Kratos Defense and Security Solutions Inc (KTOS) 2013 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions first-quarter 2013 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions).

I would now like to turn the call over to Laura Siegal, Vice President and Corporate Controller. Please go ahead, ma'am.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions first-quarter 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 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 the Kratos corporate website at www.Kratosdefense.com. It is also available on the SEC's website. 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 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 the Form 10-K and our Form 10-Q, 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. 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 acquisition-related items; amortization of purchased intangibles; and using a cash tax rate.

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 first quarter of 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 the call up to your questions.

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

Great. Thank you, Laura, and good afternoon. Kratos is off to a strong start for 2013, and we are affirming our previous full-year 2013 financial guidance, which Deanna will discuss in a few minutes. Kratos' Public Safety and Security business exceeded our revenue expectations in Q1. And PSS backlog, and bid and proposal pipeline, continue to remain at or near all-time high levels. We believe this is due in part to an overall heightened security awareness in our country.

PSS margin rates were down in Q1, as we had to bid low to in certain very large municipality and mass transit authority opportunities, which are very strategic. Now that we have won these contracts through scope changes, scope expansion and efficiencies, we expect our PSS business's margins to increase as we go forward, especially in the second half of the year, which is typical in large security system integration deployments.

Accordingly, we believe that we will see growth and margin rate expansion in PSS throughout 2013, with continued strong demand for Kratos' security and video surveillance systems at critical infrastructure sites and at municipal locations. Since we reported Q4, a number of programmatic events have occurred, which are very important to Kratos' overall business, our 2013 business plan, and our future prospects.

The U.S. Navy announced that it plans on increasing its EA-18G Growler by up to 21 aircraft in 2014 as compared to 12 in 2013. The Growler is one of Kratos' largest programs, and we believe that this planned increase is representative of the U.S. DoD's prioritization for electronic warfare and dominating the electronic spectrum. Additionally, Australia has announced that it will be ordering 12 EA-18G Growler's in 2013, and is also considering acquiring 24 additional F-18 Super Hornets.

Also, related to EW, Kratos' CWIP team recently received an important award that we are now performing on. And we are positioning for a new significant CWIP award later on this year. The U.S. Air Force awarded contract Lot 6 for the production of 202 MALD-J aerial vehicles. MALD is an EW decoy and jamming aerial drone. It's an important Kratos-supported program where Kratos provides the aircraft.

The Pentagon has requested $220 million in additional 2014 funding for Israel's Iron Dome missile defense system compared to $70 million in 2012. Kratos provides a number of electronic products in support of Iron Dome and other Israeli missile systems and radars.

The Obama Administration has announced the deployment of an additional 14 ground-based interceptors in Alaska. Kratos provides electronics in support of the GBI Kill Vehicle. The wideband global satellite constellation, which cradles ground equipment supports, has four satellites in operating orbit. WGS-5 is scheduled to launch later this year. Five additional WGS's are in various stages of production, and DISA has just recently indicated they would be open to potential additional WGS's in the future.

At the end of March, the Air Force successfully launched its second space-based infrared system geosynchronous orbit satellite. The U.S. Air Force is in various stages of producing or operating six SBIR missile defense-related satellites, and Kratos provides ground equipment and software in support of this program.

Q1 was the first time in the last four quarters that Kratos' book to bill ratio was less than 1.0 to 1, which was not unexpected, with the federal agency facing a potential March 27 funding abyss. Importantly, Kratos' backlog remains basically unchanged from Q4 at $1.2 billion. Kratos' last 12 months book to bill ratio remains at 1.1 to 1, and there is now a federal and DoD spending bill in place.

Over the balance of 2013, we expect to receive certain large production or locked purchases under existing Kratos-supported programs, which include AFSAT, ARAV and MALD. And we have a number of large DoD federal agency and international security opportunities we are pursuing, including in the cyber software product area, EW, radar, Aegis, missile defense, and the ISR areas, where awards are currently expected to be made in the second half of '13. Accordingly, we expect Kratos' full year 2013 book to bill ratio to exceed 1.0 to 1.

In the aerial drone area, we have accelerated our planned investment for two new types of Kratos CEI aircraft from our initial 2013 budget, due to customer opportunities that have materialized faster than we originally anticipated, and where demonstration flights will now be required in the second half of this year. We believe that certain of these accelerated opportunities have been pulled forward as a result of security-related global and geopolitical events, some of which have recently been in the news. And if we are successful with these flights, this could help position us well for 2014 and beyond.

The IR&D, NRE, and capital spend for these aircraft of approximately $3 million, which was previously planned to be incurred throughout all of 2013, will now be substantially incurred by Kratos in our second quarter, so that we can meet the accelerated customer required flight schedules. Accordingly, the acceleration of these aircraft builds will result in our being at the low end of our forecast Q2 revenue range, as these capital Kratos-owned aircraft we are going to manufacture in Q2 are going to be replacing customer-destined aircraft on the production line. The customer aircraft will now be manufactured in Q3 and delivered in Q4.

