items, $11.5 million of expense related to amortization of intangible assets, as well as a $5.4 million income tax benefit. We continue to believe it is also meaningful to provide our earnings per share excluding the amortization expenses, acquisition related items and the impairment of intangibles and reflect -- and reflecting a cash pay income tax.

On a pro forma basis, EPS from Continuing Operations, excluding the impairment amortization and merger related items, which includes the closeout contract settlement, and utilizing the actual average quarterly cash pay income tax provision of approximately $1 million was $0.15 per share for the quarter. Moving to the balance sheet and liquidity. Our cash balance was $49 million at December 30, plus $5.5 million in restricted cash.

For the fourth quarter, we generated $19.5 million in cash from operating activities, excluding the payment of $2.3 million of acquisition-related expenses. For fiscal 2012, we generated $57.7 million of cash from operations, excluding the payment of acquisition related expenses of $5.4 million, and have generated $41.1 million of adjusted free cash flow for the year excluding the acquisition related payments of $5.4 million and less CapEx of $16.6 million.

Our DSOs for the fourth quarter are at 94 days, down sequentially from 100 days at the end of the third quarter and down from 111 days in the first quarter of 2012. We continue to target DSOs of less than 90 days, which we believe is achievable as we expect that as milestone related contractual payment billing terms are met and as we continue and as we continue our recently implemented more rigorous billing processes and procedures for the recently acquired Critical Infrastructure business, that we will be able to continue to reduce the overall DSOs and generate additional operating cash flow.

Using the recent quarterly revenues, a four day reduction in DSOs is equivalent to approximately $10 million in cash flow generation. Debt under our outstanding notes at December 30 was $625 million plus the issuance premium of $18.7million. Our contract mix for the fourth quarter was 71% generated from fixed price contracts, 16% on cost-plus, fixed-fee contracts and 13% on time and materials.

Revenues generated from contracts with the Federal Government were approximately 70%, including revenues generated from contracts with the DoD of 65%, and revenues generated from contracts with non-DoD Federal Government agencies of 5%. We also generated 4% of our revenues from state and local governments, 11% from commercial customers and 15% from foreign customers. Backlog at quarter end was $1.3 billion, with $674 million funded.

Moving on to the guidance for fiscal 2013. As Eric stated earlier, we have not assumed the impact of sequestration in our guidance. We are forecasting revenues of $950 million to $1 billion and adjusted EBITDA of $115 million to $125 million. Included in our guidance are select investments in internal research and development, or IR&D, of $23 million to $27 million or approximately 2.3% to 2.8% of revenues. This is a fairly sizable increase from our IR&D of $17.8 million or 1.8% of revenues that we invested in for fiscal 2012.

Our estimated pro forma EPS for 2013, using an estimated weighted average shares outstanding for the year of approximately 57 million and excluding amortization of $36 million, and using an estimated cash paid income tax provision of approximately $3 million to $4 million are estimated at $0.35 to $0.50. 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 $0.25 to $0.35.

In addition, we have reaffirmed our free cash flow guidance from Continuing Operations excluding acquisition-related items after interest payments and capital expenditures of $50 million a year. This is derived by the $115 million to $125 million adjusted EBITDA less the annual interest on our notes of $62.5 million, less capital expenditures of $14 million to $17 million, less payment of taxes of approximately $3 million to $4 million, and assuming the generation of working capital resulting from the expected reduction of DSOs of approximately $12 million, which reflects an approximate additional reduction of four days to the top end of our DSO target of 90 days. We are targeting DSOs of 86 to 87 days by the end of 2013, which could be equivalent to a potential additional working capital generation of $10 million to $12 million.

