Kratos Defense and Security Solutions Inc (KTOS) 2013 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense and Security Solutions third-quarter 2013 earnings conference call. At this time, all participants will be in a listen-only mode, but later there will be a chance to ask questions and instructions will be given at that time. (Operator Instructions) And, as a reminder, today's conference is being recorded. And now I would like to introduce your host for today, Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer, and Secretary. Ma'am, please go ahead.

Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions third-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 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 the 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, federal government shutdowns, 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 and our quarterly report on form, 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 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 also 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 restructuring and acquisition related items and other; unused office space and other; amortization of purchased intangibles; using a cash tax rate; and using a statutory tax rate of 40% are considered non-GAAP financial measures. Kratos believe 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 users 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 third 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 then we will open the call up to your questions. With that said, it is my pleasure to turn the call over to Mr. DeMarco.

Thank you, Deborah, and good afternoon. In spite of the continuing challenging near-term budget environment, Kratos delivered solid third-quarter results, our bid and proposal pipeline increased to $4.6 billion; our backlog remained constant at $1.1 billion; and we are forecasting 10% sequential increases in both revenue and adjusted EBITDA for our fourth quarter.

Additionally, Kratos has not lost or had canceled any significant existing or expected contract, program, or customer opportunity, as a result of the federal government budgetary situation, though we have experienced delays in order flow, expected new contract awards, and cash receipts, particularly since October 1, when the now resolved federal government shutdown began.

In the third quarter, Kratos was a prime contract awardee on the Department of Homeland Security's five-year, $6 billion in MAC BPA continuous monitoring cyber program, we believe, affirming Kratos's position as one of the leading cyber security solutions providers in the industry and providing Kratos a significant new potential future growth vehicle and opportunity. We believe that the winning Kratos DHS program team, which exclusively includes Microsoft and Dell, along with our proprietary NeuralStar and dopplerVUE software products, is uniquely positioned for the delivery of continuous monitoring services and solutions under this new contract award. We expect release of initial tax task orders under this contract over the next few months, at which time we will begin to get a feel for our teams positioning.

We received approval today to announce that Kratos is a key member of a team awarded $450 million, single-award, five-year plus five-option year MDA contract where Kratos has a committed and defined scope of work. Though this single award contract is now under a protest, this is another new opportunity for Kratos, and we are hopeful that our prime leading the team will be successful in sustaining our teams win and this new growth vehicle for our company.

In Q3, Kratos was awarded a large new security related program with a certain US government agency for specialized security related systems which are now in production. This new program, which we are not able to formally announce, is expected to last many years and be worth tens of millions in revenue to our Company. Kratos was recently awarded a contract by Sikorsky Aircraft for CH-53K maintenance trainers, with CH-53 being the US Marine Corps heavy lift helicopter program. The CH-3 award is important as this is a long-lived strategic platform that Kratos will be supporting.

In the third quarter, Boeing and the USAF successfully conducted the first unmanned QF-16 aerial target flight test, another major Kratos supported program, which just went to the LRIP and which we believe could also go on for many years into the future. In Q3, Kratos's critical infrastructure security business continued its solid year-to-date organic revenue growth generation, with the fourth quarter of 2013 currently looking particularly strong for this business with approximate 15% year-over-year granite growth expected for Q4.

Our PSS business profit margins were below our expectations in Q3, primarily related to a certain geographic region's performance. We are taking the appropriate actions to address the situation, and we currently expect PSS EBITDA margins to expand in Q4.

Kratos's critical infrastructure security business opportunity and bid pipeline are near record high levels and we remain in pursuit of several large opportunities we are currently expected to be awarded in early to mid next year.

At this time, 2014 looks like it will be another solid organic growth year for our commercial customer base, critical infrastructure security business, which comprises approximately 22% of our Company's revenue.

Over the past few months, Kratos has made important progress with two of our most important long-term strategic initiatives -- ballistic missile and unmanned aerial targets and systems, with several successful flights of Kratos targets and aircraft and the opportunity for significant organic growth for our BMD targets business in 2014. In one of our recent successful ARAV BMD missions, the aegis ballistic missile defense system, achieved the highest successful target intercept to date and another successful launch, an intercept using utilizing a complex and separating Kratos ARAV target vehicle occurred.

In the UAS area, one of the many recent successful flights of Kratos unmanned aircraft included a new supersonic capable platform, which has several very unique performance characteristics, including as related to our UCAS initiative. We also experienced one flight test failure with this aircraft related to a certain customer program where we identified a legacy acquired design issue which will require a one-time NRE and related effort-type design and retrofit change. We have several additional flights for this new high-performance aircraft currently scheduled over the next several months, including both Blue Sky and customer-related flights and flights with increasingly demanding performance requirements over different geographic environments and terrain.

UCAS and high-performance drone systems are Kratos's primary strategic initiative. For if we are successful, it could dramatically change our growth profile in our Company. Recent meetings with customers and related public statements regarding the need for UAB swarms, the ability to perform ISR and other missions in contested airspace, all at a low cost so that high quantities can be achieved, we believe confirm our UCAS vision.