There will also be a resulting slight shift in EBITDA margin rates between Q2 and the second half of the year. Full-year Kratos 2013 revenue and EBITDA are expected to remain as we previously forecast, as this is just a shift between quarters. And we have confirmed that Kratos customers do not have an issue with the change in delivery schedule under the existing contract vehicles. Deanna will also cover this in more detail in her prepared remarks.

As I mentioned a moment ago, we now have an FY '13 DoD appropriations bill, which includes sequestration cuts, and which also provides the DoD with some spending prioritization or flexibility. As a result, we are seeing some order delays and push-outs on certain programs, with other programs like EAG 18 and Trident being solidly funded. So, net-net, the overall federal procurement and funding environment remains extremely choppy.

Interestingly, the President's FY '14 DoD budget request of approximately $527 billion does not assume sequestration. And as you know, Kratos' guidance also does not include a sustained sequestration scenario. Accordingly, the DoD budgetary situation remains very unclear, and ultimate resolution of a FY '14 federal budget -- hopefully, later on this year -- will be an important data point for Kratos and the entire industry.

Irrespective of these near-term budgetary challenges, we continue to believe that strategic and foundational national security capabilities, including MILSATCOM, RFI, ISR, EW, missile defense, radars, aerial drones, cyber, and the ability to operate in an Anti-Access/Area Denial environment, will remain priorities, and that the Administration's FY '14 budget submission, recent requests and events confirm this.

Deanna?

Thank you, Eric. Good afternoon. Our first-quarter revenues of [$252.8 million] came in above our expected range of $235 million to $245 million, due in part to stronger demand in our Public Safety business, as well as the timing of shipments in our Specialty Ground Equipment business. Our revenues increased year-over-year 20.7% from $209.5 million in the first quarter of 2012. Excluding the impact of CEI, our revenues grew organically 8.3%.

The first-quarter revenues were favorably impacted by strong demand and performance in our Public Safety and Critical Infrastructure business, which grew organically 24.6% year-over-year, and from demand in our Satellite Communications business, our Cyber Security business, and the timing of shipments in our Specialty Ground Equipment business. These increases were offset in part by continued compression in our Legacy Services business, which contracted an additional 12.4% compared to the first quarter of 2012. However, the Legacy Services business remained stable on a sequential basis compared to the fourth quarter of '12.

Our adjusted EBITDA of $27 million for the first quarter is from continuing operations, and excludes acquisition-related items and stock compensation of $2 million. From an operational segment perspective, our Government Solutions segment generated $202.2 million in revenues and $24.7 million in adjusted EBITDA or a 12.2% adjusted EBITDA margin.

Our Public Safety and Security segment generated $50.6 million in revenues and $2.3 million in adjusted EBITDA or a 4.5% adjusted EBITDA margin. Our Q1 PSS operating margins were impacted by investments we made by bidding low to win several large strategic mass transit contracts we are now performing on. We have already received an expansion of scope on one of these programs, and we intend on remaining aggressive to bid on, and hopefully winning, additional large strategic deployments in the future.

Historically, on large security deployments similar to these, we realize increased margins later on in the program, due to scope expansion and execution efficiencies. PSS operating margins in the quarter were also impacted by internal investments we are making in infrastructure areas, which include training programs -- which we mentioned last quarter -- which we believe will result in future operating efficiencies. On a GAAP basis, net loss for the first quarter was $10.3 million, which included a loss from discontinued operations of $2.1 million, $9.3 million of expense related to amortization of intangible assets, as well as a $2.8 million income tax provision.

We continue to believe it is also meaningful to provide our earnings per share, excluding the amortization expenses, and reflect any cash-pay income tax. On a pro forma basis, EPS from continuing operations, excluding the amortization, merger-related items, and utilizing the estimated average quarterly cash-pay income tax provision of approximately $800,000, was $0.06 per share for the quarter.

Moving to the balance sheet and liquidity. Our cash balance was $51.6 million at March 31, plus $5.3 million in restricted cash. For the first quarter, we slightly exceeded our expectations at breakeven free cash flow. We've generated $5.1 million in cash from operating activities and $1.8 million of adjusted free cash flow after taking into consideration capital expenditures of $3.3 million.

Our cash flow generation was impacted by an increase in our DSOs to 101 days, which occurred primarily as a result of several large contractual milestone billings, which we anticipate will be met in the second half of the year, as we achieve the contractual milestones, which will allow us to invoice the customers under these contracts. We continued to target DSOs of less than 90 days, which we believe is achievable as we expect that, as these milestone-related contractual payment billing terms are met, that we will be able to continue to reduce the overall DSOs and generate additional operating cash flow.