Certain of the capital expenditures are discretionary, as well as the IR&D that we are planning on investing in for 2013. If we feel the need to reduce certain of these discretionary items to enhance or maintain free cash flow, we have the ability to do so. From a capital structure standpoint liquidity and delevering standpoint, our current plan is as follows. Assuming we generate the $50 million of free cash flow forecasted for 2013, our cash on hand at the end of 2013 would be approximately $100 million. And, assuming the same rate of free cash flow generation for 2014, cash would be approximately $125 million by June 2014 when the no-call ends on our senior notes. If the credit markets remain as they are today, a refinance of, say, $550 million, which includes the 5% premium and includes a pay down of approximately $105 million, at the current average rates of, say, approximately 8%, our annual cash interest payments could be reduced by as much as $18 million to $19 million.

If the rates are at, say, 9%, the potential savings to annual cash interest payments could be $12 million to $13 million. Clearly, this is an opportunity to reduce our overall weighted cost of capital and is something that we are very focused on. We will continue to monitor the credit markets, along with other factors impacting the economics of a refinance.

I will now turn the call back over to Eric.

Thank you very much, Deanna. And we'll turn it over to the moderator to answer any questions there may be.

(Operator Instructions)

Mike Crawford, B. Riley.

What if any noticeable impacts have you seen since March 1 when we officially went into sequestration, especially on your services business?

Overall, we have seen nothing of any materiality. There was -- there is one potential $4 million contract that goes over a couple years that's an upgrade on a certain fighter aircraft in the radar that has either been delayed or terminated. We're not sure yet. We're not sure if it's directly related to sequestration or not, but that's the one on the products side.

On the services side, the services space continues to remain very, very tight, Mike, and -- but we have not seen this yet. We haven't seen it yet. What we are hearing is that, if sequestration stands in the next few months and furloughs occur, that contractors are going to share in the furlough cuts. That's one thing that we're hearing. We haven't seen it yet, but we're hearing that.

Okay. Thank you. And then regarding your foreign revenues, that was 15% for the quarter, did you say, Deanna, or is that for the year?

That was 15% for the quarter.

And so is that a business that you think can grow to 15% of overall revenues? I think it's been closer to 10%.

The business we think is going to continue to grow, Mike. And that includes -- this is primarily missile system related and radars that go with the missile systems and the ground equipment that support the radars. We believe that this business is going to continue to grow, particularly with what we're doing in Israel and Saudi and some of the other mid-Eastern areas and in addition to that CEI. CEI's international business looks -- knock on wood -- to be very strong second half of this year and into 2014.

Okay. Thank you. And then in terms of the internal R&D, is that primarily related to CEI?

No. It's spread kind of sort of equally across three primary areas. One area is definitely CEI. Another area is in the strategic satellite communication area. And the third area is in the electronic product area which is primarily EWEA and ISR.

Okay. Thank you very much.

Mark Jordan, Noble Financial.

Eric, a number of companies as we've gone through earning season here have talked about customers slowing down order trends and, in fact, kind of reflecting sequestration starting in the latter part of last year. Given -- they tend to be more service-centric companies. Given your product focus, have you seen that behavior yet, or is -- if it hits you it will be when they start dictating some arbitrary cuts if in fact those really happen.

Right. We have not, Mark, seen it yet and if -- let's say as we said, our assumption is sequestration as currently written is not going to happen which as we all know is an across the board 10% line by line cut. We just don't think that's going to happen. We think if significant cuts do happen, the Pentagon is going to have flexibility and, as I mentioned in my remarks, that was the House bill that came out last week, and I think the Senate bill that is coming out today is going to request the same thing.

On the product contracts, the vast majority of the product contracts we have are long-term in nature. So, if they were to take a cut here, is request for equitables adjustment. As an example, if we were delivering products for 100 aircraft. Let's say that's a five year contract, let's say that contract gets opened up, okay.

That contract gets opened up and it gets de-scoped from 90 -- from 100 aircraft down to 90 aircraft, well, the prime above us -- they did their costing with us based on 100 aircraft, and we did our costing and our labor rates and everything on 100 aircraft and with our subs at 100. To re-scope all that with 90, we will resubmit. And the cost, because you get quantity discounts, on the 90 will be higher than on the 100. And you would submit a request for equitable adjustment.