Additionally, we have recently made a submittal to DARPA related to a new drone program for scalable modular and cost-effective unmanned drone systems. And Bloomberg recently reported Kratos as the fourth-largest unmanned aerial vehicle provider to the DOD. And today, we believe also further confirming our vision, we announced that Vice Admiral Mike Malone has joined the Kratos team and will be supporting Jerry Beaman, President of Kratos's UCAS division, and identifying certain customer needs, requirements, and missions.

Accordingly, we are making significant recurring IR&D NRE flight tests and other investments in this area, and we will continue to do so. We intend on keeping you informed every quarterly report as to the progress we are making in the UCAS and drone areas to the best of our ability while complying with certain of our customers' nondisclosure requirements.

Since we reported Q2, Kratos' belief that Anti-Access/Area Denial and related strategic and foundational national security programs in the satellite communications, missile system, electronic warfare, and radar areas are national security priorities continued to be confirmed with recent Patriot, FAD, AMDR, SEWIP, NGJ, SM6, and AEHF industry awards.

Kratos typically supports or has strategic relationships with each of the prime contractors that are involved in these critical, long-term strategic programs with Patriot, FAD, Aegis, SEWIP, AEHF and SIBRS-High all being current important contributors to our business. We believe that the majority of Kratos's top 20 supported programs are critical to the United States national security profile and will be long-lived in nature, including EA-18G where Kratos just recently received the most recent fiscal year's production order.

Trident II D-5, where in Q3 the U.S. Navy carried out four successful launches of these critical leg of the United States strategic triad deterrent, and we are expecting a Q4 product order. AFSAT, where Kratos is currently in negotiating the next three years full rate production with our customer, which is expected to be awarded in 2014. Aegis, where Kratos supports SM3 and where the DOD is currently looking at a $3 billion full rate production request to RTN. SM6, where a recent award of 89 missiles and related support was made in Q3, also to RTN and Aegis readiness assessment vehicles where Kratos provides the BMD targets.

Certain satellite and [secant] related programs where Kratos is under long-term contracts, including the successor to command and control the space segment and RAIDRS. A certain federal agency unmanned aerial system program with a large potential future growth opportunity for our Company. Certain national security-related programs where we are providing specialized products to certain government agencies and in support of the Warfighter. And certain large municipalities here the United States, where Kratos is on long-term programs for the design, deployment, system integration, service, and maintenance of specialized security systems and related command-and-control infrastructure. Additionally, we support critical international customer defense systems, including Iron Dome, Sling of David, Arrow, Barak, Spyder, Patriot, Aegis, and FAD.

Regarding Kratos's capital structure, we are completing the documents related to a potential refinancing of our senior notes and we currently estimate that we can achieve an interest rate reduction of approximately 300 basis points upon a successful refinancing based on current market information. We are conferring with our financial advisors regarding optimal timing for this important transaction, and we are watching the financing markets closely with terms, interest rates, Kratos's cash balance and overall liquidity all factors in the analysis.

Our plan for Kratos's free cash flow generation remains unchanged with a pay down of debt and deleveraging deleveraging being the top priority and with no acquisitions planned. The recent federal government budgetary, debt ceiling, and October shutdown situation resulted in government furloughs; significant customer caution; procurement and new contract award delays; delays in the ability to ship product, which required a government signoff; and delays in payment to government contractors. Additionally, continuing resolution the federal government authorized on October 17, 2013, is in place only through January 15 of 2014 with the US federal debt ceiling increase be approved being only through February 7, 2014.

As a result of this budgetary situation and its current and expected continuing near-term impact on Kratos's US federal government business, we are revising our full-year 2013 guidance, which Deanna will go through in detail momentarily. Importantly, the federal budgetary environment, though challenging in the near term, has offered a unique opportunity for a company like Kratos, which provides technologically advanced systems addressing mission-critical strategic national security requirements at a low-cost, including Kratos's unmanned combat aerial systems and our ARAV initiatives.

Additionally, under the current law, federal fiscal 2014, which commenced October 1, 2013, should be the bottom for the base DO defense budget at approximately $480 billion with the defense budget forecast to grow beginning in federal fiscal 2015. In conclusion, our plan remains for our expected continued organic growth from our international and commercial customer-sourced security businesses, representing approximately 35% of Kratos's revenue to help offset the near-term US government business budgetary-related challenges, while we focus on mid- and long-term growth opportunities and using our free cash flow to delever, accreting to Kratos's equity. I will now turn it over to Deanna.

Thank you, Eric. Good afternoon. Our third quarter revenues of $226.4 million came in our expected range of $220 million to $240 million. Our revenues decreased year over year 18.1% from $276.3 million in the third quarter of 2012, reflecting the impact of the current DOD budgetary environment, which had caused certain delays in orders and awards, as well as due to the timing of product shipment and the continued contraction of our legacy government services business, which continued to contract approximately 18.5% compared to the third quarter of 2012. However, consistent with the previous quarter, our legacy services business remained fairly stable on a sequential basis compared to the first and second quarters of 2013. From an annual run rate perspective, our legacy services business is currently operating at approximately $88 million, down from approximately $100 million for 2012.