Using the recently recent quarterly revenues, a four-day reduction in DSOs is equivalent to approximately $10 million in cash flow generation, and a return to the 94-day DSO level that we were just recently at, at year-end, is equivalent to $20 million in cash flow generation. As our revenue mix is more products-focused now, our DSOs can tend to fluctuate due to the timing of shipments and satisfaction of billing milestones. Our contract mix for the first quarter was 77% of revenues generated from firm fixed price contracts, 15% of our revenues from cost-plus fixed fee contracts, and 8% from time and material contracts.

Revenues generated from contracts with the federal government were approximately 65%, including revenues generated from contracts with the DoD of 62%, and revenues generated from contracts with non-DoD federal government agencies of 3%. We also generated 7% of our revenues from state and local government, 16% from commercial customers, and 12% from foreign customers. Backlog at quarter-end was $1.2 billion with $604 million funded.

As we look forward even, though we are off to a strong start for the first quarter of 2013, due to the current sequestration and significant federal budget uncertainty, we are affirming our previously provided guidance of revenues of $950 million to $1 billion; adjusted EBITDA of $115 million to $125 million; and free cash flow generation of $50 million, with a slight shift between quarters and revenue and adjusted EBITDA margin rate, as result of the aerial drone target opportunities that Eric mentioned earlier.

Specifically, these accelerated opportunities will result in increased Q2 R&D expenditures from the current quarter level of 1.9% of revenues by over approximately 100 basis points. In addition, Q2 revenues will be impacted somewhat by the delay in the customer production aircraft Eric mentioned earlier, that were originally planned to be shipped in the second quarter, and now are expected to be shipped in the fourth quarter. This will result in a shift of revenues and the associated profit, which generate healthy margins, also shifting to the fourth quarter.

Accordingly, to reflect this movement between quarters, the quarterly breakdown of our revenue guidance is now comprised of the second quarter at $230 million to $235 million, the third quarter at $230 million to $255 million, and the fourth quarter at $240 million to $255 million. Additionally, Q2 EBITDA margins are now forecast to be between 10% to 11% to reflect that R&D spend, and fourth-quarter EBITDA margins of 13% to 14%.

As a reminder, our free cash flow guidance of $50 million for 2013 is from continuing operations, excluding acquisition-related items, after-interest payments, and capital expenditures. This is derived by the $115 million to $125 million adjusted EBITDA, less the annual interest on our notes of $62.5 million, after estimated capital expenditures of $14 million to $19 million, payment of taxes of approximately $3 million in cash, and 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.

As a reminder, our interest payments on the notes are paid in Q2 and Q4, so typically, these are lower cash generation quarters. We currently expect the milestone billings mentioned previously to be collected in the second half of the year. Also, as we stated in our last quarter conference call, and as Eric mentioned earlier, we have not included the impact of a sustained sequestration scenario in our estimates. We do continue to believe that, if necessary, we can adjust discretionary investments we are making in research and development, and capital expenditures, to maintain or enhance our EBITDA and free cash flow targets.

Finally, as you know, the no call on Kratos' bonds lapses in June of 2014. Due to the current, extremely favorable debt market conditions, and with Kratos' bonds consistently trading near 110 currently, we have started analyzing what a refinancing of Kratos' debt would look like under various scenarios, if affected over the next 12 months.

As we mentioned on last quarter's call, a refinancing under current market conditions could result in a significant reduction in Kratos' interest rate and annual cash pay for interest, with the estimated enhanced annual cash flow accreting to Kratos' equity. Our objective in an ultimate refinancing of Kratos' debt would be to significantly reduce Kratos' cost of capital, annual cash pay for interest, ultimately improve our credit position and our ability to pay down the debt, and increase the equity value of the Company.

I will now turn the call back over to Eric.

Great. Thank you, Deanna. With that, we'll turn it over for questions.

(Operator Instructions). Mike Crawford, B. Riley & Co.

Thank you and we're pleased to see the strong revenues. One thing regarding the strategic priorities is that we have seen some programs -- money shifted to some programs that didn't appear to be in any budgets, like say a THAAD battery in Guam. So, clearly, there's some shifting going on, but we haven't seen any clear top-down directive from the DoD regarding more institutionalizing this practice. Do you expect to hear more politically on this front? Or how do you see this shaking out?

Actually, Mike, the Assistant Secretary of Defense came out just a few weeks ago and specifically said that the shift to the Pacific and funding of Anti-Access and Aerial Denial capabilities are an absolute priority, and they will be strongly funded irrespective of what happens to the budget. That is -- was a very important data point in the speech that he made that we pay close attention to. Because, as you know, we support numerous of these strategic programs and platforms, including THAAD -- that one you mentioned -- that -- with the batteries being deployed.