We have been receiving letters from the government and from our customers related to that to start preparing for that. We have already, as you know, over the past year started that process, and get -- been prepared for it. So that's kind of the process that would happen, though to answer your question crisply, we have not seen anything on it yet.

All right. Could you update us on the NOL positions specifically with the companies are written off for those asset purchases and therefore your NOLs will go up? And then secondly refresh our memory as to what are the maximum you can utilize on an annual basis?

Sure, Mark. The -- our total NOLs are just slightly north of $344 million. They expire through 2033. That has increased from last year and part of that is we did some tax planning strategies as far as treatment of some of our unbilled receivables from a tax standpoint. So that did enhance some of those NOL balances.

From a limitation perspective, just as a refresher, since we had the event occur in mid-2010, the 382 limitation event, that limitation is at about $28 million per year, and that's for five years from 2010. Any unused limitation rolls forward into this year. We have used very little of that in 2010, 2011 and 2012, so there's a sizable amount that's rolling into 2013 from those unused years.

It's predominantly the balance of that $28 million times three. So and then thereafter, it drops to $11.5 million after the first five years.

And then in addition, I don't know if you asked this question, specifically related to our acquisition of CEI, if you recall we did a 338H-10 election which effectively allows us to be able to deduct the purchase price from a tax standpoint and that is roughly about $9 million to $10 million per year of additional tax deductions that we can take each year for 10 years.

Okay. I guess final question from me, and I guess this would be for Eric. Just the last sort of class of acquisitions, which would be Herley, Integral and CEI. I was wondering, obviously 2013 is probably going to be a bit of a strange year. But, based upon what you see today, what do you see as the growth rates of those kind of three generic businesses in 2013, and what would you view as sort of their normalized longer term growth potential?

Okay. So on Herley for 2013, that business will probably be approximately flat. Okay?

However, there is a -- there are a couple but one in particular, there is a very large opportunity that we believe we're going to win. And, if we win that at the end of this year, starting in 2014, it could grow 5% on top of, say, $185 million or $190 million -- $180 million, $190 million base, something like that. All right? It could if we get this, and this is one I think we're going to get it.

On CEI, CEI is going to -- CEI performed spectacularly. It performed as good or better than we thought that it would perform. We are forecasting it to grow in 2013.

However, some of these international items and some of these other items we can not talk about come online. CEI could grow 5% to 10% a year, starting in 2014. It's going to grow, and we have it forecast to grow in 2013. I feel stronger about it growing in 2014 based on some of these procurements that are coming.

And we are basically sole source to the Air Force for aerial drones, sole source to the navy for aerial drones. I believe we're very shortly going to be sole source to the army for aerial drones and international defense -- departments of defense want to fly the same equipment that the US Air Force, US Navy and US Army flies, and that is really helping us.

Integral Systems. In 2013, Integral Systems is actually going of to be down slightly from 2012. Let me tell you why. Because one of the largest recompetes in our Company came up, and we won it, thank the Lord, in December. And it's a six or seven year procurement, and it was CCSC, the Command and Control of the Space segment. We won it.

It's been renamed to something else now. And there was one bidder against us, and he bid low, low, low. We won on technical quals. So initially out the chute, because that was a long-term contract of ours, that is going down a tad this year because of how we had to bid.

However, similar to Herley, we are on a number of opportunities that we are bidding on and this is in the strategic MIL SATCOM area. These opportunities are going to happen, and, if we win any one of these, we could see a 5 %, 10% growth rate there starting in 2014, if we win them. So this is not tactical SATCOM, it's strategic SATCOM.

So those -- that's the landscape for those three. And they are working together. As you know, Herley, and we've integrated the businesses, they manufacture the ground control stations that fly CEI's aircraft. And they manufacture a significant component of the avionics and aeronautics that are in them. So, if we're successful with CEI, which I believe we're going to be that could be a one plus one equals three for us, because we provide into those.

In addition to that, on the Integral Systems side, we have not been able to put out a press release on this. We probably may never able -- be able to do so. There was a ballistic missile test shot that the MDA announced a couple of weeks ago. The USS Lake Erie was involved.

