Kratos Defense and Security Solutions Inc (KTOS) 2013 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions fourth-quarter 2013 earnings conference call. (Operator Instructions). I would now like to turn the call over to Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary.

Thank you. Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions fourth-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'd like to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos corporate website at www.KratosDefense.com. It is also available on the SEC's website.

Additionally, I'd like to remind our listeners that this conference call is open to the media and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the Company's website later today.

During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance and the potential impact of sequestration, 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 Reports on 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 also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Certain of the information discussed included 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, contract design retrofit costs using a cash tax rate and using a statutory tax rate of 40% are considered non-GAAP financial measures. Kratos believes this information is useful to investors because it provides a basis for measuring the Company's available capital resources, the actual and forecasted operating performance of the Company's business and the Company's cash flow, excluding extraordinary items and non-cash items that would normally be included in the most directly comparable measures calculated and presented in accordance with generally accepted accounting principles.

The Company's management uses these non-GAAP financial measures, along with the most directly comparable GAAP financial measures, in evaluating the Company's actual and forecasted operating performance, capital resources and cash flow. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP and non-GAAP financial measures as reported by the Company may not be comparable to similarly titled amounts reported by other companies. As appropriate, the most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the Company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the Company's website.

In today's call, Mr. DeMarco will discuss our financial and operational results for the fourth quarter 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.

Great, thank you, Deborah and good afternoon. A few months ago, the bipartisan Murray-Ryan budget agreement was approved setting spending guidelines for fiscal 2014 and fiscal 2015. 2014 DoD appropriations bill has now been approved and the Pentagon has recently submitted the fiscal year 2015 budget request and a quadrennial defense review has been submitted.

In summary, as related to Kratos, there are some puts and takes in this recent information as missile defense, EW, cyber-directed energy, railgun ISR and other leading technology areas being solidly funded and supported and other programs like AEHF, P-8, LCS and EA-18G being cut stretched out or reduced.

As a result, though sequestration remains in effect, with the fiscal 2014 and 2015 base defense budget now of about 100 -- excuse me -- about $500 billion, down from approximately $530 billion in 2012 and the US federal contracting environment expected to remain challenging, we are now having some additional programmatic clarity and indications of priorities and funding.

Importantly, with the continuing federal industry challenges, Kratos' commercial and international business today represents nearly 35% of our revenues. Our critical infrastructure security business grew 14% in 2013 with continued organic growth expected in 2014 and our commercial satellite communications business where you have seen a number of recent new contract awards the past few weeks grew 30% in 2013 with similar growth forecasted for 2014.

Also, our PSS business backlog and bid and proposal pipeline remain at or near record levels driven in part by increased threat awareness from security-conscious enterprises, including in the education, energy, transportation, municipality and healthcare areas. The growth in our PSS business and our other commercial businesses and our international business has been and is expected to continue to help offset some of the reductions in our US federal government business.

Over the past several months, several significant strategic and expected to be long-term national security programs have been awarded or have come out of protest situations, including SEWIP, AMDR and NGJ. The U.S. Navy is placing a priority on advancing electronic warfare and Kratos must make the investments now in order to increase and secure Kratos' position on these new long-term program opportunities. As a result, in the fourth quarter into Q1 2014, we significantly increased our discretionary IR&D, in many cases in conjunction with the customer. We are expecting this increased IR&D spend to be very high in Q1 of 2014 and remain elevated throughout the first half of 2014.

Since the end of Q3, we have made important progress with our strategic unmanned aerial systems initiatives, including having a number of successful flights with certain of our new high-performance aircraft and no flight failures. We have also just recently executed a contract modification significantly increasing the contract value by several millions of dollars of an important new high-performance UAS development program we are under contract on. The total value of this program to Kratos with this new contract mod is now several tens of millions of dollars. We have a number of demonstration flights on this program scheduled throughout 2014 and if we successfully execute on this contract and our milestones, this program could ultimately become the largest production program in the Company.

Additionally, and very importantly, we are now also working directly with the customer on a separate new high-performance unmanned aerial system program initiative, which is very exciting for our Company. In this new initiative, we will be producing three demonstration aircraft and we are currently planning on flight tests with this customer in 2015.