Operationally, we remain focused on cost reductions and efficiencies. And in the third quarter, we recorded nonrecurring credit and charges related to our legacy services business, excess capacity caused in part by the delays in procurement and awards, excess facilities, severance, legal, and the previously mentioned contract design retrofit cost.

In Q3, Kratos is headcount was reduced by approximately 100 personnel from 4000 to 3900, and year to date, Kratos headcount has reduced by approximately 10% from 4300 at the end of last year.

Similar to previous reports, we exclude such nonrecurring or non-core business credits and charges from our adjusted EBITDA. Our adjusted EBITDA of $24 million for the third quarter is from continuing operations and excludes a credit of $6.8 million related to a change in our unused office space accrual and excludes $5.4 million of contract designs, retrofit costs, related to the recent test failure of one of our aircraft that Eric mentioned earlier, and excludes $3.5 million of restructuring and acquisition related items, primarily comprised of excess capacity and restructuring and severance costs.

From an operational segment perspective, our government solutions segment generated $174.6 million in revenues and $21.1 million in adjusted EBITDA, or a 12.1% adjusted EBITDA margin. Our public safety and securities segment generated $51.8 million in revenues and $2.9 million in adjusted EBITDA, or a 5.6% adjusted EBITDA margin. On a GAAP basis, net loss for the third quarter was $9.9 million, which included a loss from discontinued operations of $400,000, $9 million of expense related to amortization of intangible assets, as well as a $200,000 income tax provision.

We continue to believe that it is also meaningful to provide our earnings per share excluding the amortization expenses and reflecting our cash pay income tax and excluding nonrecurring items. On a pro forma basis, EPS from continuing operations, excluding amortization, restructuring, and acquisition-related items, excluding the credit for unused office space and excluding contract design retrofit costs, utilizing the estimated average quarterly cash paid income tax provision of approximately $800,000 was $0.02 per share for the quarter.

Moving to the balance sheet and liquidity, our cash balance was $49.8 million at September 29, plus $5 million in restricted cash. For the third quarter, we generated $2.6 million in cash from operating activities and a use of $2.3 million of free cash flow after taking into consideration capital expenditures of $4.9 million.

Our DSOs increased six days from 102 days at the end of the second quarter, and it has increased 14 days on a year to date basis when compared to the 94 days at the end of 2012. The increase in DSOs is a result of the current budgetary environment as well as the shift of certain contractual billing milestones into 2014. The increase in 14 days is equivalent to approximately $35 million in impact to our cash flow as each day's turn is equivalent to approximately $2.5 million.

As a reminder, our second and fourth quarters are the quarters that we pay the semiannual interest payments under senior notes so those are typically our lower cash generation quarters before taking into consideration the current budgetary environment. We continue to target DSOs of approximately 90 days on a long-term basis, which we believe is achievable in a stable budgetary environment as we expect that the 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.

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 and contractual milestones. Our contract mix for the third quarter was 82% of revenues generated from firm fixed-price contracts, 13% from cost-plus-fixed-fee contracts, and 5% from time-to-materials contracts. Revenues generated for contracts with a federal government were approximately 63%, including revenues generated from contracts with the DOD of 59% and revenues generated from contracts with non-DOD federal government agencies of 4%. We also generated 7% of our revenues from state and local governments, 21% from commercial customers, and 9% from foreign customers.

Backlog at quarter end was $1.1 billion with $543 million funded. Backlog at the end of Q2 was $1.1 billion as well.

Today, we updated our previously communicated full-year fiscal 2013 financial guidance as follows. Revenue of $955 million to $975 million, adjusted EBITDA of $102 million to $106 million, and adjusted free cash flow of $5 million to $15 million. We are also providing fiscal fourth-quarter 2013 financial guidance. Revenue of $240 million to $260 million, adjusted EBITDA of $26 million to $30 million. The updated free cash flow estimate reflects a few days improvement from the year-to-date increase in DSOs of 14 days, which has impacted our cash flows by approximately $35 million. This is equivalent to estimated cash EPS using an estimated annual cash tax pay of $3.2 million, excluding annual amortization of $36.3 million and excluding restructuring and other acquisition-related items, contract design retrofit costs, and the credit for unused office space of $0.10 to $0.20 for fiscal 2013.

Kratos's guidance also reflects a continued significant investment that we are making in our internal IT security and infrastructure area, which is being driven in part by perceived increased threat profile as a result of the nature of certain work we are performing and assumes that operating margins in our public safety and security business will prove improve sequentially in the fourth quarter back to the levels realized in the second quarter.

From a capital structure standpoint, we have been preparing the documents for refinancing our senior notes and continue to confer with our financial advisors on market conditions on the appropriate timing to refinance. As a reminder, if we were to refinance today, there is a 5% premium due of $31 million plus approximately $40 million of make-whole and estimated related fees. The estimated make-whole reduces approximately $5 million each month as we move toward the June 2014 no call day. As a result, if we were to refinance today, we would refinance an amount greater than the current $625 million principal balance to fund the aggregate refinancing cost I just discussed after taking into consideration our cash on hand.