Okay. Thanks. And then on the Growler, one of your largest programs, actually, it looks like GE just got an award from the Navy today to produce six more Growler engines.

Yes.

So this is a platform clearly that's going to fly many years into the future. In the past, there's been talk of a next-generation Jammer or even using the Joint Strike Fighter for EWEA functionality. What would be the pros and cons of using like a -- particularly the Joint Strike Fighter for that?

Yes. In the electronic warfare area, Mike, there is a significant discussion going on right now regarding stealth, which, obviously, is supposed to be invisibility to detection. But if you have an aircraft that's a fifth-generation stealth aircraft, and it's loaded up with EW and EA electronics, et cetera, that radiation hypothetically could give that platform away.

And a lot of this is stuff we can't talk about in an unclassified environment, but one school of thought is that is why significant additional amounts of money are being put into the Growler and other EW platforms. And it's expected to continue into the future because of that issue I just mentioned relative to stealth.

Oh, okay. Thank you. And you did have solid performance in the PSS sector. I imagine the bookings -- have you seen a material increase in bookings just in the past month there since the attacks in Boston?

We have seen a significant increase in the number of Requests for Proposal and Requests for Information in the past 30 days. Significant.

And what's the cycle on something like that?

Some of them are very, very near-term. It's 30 to 60 days. The large ones can be -- in this business, can be six-month procurements.

Okay. All right, thank you very much.

You're welcome.

Mark Jordan, Noble Financial.

The first question is relative to the drone initiative you have underway. Many times -- again, this is being self-funded, obviously, that means that you're taking a unique concept to the table that the military finds intriguing, but yet hasn't decided to fund directly themselves. Could you discuss what unique capabilities CEI has that allows you to put together a package? And what market it is addressing and the sense of the market size that this could address?

Yes. And Mark, I'm glad you asked that question. Let me bifurcate it into two areas. Number one, we are absolutely being funded right now by certain agencies for new types of aircraft. Absolutely, unequivocally. And that's all we should say on that. On the ones we're -- we are putting our money in to build credo CEI capital assets that we will own initially, so that we can go fly and show the performance characteristics for potential customers.

Mark, this is what it's coming down to. Over the last 10 or 15 years, virtually every -- and I mean that very literally -- virtually every unmanned aircraft has been built to fly in uncontested air space. They're propeller planes. They have big radar cross signatures -- where the US owns the sky. This is for asymmetric warfare and tracking down terrorists and killing them. All right?

With this Anti-Access/Aerial Denial concept I'm talking about, Anti-Access/Area Denial, one aspect of that is contested air space. Contested air space -- fully contested air space, where a potential adversary, like, hypothetically, an Iran or a Syria or a North Korea or somebody bigger, had significant fourth and fifth generation surfaced air missiles. And you need different types of aircraft that have different types of characteristics, different types of speed, different types of performance, to be able to perform either ISR omissions or attack missions in that airspace and survive. That is the exact market we are pursuing.

There is some public information out there on the potential size of this market. It is -- it's as big or bigger than a Predator or a Reaper market. It's multi-billions of dollars. And the budget scenario is actually helping us in a way, because these are much less costly than a $20 million to $30 million Predator or a $200 million Global Hawk. These are multiples but exponentially less costly, with significantly enhanced performance. And there are some opportunities, some customers, they've said we would like you to fly your aircraft for us and show them what you can do. And they've pulled that in -- we expected that occur in '14; they've pulled it in, into the last half of this year. And so we're going for it.

What is the incremental capability you are currently developing so that you can do that demonstration in the second half?

I probably shouldn't talk about that, sir.

Okay. Move to a different subject.

Yes.

The Public Safety and Security business was $50.6 million this quarter. In the fourth quarter, which you described at the time as, I think, being still residual damage from Hurricane Sandy, depressing revenues. Now the sequential growth -- now, obviously, there is some seasonality here, but can you give us a sense of how that group's revenue should evolve through the quarters, given the wins that you have had? And sort of a sense of how they might flow Q3 through Q4?

Right. Overall, Mark, for the year, I think our PSS business last year did just over $180 million in revenue. I believe that's where it came in. We are looking for it this year to do well north of $200 million in revenue, and we are off to a great start on that. Okay?

We -- I would envision right now what I would see, I think Q2 is going to be somewhere near where Q1 is. Okay? But Q3 and Q4, we've got some stuff that we're going to start building out, and I think we'll see a little pop-up -- you know, 5% to 10% each quarter, in Q3 and Q4. The backlog's there. The backlog is there and the bid pipeline is fantastic right now.

A last question, if I may. You've not said anything terribly complimentary over the last year or so relative to your legacy IT business. Do you feel that the programs that you are currently on is a sustainable long-term business in this $80 million to $100 million range, and therefore should not be a drag sequentially in '13 and '14, as it was in '11 and '12?