We built the target. It was our medium range ballistic missile target. Very importantly, it was tracked with information passed off by a satellite. Integral Systems is involved in that aspect handing it off to Aegis System which were also involved in. So the pieces are all coming together for us on these three.

Thank you very much.

John Nelson, State of Wisconsin Investment Board.

I want to thank you and your team for managing through this difficult -- especially difficult defense environment that we're experiencing. The -- my question's related to, first, why don't -- could you tell us a little bit more about the -- what's encompassed by the critical infrastructure security business?

Sure. And, John, when you ask what's encompassed, some of the major programs we're on, what we're doing right now?

Yes.

Absolutely. One of our largest customers is the MTA of New York. We are involved with MTAs mass transit authorities across the country including on the West Coast. One of the largest one is in New York.

In the past week, you may have seen that the New York MTA is receiving several hundred million dollars of federal funding to rebuild their infrastructure and their subways, et cetera. Well, under the ground, we are one of the primary contractors that engineer, design and deploy very sophisticated security systems including video surveillance, access control, thermal imaging cameras and some other elements we cannot talk about that are monitoring, basically providing ISR underground in the MTAs, in the tunnel network.

We are also involved with another municipality. This one is on the West Coast. We are putting wireless surveillance apparatus in their bus network and in their other mobile transportation network elements. It's a several million dollar opportunity.

Some of the other big programs we're on are in the petrochemical area. This is going very, very good for us right now. This has to do with security systems; thermal imaging cameras; CBRNE, chemical, biological, radiation, nuclear and high explosive sensors at the refineries on the transport, the pipelines and the electrical transport. This is wireless and wired, all tied into a command and control infrastructure.

And, John, very recently and sadly we just were briefed on this in the past couple of weeks, we are seeing an uptick in the education area and putting sophisticated security systems at schools. So that's what's happening right now in that area.

Okay. With regards to this -- the infrastructure security business, are you devoting enough resources to, both in the commercial business and in the municipal business, to fully develop these opportunities?

Right. John, this is an area that is a real opportunity for this Company, because it is not being impacted at all whatsoever by the federal budgets because of the customer base. We are all over this one.

We actually -- very candidly, we -- Deanna and I and the executive team made a decision with the president of that division to put back into that business $2 million of additional training this year. We could have taken it to the bottom line, additional EBITDA. We put it into training for the specialized engineers and technicians that are deploying these systems, because the opportunities we see here are so great.

This critical infrastructure strategic asset security area in this country is very, very strong right now. It's as strong as we have seen it in a long time. And we think it's because of the threat profile that we're seeing and also because, in certain areas the economy's coming back, and there's building going on, and state-of-the-art security systems are being put into it. And we are absolutely dedicating the resources to this.

Great. Can you throw out for the shareholders a possible -- an estimate as far as the potential growth of this business over the next three to five years? Either in terms of the total addressable market or in terms of what your goals are for the Company for those divisions.

We are expecting this business to organically grow at least 10% a year. At least -- that's the bottom of it -- at least 10% a year.

Okay. All right. Good. The other -- my last question is regarding the increased R&D. Without going into anything classified, can you give us a general idea as to where the money's going?

Yes. A significant amount of the money is going into this anti-access area denial thrust that the new defense strategy is pushing which has to do with the Pacific Rim. And, John, it has to do with -- basically what's happening in the industry right now, and it's accelerating right in front of us, is virtually anything tactical that is supporting the Army or the Marines is getting de-funded and de-scoped significantly.

Significant money is coming out of fighting asymmetric warfare against -- in Afghanistan and Iraq. The money is being shifted right now to strategic platforms. So you heard me mention before strategic satellite communications. So these are ISR satellites that are [geos]. These are not tactical COM satellites that people are talking over necessarily.

There's a significant amount of funding going into this areas because of the pivot to the Pacific. We have R&D going into the strategic SATCOM area. In the aerial drone area, you may have seen in the past month, that MALD, the miniature air launched decoys, we build the aircraft for those UAVs. Those are now going to be put on the Predator and the Reapers. Okay?