While a refinancing would result in upfront refinancing costs, we are expecting the refinancing to overall reduce our interest expense, even accounting for the incremental debt, and to extend our debt maturity profile. Importantly, we are evaluating options to allow for us to begin reducing debt immediately with our cash generated from operations. As we have discussed on previous occasions, we continue to confer with our financial advisors to determine the appropriate timing of such a refinancing, weighing the various upfront costs versus current market conditions and the benefits associated with the refinancing. If the refinancing is successful, this could significantly increase Kratos's free cash flow, and we plan to use the additional free cash flow to further delever our balance sheet with the goal of increasing Kratos's equity value.

Very good. Thank you, Deanna. Now I will turn it over to the moderator for questions.

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

First, what did you do to attract Mike Malone from Boeing or is it that he saw at your unmanned combat division to get him to leave Boeing?

Mike, we are making very good progress in this area right now with Jerry Beaman, and Admiral Beaman had a relationship with Mr. Malone. And he came on out and he saw what he was doing. He reviewed the aircraft and the performance characteristics and our roadmap. And I believe he believes, as we believe and as I believe, that we have a real shot here in this environment to do something significant.

Okay. Thank you. Could you also just review again what happened with this aircraft test failure? Was that related to the UCAS division or was that something else?

It was not in the UCAS division. It was an aerial drone that has significant, what I will call, precursor attributes, potentially to it. And it was an environment that had never -- we have never performed before with this plane. It hadn't been done before. And the type of performance characteristic that these platforms have from time to time, there are going to be setbacks, and that was one. As you know, Mike, I always like to look at the glass half full, and we have had a number of successful flights with our aircraft since we last spoke, including one with this particular aircraft for just under an hour.

And, Deanna, did that show up in the cost of product sales?

It does. It does. Yes.

Okay. Thanks. And then, last question. Switching gears a little bit, what does it mean to have a Microsoft and Dell exclusive?

Right. Mike, this is how I am looking at this and how I believe our team is looking at it. The DHS contract is for continuous monitoring of every civilian federal agency. I think there are 33 of them and I think 32 of them have already signed up. The only one that hasn't is GSA and I think they are going to in January or February. This is the successor to FISMA so instead of data point in time assessing cyber threats, this is continuous monitoring for cyber threats. A significant number, if not every federal civilian government agency, uses Microsoft or has Microsoft operating system or Microsoft products, Microsoft asset management, et cetera. And a significant number, if not all federal civilian government agencies, use Dell hardware.

So our strategy was to get them on our team. We are the prime. Get them on our team exclusively, with the thinking that there is going to be have an inventory for example of all of the devices out there by the various agencies and the agencies that decide to move forward with this continuous monitoring contract.

If they are going to take an inventory initially, it is going to be cheaper and less costly if they already have licenses to go through it with Microsoft. If they are already running Dell hardware, they don't need to acquire additional hardware to perform certain functions under the contract. So our angle, and we are hopeful we're going to learn this very soon when task orders start coming out and we are already having discussions with customers ahead of the task orders, which is how we need to work this, that we will have our team -- our team will have an advantage; a cost advantage and a technological advantage -- cost because the customer already have the significant asset footprint and technological because we have the guys that are running the technology on these systems. And they are exclusive to us. And so, we will see. This is going to be very, very interesting over the next six months.

[John Nelson], State of Wisconsin.

Eric and Deanna, I can't remember -- and I have been on these conference calls for many years -- when you have given -- you have rattled off as long a list of potential opportunities. And I think that is a good tribute to you and your team. Could you expand a little bit more on the potential timeline for some of these opportunities as far as when they might be decisions might be made in the scope of next year versus 2015 or later?

Yes. I believe right now our support on the Trident program, which is one of the largest programs in the Company, I believe that that will be determined and will be awarded in Q4, at the latest Q1. I believe the Air Force contract, AFSAT, that we are in negotiations now on lots 11 through 13 -- we are currently producing lot 10, and lots 11 through 13 will be three years. And those are sole-sourced because we own the data rights. Right now, current estimated timing on those is mid-2014. I mentioned there are a number -- it is four or five large opportunities in PSS, our critical infrastructure security business -- that I am hopeful we are going to win. It is going to be very competitive, but I am hopeful we are going to win. I think those are all expected to be awarded right now in Q2 and Q3 of 2014. On the unmanned systems side, John, that would be a first half, right now, 2015 event.

Okay. Great. Is Kratos doing any work with Boeing and Lockheed on the SR-72? Or can't you say? I mean, if you can't say anything, that's okay.

Yes. Thank you. Thank you, sir.

Okay. How about any additional information that you can provide us with on the UCAS program as far as near-term plans or scope?

Near-term plans are, we are working -- we have been working and we are continuing to work with customers and potential customers on mission and requirements and performance characteristics for the aircraft. We are -- we have a very -- Admiral Beaman has a very good idea and a very solid vision of where he sees this going, and his recent discussions with a number of entities is literally confirming it every week. Our success in bringing Vice Admiral Malone on board, I look at as a huge coup. He gives us access to additional customers and potential customers that Admiral Beaman can't interface with for another, I think, seven or eight months because of the one-year limitation because he left the -- he retired last August. So and over the next -- as I mentioned, over the next five or six months, a number of flights with -- John, I am going to use the word precursor aircraft. I will use that for now. That may change in the future, that have characteristics that are directly -- would be directly attributable to the final airplane.