Yes. We had -- as we talked about in the release and as Deanna talked about, we had a very big drop from year-over-year from Q1 '12 to Q1 '13. However, from Q4 '12 to Q1 '13, it flattened out. Let me tell you why. Because we have no big re-competes until, I think, 2017. We're basically bolted in now.

There may be some small ones here and there, but of any order of magnitude, we've been through the re-compete cycle. And it used to be if you were the incumbent in this space -- in the services space -- the incumbent would win the re-compete 90%, 95% of the time. Unequivocally today, unequivocally, in the low-priced, technically-acceptable environment, you are at a disadvantage big-time if you're an incumbent.

So, crisply answer your question, I think we have stabilized, and I think we are going to remain stable for the next three, four, five years for the primary reason no major re-compete are coming up.

Okay. I lied. One last question. In your comments, you talk about the potential for refinancing your debt. On your fourth quarter call, you established a very defined timeline to refinance that debt in the summer of 2014. Is it fair to say that that has changed, and if opportunity presents itself, what you have said is that you will -- you could see that done at any point in time between now and mid-year next year, if not -- so, therefore, that would be the worse case, mid-year next year, but possibly before that?

Absolutely, Mark. Our cash flow last year was extremely strong. Deanna and I recently had some very solid meetings with the rating agencies. They -- no question, they understand our business model, our programs, our contracts, the stickiness of them, and how they're lining up. And added to that, the market conditions right now, and if we could do it -- if we were to do it today and tender the notes, the reduction in annual interest payment is significant -- increases cash flow to the shareholders significantly, all of which, of course, accretes to the equity, because we're not making any more acquisitions of any size, if any at all. And, so, this is something we are very seriously looking at today.

Okay, thank you very much.

Thank you.

John Nelson, State of Wisconsin.

Hi, Eric and Deanna, and again, congrats to your team on delivering a very solid quarter and good, strong results on an operating basis. My question relates to the critical infrastructure business. You had mentioned that you had bid low on several major projects to get kind of fully established in this and build your reputation. Is there -- who do you compete against in that business? And has there been much of any new competitors entering the market over the last couple of quarters?

Thank you for the kind words, John. Our primary competitor, historically, has been Convergent, which is a private company that was recently acquired by a private equity firm, I think, for like 12 or 13 times EBITDA to enterprise value. And they are -- we're roughly $200 million in revenue; they're about $300 million in revenue. That is our primary competitor.

There were two large defense primes -- I won't get into the names here -- that were very serious competitors up until a couple of years ago, and each one of them blew themselves up in the industry with customers and issues. And they've kind of exited. However, there is -- there are a couple of large defense contractors that are trying hard to get in this space.

We lost a significant opportunity west of the Rocky Mountains, and I cannot believe how low these guys went. I just have no clue how they're going to do it. None. So we're not going to do anything stupid like that, but on the big ones, $20 million, $30 million, $40 million, $50 million deployments, in the past four, five months, a couple of big guys have been showing up. So that's what's looking like right now.

Okay. And has your assessment or estimate of that critical infrastructure market -- total available market over the next couple of years gone up significantly with what's been happening lately?

John, I try to calibrate myself on stuff like this, but I will tell you, we -- Deanna and I and the team here, we routinely meet with that Division President and his guys. The market opportunity right now -- and we have been doing this for 10 years; it was much smaller, obviously, 10 years ago -- it's never been stronger. Ever. It's incredibly strong in municipality, cities; mass transit, subways and buses; educational facilities -- campuses, healthcare facilities; hospitals -- there are hospitals going up all over the place. All right?

And the energy industry, the pipelines, the refineries are ripping. And another one that has recently come to light in the past six months where there are just an incredible opportunity, it's in protecting data centers -- the switching equipment for the Internet.

So it is extremely strong. I do not envision a revenue issue here. As I indicated, I think there's going to be some margin competition coming, but we've got the past performance quals. We've got the better past performance quals than anybody. And this is not necessarily a low-priced, technically-acceptable area. Best Value does matter sometimes. So we feel real good about the opportunities here.

Okay, good. Are you staffed up enough on the marketing presentation side to grab a fair share? (multiple speakers)

We are continually looking at rebalancing the organization to make sure that we have the right cost structure in place, but we also have enough business development and sales assets in place, so we go after every opportunity that is practical for us to execute on. So, yes, sir.

Okay, thanks very much.

Thank you, sir.

Michael Ciarmoli, KeyBanc Capital.

Thanks for taking my questions. Nice quarter, as well. Eric, if I can just put the pieces together here, maybe back of the envelope, you've got expectations to grow the PSS segment, you said, I guess, well over $200 million. If I were to call that $210 million, $215 million, looking at the midpoint of your guidance, that would assume sort of the government gets into a run rate of the $186 million or so for the remaining half of the year, and kind of trends down year-on-year. Is that the right way to look at it? And if so, what's driving that contraction in the Government Solutions segment?