We are putting R&D money into exploiting our portfolio of items in the aerial drone area, onto other platforms. And, again, the primary reason is because the vast, vast majority of drones today are propeller planes, and they were designed to fly in uncontested air space where we own the sky. And, consistent with the pivot, now they are looking that the next generation has to fly in contested air space where we will not necessarily own the sky. And that is where something like the MALD or the CHAMP, that's another program we're involved in, very interesting electromagnetic drone, CHAMP. We're putting money into areas like that.

And then on the electronic warfare and electronic attack side, a lot of this we can not talk about, but I will say that, as we all know, our government has put billions of dollars into the electromagnetic spectrum, into communications. And so protecting that electromagnetically and then attacking the other guys through electromagnetics, those are areas where we're putting R&D.

And is there -- are there -- what are the possibilities of eventually, if not immediately, making use of some of these -- of your R&D developments and carrying them over to the -- either the municipal or commercial side as far as the infrastructure?

Right. It's -- there is not a link there, John, on those IR&D developments because those IR&D developments I was talking about literally are, if we face a potential nation state adversary. Versus the municipal products, it's a different type or a different threshold of technology -- It's different. We are putting our IR&D, if you will, on the critical infrastructure security side is going into the people and the engineers and the technicians and deploying these systems to satisfy the opportunities that we have.

Okay. Good. All right. Thanks very much.

Michael Ciarmoli, KeyBanc capital.

Eric, maybe if we could just follow up. You mentioned the Integral Systems. You won a recompete. The business is going to be down presumably because you had I guess a low bid. You've got to be more competitive.

How are you assessing that environment across your other contracts that are coming up for recompete, just accounting for either reduced profitability or revenue because the competitive environment's just the way it is? Is that something we should be thinking about as it might be a little bit of a headwind to the top line?

That's an excellent question. Michael, literally any type of services bid, that's a generic services bid, where we don't have a product or some IP that can differentiate, it's turned into a cost shoot-out.

Let me give you an example of that. In the last month, we -- a very large bid we lost. It was on the LCS trainer. And, overall, it was $200 million to $300 million worth of opportunity, cubic one. Okay.

We, on the Sunday before we submitted the bids, I was on the phone with our division President and I was worried we had bid too low, and we were going to be risked up where the customer takes your bid and they say you can't do it for this, and they risk you up, and they add dollars to your bid. Okay? Okay.

We lost. We came in third place. The guy that beat us, the guy I just mentioned, tens and tens of millions below us. I have no clue how they don't blow their brains out on this thing. Okay.

So we are -- where it's a pure services type of opportunity, we are looking at these, and we are assuming if we're going to win, we are going to take a 20%, 30%, 40% haircut on the recompetes. The good news, Michael -- the good news is, in the last two years, knock on wood, we've gone through our recompete cycle. We're bolted in now, no major recompetes. I think the next big one of any size that comes up is where we're running a range, and it's four years from now.

Okay. That's helpful.

Yes. Our business -- the services business going from $250 million to $100 million over the past three years, that's where we've just had our clock cleaned in these recompetes.

Got you. How about just to stay on the contracting environment. What sort of expectations do you have baked in for this year, new bookings, new orders flowing from IDIQ contracts that could potentially be pressured or targeted since the DoD has a lot of flexibility not to execute on those contracting vehicles?

Another great question. That IDIQ and that MAC area is getting crushed. Those task orders that used to be -- if it used to be a 10 year MAC or a 10 year IDIQ, you'd see a 5 year or a 10 year task. Now we're seeing one year task, six month tasks. I think I mentioned this before, we've literally seen a couple of one month tasks with 59 months of options.

Okay.

Okay? So thank God, very, very, very little of our business in our forecast is under IDIQs.

Okay.

It' single. We have built the Company now on single award contracts. Even in the services business that we have left, very little of that's on IDIQ's. They're single award contracts. We have a bunch of IDIQ vehicles that we spent a bunch of B&P on over the last five years, and we're getting killed on the task orders.