Okay. And if things went according to plan, do you have any timeline or estimate as to when you would have a product ready to introduce to the government -- present to the government? Or can you?

I -- John, if you could see me, I am smiling. And I will answer it this way. I can assure you that Admiral Beaman's timeline is much, much more aggressive than mine. But I don't want to say it out -- I think we will feel a lot more comfortable talking about it either in Q1 or Q2, after some more flights.

Okay. And then, just can you expand a little bit more on what is going on with the nondefense security systems integration business?

Yes. Opportunities, John, remain extremely robust. It is amazing how security conscious commercial critical infrastructure security companies and entities -- chemical companies, oil companies, rail companies -- how conscious they are right now because of the threat profile and the information that they are receiving. Additionally, the threat profiles on metropolitan areas and mass transit relative to them, it is as robust as I have seen since I have been with the Company and we have built this. It is getting more and more competitive. There is no doubt about it. However, our path performance, qualifications, with some of the cities that we have in the mass transit enterprises that we have our second to none and that has helped see us through on a lot of these. I will tell you, I like to say the bad with the good. We just recently lost one at a city up in, kind of, sort of, near the northwest where we were underbid. And we are seeing that here and there. And I believe -- I truly believe, John, this business is going to continue to grow organically very, very strongly into 2014, and we are going to manage the heck out of it to improve those margins.

Mark Jordan, Noble Financial.

Question relative to the contracting environment. We started to see push out and delays in 2012 in anticipation of sequestration and budget cuts. And that seems to have obviously continued and be accentuated here in October with the shutdown. As the DOD responded to those pressures, I think they focused on the shorter cycle procurement programs, many of the things that you do, which are where you can postpone contracts, postpone deliveries. But, over the longer-term, if you are going to live within a lower budgetary environment, you need to address some of the long-cycle procurement items like planes, ships, absolute headcount of the military, things of that sort, which are only changeable over the longer term. With that preamble, my question is, as we move into 2014, do you think there will be more predictability in your shorter-cycle procurement businesses moving forward, compared to the uncertainty in 2012 and 2013 as the DOD focuses on other areas for efficiencies and cost reductions and you get more visibility of your base longer-term programs?

Mark, if it was July or August, I would have said to you, absolutely, yes. I would have said to you that sequestration is going to be here, we are going to have a $480 billion-based defense budget, we are going to get a budget on October 1 of 2013 for federal fiscal 2014, and then we are going to -- it is going to give us some predictability. Then, we went through September 30 and October 1, with the shutdown, a CRA that only goes through January 15, and a federal ceiling limit through February 7. I don't know right now. I just don't know -- I don't know what's going to happen, and our customers don't know what is going to happen. They are very cautious. That is the tone -- cautious right now. If they have got $100 to spend or obligate, they are spending or obligating $70 and they are holding $30 in their pocket to see what is going to happen. And that is kind of what we see right now.

So right now, Mark, if I had to speculate, I think 2014 is going to be choppy on the DOD side. That is 60%, 65% of our business. We are on some great platforms so our choppiness is banded. There is a band around it, which is very reassuring to us. And that is one of the reasons I went through a lot of those programs today. I wanted to reiterate to people that the programs we are on are fundamental to the national security of the United States. We are not going to be de-orbiting satellites. We are not going to be decommissioning Trident ballistic missile submarines. The thing with product upgrades et cetera within the band is going to move around a little bit, but it is funded; it is going to be solid. And when we get clear of this environment, whenever that is, we are going to be really, really well positioned. And I think the Lord, literally, every day that 35% of our business is security -- is commercial security customer focused or international focused, especially in the missile and the radar area because people are arming to the teeth right now.

Okay. With the UCAS program, have you demonstrated extended on station capabilities?

We have not.

When would you expect that to occur?

I would rather, as I mentioned to Mr. Nelson, we will probably be in a better position to discuss that in the middle of next year, sir.

Okay. Could you say, in that program or initiative area, do you have a sense of what your -- that investment has been in 2013 and sort of a band of what it might be in 2014?

On the IR&D side, the investment --

On the IR&D for 2012, Mark, is --

2013.

-- is roughly -- it is about $10 million.

In 2013?

Yes.

In 2013. So the IR&D side, Marc, it is about $10 million. In addition to that, there is the cost of flying. And when I use the term blue sky flights, those are noncustomer flights. Those are internally funded flights where we find them. We fund the range cost. We fund the people that are out there. We fund the aircraft. So, I am going to guesstimate that, on top of the $10 million, there is an additional $5 million or so.

Yes. And the $10 million that I mentioned, Mark, there is a portion of that that is actually in the R&D line. There's some in cost of sales as well.

Right. Yes. But I am looking at a fully loaded program cost where you would say it is probably in the $15 million range. Would you hazard a guess at what that might be for both parts in 2014?

I don't. It depends on what happens over the next six months with the flights. That will drive it. That will drive a lot of it.

All right. A final question for me. Relative -- as you said, there seems to be a growing understanding of need for different form of UAB that could live in contested airspace. Has there been a movement by the DOD to formalize a program of record and solicit folks to get involved in this initiative or are you truly the only one out there addressing it now with what, in essence, is more of a commercial model versus the DOD sponsored initiative?