Right. As we sit here today, our government section sector looks strong, solid. We are definitely -- we have definitely seen -- as we put in our press release and as we talked about -- some opportunities; they're moving out to right. No doubt they're moving out to the right. They're not being canceled -- so this isn't like MEADs or the PSST or something like that that's being canceled. They're moving out to the right.

To answer your question crisply, the budgetary environment is still an unknown. We have not built an across-the-board 10% cut in our $600 million, $650 million of federal budget of business in our guidance. We have not done it. The reason why we haven't done it is because I do not believe that sequestration is currently written by law a 10% cut across the board by cleaning line items, so you only build 90% of a submarine and it sinks. I just don't believe that's going to happen. I could be wrong.

So we are being -- hopefully, we are being cautious, okay? We feel strong about our PSS business so we are putting our foot forward there. That's why I'm saying I think we'll do more than $200 million. I do feel less confident, but not orders of magnitude, on the government side, but I just feel less confident because of the budgetary environment. And, as I said, this 2014 negotiation, this is going to be critical. Because I believe this is going to lay down what we are going to see for the next two, three, four, five years.

Yes. No, that's helpful. That's perfect. I get it. What about reprogramming risk? I mean, do you guys have any insights there? As you look at your portfolio, certainly, it looks like power projection, Asia-Pacific is going to get the resources. As you look at your portfolio of what might be on that list of not getting the resources, how do you size up that risk?

Right. So we have done a program-by-program analysis in our Company. And we looked at the OCO budget -- because, obviously if you are involved with the OCO budget, you've got big, big risk. We have virtually zero in the OCO budget. Virtually zero. Okay? We are in the base budget.

What we are seeing, Michael, is the tactical systems, specifically related to Army and Marines. So these are tactical UAVs, tactical satellite communications -- so small, very small aperture terminals; command post platform -- we're on the command post platform. That has gone to zero. Those are being significantly cut, with money being shifted out of them to strategic platforms. So we've looked at that and we've tried to calibrate what that means.

We -- I believe -- okay. I think the biggest risk items we have -- okay? let's talk about the total combat ship. We're sole-sourced on the mission modules. 20 ships are under contract. They are under contract. They are talking about building 55. I do not believe they will build 55 ships, but I believe they will build 20. I believe that. Okay? So I think that we're good there for the next four or five years, because I don't think they're going to terminate those for convenience, because the cost for seeing those are significant. Okay? So I think there is some risk there.

I think there is a slight risk that when the P-8 goes to full rate production later on this year, that maybe they will build one or two less airplanes a year. And you know, that's a big, big opportunity for us. AMDR -- okay. We are all over AMDR. AMDR recently was de-scoped significantly with the satellite constellation piece being terminated. We were on that in a small way. It's gone. We've taken it out. So we're trying to, as things -- they're fluid, but as things materialize, we are trying to stay abreast of it, and that's kind of the analysis we're going through.

Okay, okay, that is helpful. And, then, just the last one for me. I understand that the low bidding on public security or the public safety, the margins pressured. Is this just going to be, as we see more intense competition here -- I mean, is this going to be the new normal -- ultra low margins? Do you always envision the opportunity to have scope and execution bring you back up in the margin profile? Or does this sort of start becoming emblematic of what we are seeing in the cyber world, just competing on price to get the opportunities?

Right. No, I do not believe it's the new normal. Let me tell you why. A significant amount of our revenue in our critical infrastructure, security or public safety business is with strategic accounts. And so a strategic account, for example, is a bank. A bank has a national footprint. A bank has offices across the United States and the world. They want a ubiquitous security system, access control system, surveillance system, facial recognition system at all of their locations. Okay?

We are designed in and under contract on a significant number of the largest banks in the United States; healthcare providers in the United States; investment banks in the United States; petroleum companies in the United States. We're in; we're under contract. We have designed, we have deployed, and we've got the maintenance contracts. Those are very difficult to open up for competition.

Okay.

Very difficult. Okay? In certain areas of the country -- I'm not going to get into it specifically for competitive reasons -- we're the man -- we are the man. We are the man, okay? Let me give you one more reason why I don't -- I think it's -- I don't think it's going to happen.

As you know, we are a pure system integrator. We don't build products. We don't build the products; we deploy -- cameras, radars, CBRNE, sensors, things like that. We have agreements in some regions, exclusive agreements with certain of these equipment providers, and you'll have a petroleum company that will only use their equipment -- we have the exclusive agreement in that region, we get the work.

Okay.