Okay, last one from me. How would you -- if you were to look at your program portfolio going into 2013, your top handful, your top five programs. How do you feel about the risk around those programs either on -- I guess we know what they would be under a 10% haircut. What about more a surgical haircut if the DoD has some discretion? Do you feel confident in the stability and sustainability of your top programs?

We really do, and let me tell you why. Let me give you an example, okay?

Many of our top programs has to do with strategic satellites and geosynchronous orbit satellites. The reason I feel extremely comfortable with those, because I don't think it's practical to shut down a satellite or de-orbit a satellite or re-orbit a satellite or put a satellite on furlough to save money, especially if you do that, now you have a hole in your constellation. You've got a hole either in your COM constellation or your ISR constellation or your missile defense constellation. So, I just believe those are going to be funded, because the cost benefit analysis is incredibly negative on something like that.

In the aircraft area, the longer the F35 gets pushed out, the better it is for us. You know, because we're on the 18G. We're on the F18. We're upgrading F15, F16, I mentioned one of those earlier, so we feel pretty good about that. However, Michael, if sequestration as written by law does happen, which I just don't think it is, but if it does, that 10% cut over time will catch us.

Right, right.

Because if we're on a five year production contract, we're three years in, even if it doesn't get re-scoped, three years from now if it comes up in the middle of a 10 year sequester, we're going to take a 10% haircut. Right? But I just don't think it's going to happen that way. I think discretion will be given to the Pentagon.

Okay. Okay. That's fair. Perfect.

That's all I had. Thanks, guys.

Tyler Hojo, Sidoti & Company.

So just a first on a question on goodwill. Not all together that familiar with the acquisitions that you made a few years ago in the government services business. How much goodwill do you think is remaining on the books from those assets that you acquired?

What I can tell you, Tyler, is the acquisitions that we made prior to 2009 which were -- they were primarily all services businesses. The goodwill that we had remaining at the beginning of 2009 was $110 million. So the impairment that we just took is related to goodwill was about $85 million, $86 million, and that was substantially related to that business. So there is some left but not a sizable amount.

Okay. So if you look at this government services business at $100 million today, Eric, where do you think the bottom is?

Right. I think the bottom for us is $70 million to $75 million, because there are a handful of core contracts that we have that go through 2016, 2017, 2018. Basically, when they were up last time, we won them sole source because of the nature of the work.

I think between now and then we could continue to see a $5 million or $10 million a year nick here and there as some task orders come up if we don't -- if we're not successful. The big drop off is over, though. It's done. I think at $70 million or $75 million, we're bolted in.

Okay. Again going back to the goodwill impairment test, I haven't gone through the K yet. Maybe there's some detail in there, but could you maybe talk about some of the recent acquisitions and how they kind of fared, how much cushion there is in regards to the -- kind of the impairment test?

How we do the impairment test, Tyler, is we look at the entire segment of KGS, Kratos Government Services, so we look at the --

Okay, got it.

It's all at that reporting unit level. We don't actually drill down to each unit because it's at where we're reporting our segments. So it's all at that top level.

Okay. And there's pretty good synergies between all those assets.

Yes.

Okay. Got it. And just a follow-up to the R&D spending question before.

Eric, you mentioned in some of your prepared remarks that you had a little bit of flexibility to kind of rein in some of the growth on that spending line item, if need be. I'm just kind of curious what kind of production time line does it take to kind of see these three areas that you mentioned from start to finish? Is it like 12 to 18 months or how do you think about that.

Yes. In the satellite communication area and in the electronic product, electronic warfare area it's 12 to 18 months at most. It's very quick.

Got it. Okay.

And the unmanned area, 36 months.

Okay.

Aircraft.

Okay. But that's kind of the longest that you have, about 36 months?

Yes, in that ballpark, yes.

Just a clarification, Deanna, if you don't mind. You mentioned the $0.15 pro forma earnings number on the cash tax pay for Q4.

Yes.

Could you just walk through the math one more time in regards to how you derive that number.