Mark, for competitive reasons, I don't want to get into too much on that topic right now. But, there is in the public domain, particularly in the last three months, there is definitely an increased awareness happening now that -- I go back to the famous saying that one leader said. Quantity has a quality all of its own. And we may have one -- our country may have one platform that can take on 100 of the bad guys, but then there are another 300 to come. And people are starting to be aware of that, especially operating in contested environments. So that, again, for competitive reasons, that is all I should probably say on that right now, sir.

Okay. Final question. Relative to refinancing, you obviously gave a lot of specifics, but would it be fair to say that you would be disappointed if your company did not answer enter 2014 with a different capital structure?

We would be disappointed. We will be disappointed if we don't refinance this debt at a significantly reduced rate that significantly increases the cash flow of this Company that we plan on letting accrete to the equity. And if all those points mean that we can get those terms and those conditions between now and the end of the year, and we don't get it done, I will be very disappointed.

Tyler Hojo, Sidoti & Company.

Just firstly, I would like to visit the reduced free cash flow guidance for this year. It looks like the biggest delta there is really predicated on the inability to achieve the DSO target. And just in context with some of the conversations you have had with some of the other questioners, I am just kind of curious if you cannot reach 90 days under a stable environment and you don't expect a stable environment in 2014, is free cash flow just going to remain kind of lackluster here for the foreseeable future?

Well, there is a couple of pieces, Tyler. So there is the unstable environment, but there is also contractual milestones that will allow us to build. So once we hit those contractual milestones, we should be able to reduce the DSOs. It is outside of a stable or unstable environment. So that piece can and will and we do expect to happen. And in addition, we have got some increased DSOs in our public safety business, which is really driven by focus, which we plan on putting a lot more focus on it from a cash collections perspective that we can drive in any kind of type environment from the DOD perspective.

Okay. Thank you for that, Deanna. And, Eric, I am just kind of curious. I mean, we have talked about this being -- thinking about this business as a $50 million a year free cash flow business. I mean, has that changed a bit? I mean, how should we think about the business on a go-forward basis from a cash flow perspective?

Right. I don't believe it has changed because I can see it sitting in receivables on the balance sheet.

Right.

I can see it sitting there. And on the government side, on the government side, when DFAS walked off the job, when they were furloughed, and they couldn't come out and sign off on shipments, that started moving things out. That is number one. Number two, we were sitting here today. We have two significant milestones with two international customers -- international. These have nothing to do with that US DOD. They have moved from Q4. Right now, the execution point is targeted for Q1. Nothing to do with the DOD. But most importantly, is what the Deanna said and it is disappointing to me.

Our critical infrastructure security business. Tyler, the business has been focused on growing, and it has been doing that. It is incredible. I mean, I believe we are going to achieve 15% year-over-year growth in Q4. Okay? The eye has been taken off the ball on collecting the receivables. And what makes this even more frustrating is a good number of these receivables, they are not with mom-and-pop's. These are with national financial institutions. National energy companies, large metropolitan areas, and it is just sitting there and you can see it. And so that is why I'm getting -- I'm getting a little emotional here because I am not happy about this because I can see it sitting there, and it is up to us to go get it. And I can assure you over the next two quarters, that is what we are going to do.

Okay.

And, Tyler, just as a reminder from a DSO perspective, at the end of last year we were at 94 days. So it is -- 90 days is not impossible to achieve. We were there nine months ago, and our focus is to get back to that level. Obviously, with a more product centric mixed business, that is a little choppier from a collections perspective, but, as Eric said, there is some fairly sizable billing milestones with foreign government customers that, once we hit those flights, we should be able to bill those. And they are sizable amounts, which should bring the DSO down.

Okay. All right. Well, that is something to look forward to in the near future.

Yes. Yes.

Okay. Wonderful. And, just moving on to something else, I just wanted to get -- if you can, provide a little bit more detail into what impacted the PSS margins in Q3? I mean, you have made some kind of vague commentary around that. But if you could be a little bit more specific, that might be helpful.

I will be as specific as I can, considering the circumstances. There was a management issue, number one, that has been addressed definitively. That has been addressed. That is number one. But, number two, in this area, we are back to the growing. We are growing, growing, growing. And it is great to sell this stuff, and it is great to put together the EAC and put together the deployment plan and the labor plan and everything, but then we have to manage it to what we submitted. And we didn't do that. And we are going to do that, and we are re-addressing the cost structure. We are looking at it again. As you know, we took a look at it the end of Q1 and Q2. We made some adjustments, and in Q2, I think our EBITDA margins went up 300 basis points. I am confident that we are going to achieve that similar type of expansion in Q4, then we are going to sustain it going forward.

I mean, is this a function of the competitive environment is just getting much more competitive on some of the new wins that you are having so you basically need to react by lowering the cost structure once the contracts ramp? Is that a (multiple speakers) way to think about it?

That is absolutely a piece of it which is why I said we are going to be revisiting the cost structure. Absolutely, Tyler.

Okay. That's great. And then the last one for me, I guess for Deanna, if we look at the delta in terms of the cash EPS guidance, what is the biggest incremental expense that is moving that?