So, I'm not going to tell you that I believe as larger, primarily municipalities and ports and harbors. As these come out, as I mentioned, there are two guys, one in particular -- I don't know what they're doing, but they're going low. Okay? I'm hopeful, like the other two guys who blew themselves up, in the next year or so, these guys are going to blow themselves out because they can't execute at that cost.

Okay. Okay, fair enough.

All right.

Very good. Thanks, guys.

Thank you, sir.

Yair Reiner, Oppenheimer.

So, first, you gave us the organic growth for the PSS business. Could you just tell us what the organic growth was for KGS?

It would just be -- I didn't do that calculation, but it would just be the balance of that. So if we're growing organically at 8.3% total, and PSS is at 24.6%, then KGS would be the difference. But you have the services revenue declining 12.4% as a result of that.

Got it. And then the margins in KGS, they were down a bit both sequentially and year-on-year in terms of the EBITDA margin. Can you just discuss kind of the puts and takes there?

Yes, a couple of things. So, one, some of the revenue increase in the first quarter was the result of increased shipments of our specialized ground equipment. And that typically is -- generates a lower margin than some of our other products. So it was a product mix from a gross margin perspective, as well as we have increased our R&D spend in that business unit as well. So it's a combination of those two items.

(multiple speakers) Got it.

Because we (multiple speakers) revenues as well as R&D.

Got it. And then, Eric, you mentioned the EA-18 or the F/A-18, they were probably all surprised by how strong they were funded in the budget. Can you just give us a sense of what your content is on those platforms?

On EAG-18, it is a 2% to 4% revenue generator for us. And so if you take the number of airplanes I just mentioned and you divide -- you will get there, sir.

Got it, okay. And then one last question on the guidance. You mentioned a number of puts and takes in terms of free cash flows as we move through the year. Can you help us in terms of modeling how we should think about cash flows on a quarterly basis?

Yes, so the free cash flow for this quarter was about $1.8 million. I would say for Q2, it's going to be probably in that same neighborhood to break even, since we do have the interest payment of $32 million in Q2. Q3 and Q4, I think is going to be where will be our strongest cash flow generating quarter. It is very similar to some of the trends we saw last year, especially given where DSO has increased to 101 days as a result of some of these milestone events that we have not achieved yet, but we anticipate achieving those in the second half.

So we see that the DSOs -- we expect the DSOs will come back down to that 94, 95 day level, and that's about a $20 million generation there. So we expect that to occur in the second half.

The primary driver here is our CEI business --

Yes.

-- Where on the UAV's and the aerial drones, it is substantially virtually all milestone payment-driven. And there are some very, very large milestones that are going to be hitting Q3 -- very big.

Okay.

Big, big, big.

And then just to follow up on Michael's earlier question about the second half, it does look like KGS organic growth you're looking at is down somewhere, I think in the low double digits. You're not modeling in sequestration, so could you just talk about the specific programs or whatever it may be that you see really impacting the second half results?

Absolutely. So we have had, in the Satellite Communication area on the Ground Equipment area, okay? At the -- if you take a look at last year, our Q3 and our Q4, those quarters' revenue and profit spiked significantly. And they spiked around the 9/30 federal fiscal year-end. That typically happens in this industry, especially in the satellite, ground equipment and software communication area, when agencies want to spend all their money heading into 9/30. They want to obligate as much as they can heading into fourth quarter. And so they order a bunch of stuff. And the satellite ground equipment and the related software is very quick turn. And so we build it and we ship it. Okay?

Our guys are telling us that's going to happen this year. We are being very cautious on this. Very cautious, because of, obviously, the budgetary situation. Okay? That's number one. Okay.

Number two, in the first quarter that we just came off of, we had a significant number of shipments of ground equipment that supports missile defense systems. Okay? We think that that's going to happen again in Q4. I believe it's going to happen again in Q4.

We are being very cautious on it. That's just two examples of some lumpy stuff with some high -- high-margin equipment that we expect it's going to happen. We are being cautious in what we are modeling among ourselves because of the budgetary environment. Michael just talked about the reprogramming. I tell you what I think -- I think that we are going to be good, but I just don't know.

Got it. That's very helpful. Thank you.

Yes.

Sheila Kahyaoglu, Jefferies.

It's Sheila Kahyaoglu. I just wanted to ask, in terms of the book to bill within Government Solutions, what was that? And in terms of your -- the proportion of your sales from Government Solutions for 2013, what is currently in the backlog?

So the book to bill in total was 0.6 to 1. PSS was 1.2 to 1. I'm just trying to grab the book to bill for our government sector. It was at 0.4 to 1.

And what proportion of your sales is currently in the backlog for GS?

For 2013?

Yes.

Okay, so our total backlog did about $1.2 billion. Typically, it is anywhere from -- our funded backlog is about $600 million. It is anywhere from 60% to 70%.

Okay, thank you. And then just to follow up on an earlier question, you mentioned early aggressive pricing for a municipal contract. Can you maybe give us an idea of the size of some of these contracts and the length of time that the contracts are for?