Sure. There's actually -- I don't know if you pulled the financial tables that was attached to the press release. There's actually a table on the last page that walks through each item. But it's -- you take the loss from Continuing Operations, because it is before Discontinued Operations. We add the -- which is $96.5 million of a loss.

You add the amortization of intangible assets of $11.5 million. You add the $96.6 million of the impairment of intangible assets. You add the close-out of the acquired contract settlement of $3.2 million.

And then you back out the credit, the gross credit of the M&A related items of $5.4 million. So you get a net adjusted income from Continuing Ops before income taxes of $9.4 million minus $1 million of cash taxes to get to $8.4 million, divided by the 56.6 million shares.

Yes, I definitely missed that table. I'll go back and look for it.

It's just the second to the last table.

Okay. Got it. Thanks so much.

Greg Konrad, Jeffries.

Just a quick question, just to go back to Public Safety and Security. The results in the quarter were quite good on the revenue line. Is there still any disruption there from Sandy, or is that business pretty much all back online?

It is not 100% back from where we thought it would be because of Hurricane Sandy. And that you can see, that there are still certain areas in the MTA network that are not 100% back online, and there is still damage in there, and the resources are still allocated to fix that. I believe, we believe Q2, it should be coming all the way back, definitely second half of the year.

Okay. And then just in terms of within PSS you had intangible charge. Is that -- is there any legacy government business in there or what is that intangible charge related to, the $12.9 million.

Greg, that's related to the trade name of HBE. When we originally acquired HBE, we had expected to use that trade name of HBE indefinitely, and the decision was made from a branding perspective to no longer use that indefinitely. So, because of that decision that we made that we would not use that trade name indefinitely, that resulted in the impairment of that as well as the acceleration of some of the amortization that now will be amortized for the remaining value of the -- that trade name.

So it has nothing to do with the government business, it is just related to the assignment of purchase price allocation when we originally acquired HBE and our original expectation to use the name -- the trade name indefinitely.

Just last question. I know that there was a press report that there were a couple small amount of furloughs. And on all the calls we've heard a lot about defense contractors kind of taking on infrastructure, headcount just to be more competitive and kind of prepare for uncertainty. Are there any initiatives that you can point to kind of to look at your infrastructure and headcount?

Oh, yes. On the infrastructure side, for the past two years we've been aggressively consolidating our facilities, aggressively. We have a major matricy. We have one of the executives who is specifically assigned to this of every facility that's in the Company, where they are, when they come up, and how we can co-locate them when they -- when leases some up and that is ongoing.

This year is a big year for us as it was a couple three years ago. We've got some big facilities coming up that we're going to be consolidating and reducing down. When you do that, what goes with that, and we have a separate initiative on this, is all the IP egress, ingress points across the Company, we have multiples of those. We have an initiative right now, we're going to take that down to two by the end of this year which should, going forward, result in a significant cost savings.

In addition to that, we've made a decision and we're rolling out on this and we should have this done by the end of the year, is that we're going to be consolidating some of the communication in the Company, some of the carriers in the Company.

On the travel side we have an initiative going right now. We're going to have this in place in the next couple, three months where we are going to be negotiating with the three or four major carriers, major discounts on travel where we're mapping that out with a consultant, on the various routes we get to reduce that cost down. We have been aggressively doing this across the Company.

Thank you.

(Operator Instructions)

Yair Reiner, Oppenheimer.

First, Deanna, could you review the organic data? It went by pretty quickly in the beginning of the call.

Sure. So on -- what I did was compare apples-to-apples, Q4 2011 as if we had acquired CEI and the critical infrastructure business. So on an apples-to-apples basis the organic growth was 1.3%. If you strip out the impact of the 21.6% reduction year-over-year in the traditional services business, then that organic growth rate was 3.9%.

Got it. And did you provide what the organic rate would have been if you look at the businesses you had last year at this time how they would have done relative -- they would have been doing now without the acquisitions you have had in the interim.