Well, obviously, we are working with the lower base EBITDA so that is driven by some SG&A. So we had some increased SG&A as a result of enhancing our internal cyber security protection. That is part of it; it's part of the infrastructure cost and compliance related to that. And as a function of revenues, R&D, the investment in certain of these key areas is also driving that EPS as well.

Okay. That is part of that $15 million we were just talking about.

That's correct.

Okay. Wonderful. Thanks a lot. I'll hop back in the queue.

Greg Konrad, Jefferies.

Good evening. I was hoping just to talk a little bit about cyber. You mentioned it in relationship to the DHS contract, but I was just wondering kind of how would you size that business and overall opportunities outside of DHS?

How would I size our current cyber-related business?

Correct.

Both terrestrial and space-based, I am going to guesstimate about around $100 million is the current business size.

And do you see a lot of opportunities to grow that business outside of the DHS contract?

We do in certain niche areas. The general cyber security environment is commoditizing just like all the other government services. It is commoditizing right in front of us. It is all turning into a cost shootout, which is why we have made and we are continuing to make significant investments in our software products -- NeuralStar, dopplerVUE, and a new suite that we announced about two months ago where we are starting to see some traction. All right. I don't see for us, outside of that DHS area, that the cyber security opportunity is huge for us.

I think that we are going to have -- that we are going to continue to have some moderate success because of the target markets we are going after with these specialized products is small, with our software products that bring very high margins. But the potential flywheel for us will be that continuous monitoring contract and the consolidation of all the continuous monitoring oversight by the DHS and the matching money that they are going to give other agencies. And also importantly, and I didn't mention this before, but I should have. This contract vehicle also allows municipalities and state and local governments and other agencies to use it. And, as you know, we have significant access to that customer base through our PSS business.

And then just when you think about Q4 and the range for guidance, how much visibility do you have for the final quarter of the year? I guess I'm just kind of thinking about what is in backlog and what type of orders are at risk and how you get from the bottom to the top end of the range.

Right now, we are very comfortable with the ranges we have given. Very comfortable.

And then, can you just remind us, do you have a position on AMDR and kind of any opportunities that that program gets moving to maybe pick up share?

As I said in the prepared remarks, and I said it very carefully, we have contractual relationships or strategic relationships with all of the primes on programs like capital and NGJ, SEWIP, AMDR, and we are very pleased. Very pleased that NGJ was awarded and that -- albeit, protested; that AMDR has been awarded, albeit protested and an stop-work has been issued; and hopefully SEWIP block three was going to be awarded the next couple months, because those are the types of areas, as you know, our microwave business, in my opinion, is second to none at.

Okay. Then, final question. I don't know how much visibility you have in this, but when you think about the microwave business, talking to other contractors, it seems like there has been some difference between kind of the spares and repairs business and the OE new builds business. Have you seen additional weakness kind of in that more spares and repairs business?

The biggest part of our business is not spares and repairs. Right now, the big pieces were in full-rate production like on Trident and EA-18G and Iron Dome and Spyder and Barak and those systems. I am thinking. I can think of one area where we have seen some weakness, and it was on F-16 radar in the spares and repairs. One, but it is not jumping out at me.

Michael Ciarmoli, KeyBanc Capital Markets.

It actually Kevin on for Mike. Most of my questions have been answered. Just a couple here. Looking again, you touched on the R&D spend in the UCAS and the unmanned products. Wondering if you could give us idea of how much of that is being spent for work that is already kind of assigned to customers versus work that you are still competing for internally versus customer funded as another way of looking at it.

The vast, vast majority of the IR&D spend is, as the acronym says, internal research and development. That is not customer funded. In other words, we are not getting a check from a customer on it, but it very well may be or is customer targeted where we are doing something for a particular customer or customer set to achieve a requirement. We receive a significant amount of money across the Company in the microwave area, in SATCOM, area and in the drone area that one could call funded R&D or funded development that is in revenue, and that is in cost of sales.

Okay. That's helpful. And then, what did you see once the government shutdown ended, I mean, what did bookings looked like -- did flow really pick up right away? Was it sluggish to pick back up? And maybe if you could give us some idea of how much of this shift in the EBITDA cash flow outlook for this year was kind of directly attributable to the shutdown versus other reasons.

Right. The biggest part of the receivables are those international milestones, which is not related to the shutdown. That is the biggest part where we need to achieve some objectives. We are currently scheduled to get back out there and achieve them in the first quarter, I believe. There is that piece. For the first part of your question, lead right up to the two weeks prior to the end of the fiscal year, but most importantly, after the shutdown has happened and continuing, things are choppy. There are orders where we are designed in. We are designed in on the platform or on the program. We had a commitment scheduled -- in particular, this is in our modular systems division -- where the order has not been placed. It is sitting there. And I analogized that to the statement I used a few minutes ago on caution. There is just -- there is still caution out there, and I can understand it because we are operating under a CRA that goes 15 days after 12/31 and then we saw what happened before. Customers are cautious. And it is just that -- is just choppy right now. It is very choppy.

Okay. Understood. And then, last one for me. I was just wondering, Eric, if you could give us some color on what you are seeing internationally in terms of opportunities and new business pursuits.