Yes, so the one that we lost, we bid [30], and I thought that was extremely low. And the competitor bid [27].

Okay.

Another big one we won, we bid [20]. Another big one we won, we bid [18]. Okay? Another big one we lost was another [30].

And how long do these contracts extend? I mean, since you are a system integrator, is it installing new equipment and servicing -- so a six-month contract to a year, so it's quite sticky?

Yes. So the deployment of the system typically goes anywhere from 9 to 18 months. The deployment of it. Okay? That assumes that base contract. Because it is very important to note with the contracts, which is why at times you've got to be strategic and bid on them, you're going to deploy 1000 cameras and sensors in a subway system. But through discussions in the proposal, you know the opportunity is 4000. And once you win that base contract of 1000, then there are scope increases to get you to the 4000. Okay?

So the base contract, in my example of 1000, nine months to 18 months, okay? Very importantly. 15% to 20% of this business is maintaining and operating the systems once you put them in. Because you designed it and you built it. And those are long-term annuity streams that go indefinitely.

Okay, got it. Thank you very much.

Yes, these are extremely, extremely sticky customers. Because you have designed the architecture for that system into the command-and-control infrastructure.

Okay, thanks. That's helpful.

You're welcome.

Bhakti Pavani, C.K. Cooper & Company.

(multiple speakers) My question was related to the price pressure that you are currently experiencing in the PSS area. I was curious to know, is that a similar kind of price competition of the price negotiations you are experiencing in the KGS segment as well?

No, it's a different animal. In the -- good question, Bhakti. In the KGS area and the services area, there were those three procurement rules that, when Obama came in, he changed them. And one of those was to push the industry to lowest price, technically-acceptable work. And so in the KGS area on services contracts and IT contracts and what not, 50 guys will bid for an ID/IQ contract. There will be 10 winners. So, yesterday, you saw the Navy announced a multibillion-dollar award, an ID/IQ pillar contract. There were 15 winners. Okay. There were 19 bidders. Okay?

So now those 15 guys, they've spent all this B&P and they bid. They got nothing. Now the Navy will put out a task order, and the task order will be $50 million over a couple of years to do something. Those 15 guys bid. They all put in a bid. The Navy opens the 15 bids. They go to the lowest priced one. They put the other 14 aside, then they line up the technical quals in the bid against the technical specs. If it's compliant, they win. They throw the other 14 away.

That's what's going on, on the defense side. There's no thinking. It's lowest price technically-acceptable. Versus what's going -- what we're seeing on the PSS side is, the majority of these past performance qualifications, expertise, best value still applies. However, if certain people are bidding 10%, 15%, 20%, 30% below you, that municipality has a hard time justifying going with the other guy for political reasons.

Got it.

Especially if the guy that's bidding is a name-brand defense contractor.

Also, taking a look at the current quarter's book to bill ratio, would you maybe walk us through what are your growth expectations for the KGS, segment-wise?

Right. (multiple speakers) We --

I mean -- okay. I'm sorry.

Right, so we have been chatting a little bit about that before, Bhakti. So what we see right now is we've got a number of bids that are in, in the electronic warfare area -- I've talked about a couple of the programs like CWIP, for example. And we've got some THAAD opportunities. We have some Patriot opportunities, both domestic and international. Okay?

We are expecting a significant drone order from an existing customer that we think we're going to get. So we have a number of items out there that we believe we are going to get in the second half of the year. These are large importers. They'll be one or two-year production runs, okay, that we believe we are going to get. And we looked at it, and if it maps out where we hit the revenue range that we've got in there, and we hit these bids, the percentage of these bids we think we are going to get, we think we are going to come in over [1.1] at the end of the year.

Okay.

That's how we are mapping it out as we are starting to plan 2014.

That's helpful. Just one last question. In your prepared remarks, you mentioned about ramping up the R&D in the second quarter. What is the cycle time for the drone that you are working on?

Okay, so the cycle time -- we had already started working on these last year. Okay? We initially had expected these to be complete by the end of this year, with flight requirements on the customer flight schedules in the first half of '14.

Customers -- two customers have come to us and they have said, for their reasons, it would be very much appreciated if you could fly these in Q4. So we have pulled in -- we are pulling in the cycle time. We are getting additional time at ranges which cost money. We had ranges scheduled later in the year; now we have to get range time. So we are pulling all this in. And so the typical cycle time on something like this, on these types of aircraft, were 18 months, and we're pulling it into 12.

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

Thank you.

Very good. Operator, any other questions?

At this time, I am showing no further questions. I would now like to turn the call back over to Eric DeMarco for closing comments.

Very good. Thank you for joining us this afternoon. And we look forward to chatting with you when we report our second-quarter results. Thank you.

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.