And that's -- and the reason why that was difficult to do, and we looked at it, is because, as I mentioned a few minutes ago, Herley, for example is a significant provider to CEI of electronics and avionics. And now that we have merged with CEI and we own them and Herley, the revenue from Herley to CEI gets eliminated, because you can't count it twice. You do get -- you get the profit of course if it's a commercial sale. On the government side you have to be careful.

Similarly, with some of the other businesses in our unmanned systems business, we've moved the ground control area. We have built ground control stations that fly -- unmanned systems. That's in our UAV segment as well, so it's combined in there. So it's truly integrated which is why we didn't strip it out, because it's getting lost through the integration.

Got it. And then if you could just -- you provided some useful information about the sequential trends in the quarter that you're expecting in terms of the year. Can you maybe give us a sense of how you expect KGS versus PSS to line up over the course of 2013?

Yes. I -- we gave them on the Company as a whole, and, very candidly, I don't have that handy. Deanna? We don't have that handy. We're just giving it for the whole Company consolidated.

Yes.

Great. Thank you.

Bhakti Pavani, CK Cooper and Company.

Just a couple of questions. You -- Eric, you talked about how the contract has been changed in the IDIQ. Taking into consideration the sequestration scenario, how has your strategy towards the bidding on the contract changed?

And the second question is are you experiencing the same kind of commoditization or cost problem on the product side as is happening on the services side?

Right. So, on the first part of your question, Bhakti, back in 2009, right after this administration came in, and they started what was called the better buying power initiative, okay? This is what caused us to change our strategy to go away from services.

If you go back and you take a look at that initiative, it lays out that they're going to move to MAC contracts and that they're going to shorten the tasking. That they're going to go to lowest price technically acceptable, and that they're going to increase the amount of small business set-asides. So, we started going away from or de-emphasizing the services business right after this administration came in, and he said the rules are going to change. And then on top of that the following year he came out, and he said we're going to start in-sourcing 40,000 or whatever number of contracting jobs there were.

So as we sit here today, not because of the sequestration, but because of the procurement policy change that the administration put in, it just worked out for us that very, very little of what we do is under MACs or IDIQs right now. And it's a good thing because very -- more often than not when we bid on those, we are losing. We are losing horribly on the cost side. We are getting under-bid.

So our bids, the vast majority of the bids we are involved in, vast majority. I'm not talking 50%, i'm talking on the government side, 90% plus, these are single award procurements. You bid, you win, you get funded and you start to work and the vast majority of those are product-centric where we are either manufacturing a product, or our work is around our product or the government's product.

So there's some differentiation which is playing into our favor right now under the current sequestration rules, because, under these current rules, what we're seeing, and we haven't -- it hasn't hit yet, is the services side is going to take a hit. Because, if you just think about it logically, if you've got a five year production contract, as I mentioned before, if you're going to renegotiate, that you're going to pay. There is going to be a request for equitable adjustment versus when your services task orders come up every six months or three months or nine months, you just cut the contractor's workforce by 10% or 20% and you hit your sequestration objective. It's a lot easier.

Also talking about the $1.9 million backlog that you have. Taking sequestration into account, what is the probability of the already awarded contracts being cut? If you could provide some color on that?

Okay. Deanna, the backlog number.

Backlog is $1.3 million, Bhakti.

Oh. I'm sorry.

Bhakti, I don't know the answer to that, but I -- but tying into what we've been saying consistently on call, I think it's very, very, very low. Very low, that that backlog, any material or major portion of it would be cut because of the nature of the work that we do or the long-term nature of the production contracts that we do.

Okay. Just my last question. What is the depreciation and amortization should be expected in 2013?

Yes. So the amortization is $36 million, Bhakti, and the depreciation is $17 million.

Okay. That's it from my side. Thank you very much.

This ends our Q&A session for today. I'll turn it back to Management for closing remarks.

Very good. Thank you for joining us this afternoon. I believe our next scheduled discussion will be when we report Q1. Have a good afternoon.

Ladies and gentlemen, thanks for participating in today's program. This concludes the program. You may all disconnect.