Yes. Internationally, the opportunities are in missiles -- are primarily in missiles and radars. And these are offensive missile systems and missile-defense systems both tactical and ballistic missile defense systems. The opportunities are significant. We have been seeing many of them in the press recently, what is going on with that. What is going on with Patriot. There aren't a lot of specific announcements out of Israel relative to what is going on there. But Iron Dome is growing. Arrow -- Arrow 1, Arrow 2, Arrow 3 are all going. Missile systems related to India from Israel are growing significantly. So there are significant opportunities in the missiles and related radar areas out there, and I think virtually every system I just mentioned to you, we are designed in and on them. And so as the OEMs, God willing, are successful in these areas, so are we, and we go with them.

(Operator Instructions) David Olkovetsky, Jefferies.

I wonder if you could just give us a bit more sense on what is happening with the expected milestone payments with regard to the production contracts now that we are 48 days into calendar slash fiscal 4Q. Have you been able to collect on any of those yet? Are you seeing any more push back with respect to your receivables?

Right. Yes. We have continued to collect milestones in many areas across the company. The 2.5 or 3 week delay did gum things up, especially relative to DFAS coming out and signing off things that would result in a shipment, and then you achieve the milestone to bill it. But those are occurring. They are happening. The foreign ones are the ones where the events are not scheduled to occur to achieve the milestone until the first quarter.

Got it. Okay. And then I just want to make sure I am looking at the numbers correctly. Are you anticipating a further working capital outflow in the fourth quarter?

No.

Oh, no.

No. We are assuming a moderate reduction in DSOs of a couple of days.

And that is $2.5 million per day, correct?

That is correct. And it also reflects the interest payment so we do have the quarterly interest payment that is due the first week of December on the bonds.

Got it. And then, switching gears a little bit with respect to your capital structure, I just wanted to get your thoughts. What is your ideal structure look like at this point? Are you thinking of possibly switching to a term loan or are you planning to stay with senior secured notes?

It obviously would depend on the terms and conditions that we could get off of each and strength in each market at the time. I mean, if the term note market, is strong as hell and we could get an incredibly low rate in the term note market, I would consider going and getting as much is possible term notes as I could get at the lowest possible rate because I can pay them off. It is like 1% a year, as you know, for the six or seven years, then a bullet at the end. That would be really good. Similarly, on the bond side, bond rates have been and bond terms and conditions are back to where they were in May, and as you know, some of the bond structures out there, you can actually take out bonds now and you can pay off 10% a year at 1.03%. Well, depending on what that rate looked like and those have very few the terms and conditions, I would have to look at that or we may play them off each other and try to get the best on each. I know that is not a direct answer, but we are going to put in place the lowest cost capital structure, including the flexibility to pay things off, so we can execute this business plan that we can.

Okay. Thank you. That's very helpful. What is the minimum level of cash that you are comfortable sitting with?

About $50 million.

About $50 million.

Yes.

Okay. And then with respect to capital expenditures, I don't know if you are done with your done with your budgeting process yet for 2014, but are you thinking somewhere along the lines of what you have seen so far in 2013?

There probably should not be any material changes from 2013's level.

Okay. Got you. And then, just on free cash flow side, I understand that there is a lot of uncertainty with respect to what is going on in the federal government. Excluding any changes to the capital structure, do you envision any strengthening in free cash flow generation in 2014 relative to 2013 or is it just too early to tell?

Yes. We do expect that to occur. The DSOs both from the international customers as well as PSS, that will, on its own, drive the free cash flow generation as well as on the DOD side.

Okay. Then just on that DSO front, what is the approximate level of days that you actually anticipate achieving? Or in a conservative case scenario, what is the level of DSO reduction that you anticipate?

Our long-term goal is to be at 90 days, and we were at 94 days at the end of last year so we know that is achievable and that is our expectation to get back to that level.

So you view 90 days as a reasonable level to get back to it 2014 or is that more of a 2015, 2016 type event?

That would be our target. Absolutely.

Got you. And then, exclusive of changes to working capital, can you give me a sense for free cash flow generation outside of that?

You mean other working capital uses.

(multiple speakers) relative to 2013 -- 2014 relative to or 2013. Or is it too early to tell on that front. That is (multiple speakers)

We haven't provided any guidance yet for 2014 for the obvious reasons because we are waiting to see what is going to happen at -- in January and in February. But, Deanna has walked through in the past if you use $110 million of EBITDA or $105 million of EBITDA and you assume an interest rate and that, as we talked about, very well may be changing with the refinancing, subtract the interest rate, subtract the cash -- the CapEx. We pay cash taxes, I think, of $3 million or $4 million a year in that ballpark. This is excluding any DSOs. You come to a number. You should -- I don't want to give the guidance for next year. You should run the math, but that is the way to look at it. (multiple speakers).

I am showing no further questions. So I would like to turn the call back to Eric for any concluding remarks.

Thank you very much for joining us. We are truly looking forward to speaking with you again when we report Q4 in Q1 to provide progress on how the business and some of these initiatives are doing. Thank you.

Okay, ladies and gentlemen, this does conclude your conference. You may now disconnect. And have a great day.