As you know, we are also making a significant discretionary internally-funded investment in the UAS area, which we expect to continue throughout 2014 with these investments impacting our near-term EBITDA. We are truly fortunate that we have these opportunities. Certain of which I believe are directly related to Vice Admiral Jerry Beaman joining Kratos last August and Vice Admiral Mike Malone and if we are successful, these initiatives could truly change our Company.

We are also under contract in the unmanned ground system and robotic area where we are providing on-board command-and-control systems, communication systems, ground control systems and other UGS products. We see a large potential future opportunity in this area with one example being the DoD-mandated conversion of tens of thousands of wheeled vehicles from manned to unmanned over the next few years. Kratos' total combined unmanned aerial, ground and robotics systems business across the Company today is approximately $150 million in revenue.

In the cyber area, in 2013, Kratos was awarded a prime position on the DHS continuous monitoring MAC ID/IQ contract vehicle affirming Kratos' position as one of the leading cyber security companies in the industry. Task orders have just recently started coming out under this MAC with several expected over the next few months that we are tracking and are planning on competing for.

We also entered into a strategic partnering agreement with Norse whose significant shareholder is Oak, which is also Kratos' largest shareholder. Norse offers proactive intelligence-based cyber security solutions and continuously collects and analyzes real-time high-risk Internet traffic to identify the sources of cyber attacks. Norse is the only provider of live actionable cyber threat intelligence that enables organizations to proactively defend against today's most advanced cyber threats, including zero day in advance persistent threats.

Kratos currently works with the healthcare organizations around the country to improve patient data security and privacy and to share compliance with HIPAA and HITECH and our initial focus with Norse will be the delivery of live threat intelligence to help healthcare providers secure electronic-protected health information or EPHI. I encourage you to take a look at Norse as I believe you will understand why this new strategic relationship between Kratos and Norse is so exciting for our Company.

Similar to our UAS initiative, we are excited about the future possibilities of the Kratos Norse partnership security offering with 2015 potentially being an inflection point for Kratos in the cyber area as a result of this relationship. Kratos' cyber business is product-focused and including cyber work we are doing in the satellite communication area, total Kratos cyber-related revenue today is approximately $150 million.

We recently announced that we were awarded a prime contract position for all seven zones in the SeaPort-e MAC ID/IQ contract vehicle. This is an incredibly important contract vehicle for Kratos, one where we have performed several hundreds of millions of dollars of work, including in the leading technology, directed energy, railgun and weapons systems areas and we are currently in pursuit of several hundreds of millions of dollars of new opportunities.

In the leading technology area, Kratos is also under contract providing product and supporting the hypersonic vehicles, unmanned system and BMD programs, all of which remain priorities in the FY15 budget request and the QDR. For example, the U.S. Navy has just recently announced it will be deploying its first ship with a laser weapon this summer, the USS Ponce.

So in closing, the US federal government contracting environment remains very challenging and sequestration appears here to stay with the bipartisan spending agreement indicating that fiscal 2014 and 2015 will be the trough of the DoD budget. However, as I mentioned before, we have diversified nearly 35% of our business away from DoD funding. Our critical infrastructure, commercial satcom and international businesses are growing. We are working directly with customers on some large new program opportunities that the FY15 budget request and QDR indicate are priority areas and we are continuing to make progress on our most important strategic focus area in unmanned systems. Deanna?

Thank you, Eric. Good afternoon. Our fourth-quarter revenues of $235.7 million came in below our expected range primarily as a result of continued delays in bookings and shipments due to the continued challenging federal budgetary environment, including a continuing resolution lasting throughout the fourth quarter impacting over 65% of our business.

Our revenues decreased year over year 10.6% from $263.6 million in the fourth quarter of 2012 reflecting the impact of the fiscal 2013 DoD budgetary situation, which caused certain delays in orders and awards, the related impact to timing of product shipments and the continued contraction of our legacy government services business, which continued to decline approximately 9.3% compared to the fourth quarter of 2012.

From an annual run rate perspective, our legacy services business is currently operating at approximately $85 million, down from approximately $100 million for 2012 or an annual 15% decline. Our bookings were particularly strong in the latter part of the fourth quarter, especially in our electronic warfare and satellite communications training and cyber security businesses, with an overall book-to-bill ratio of 1 to 1 for our entire Kratos government security solutions segment. However, as many of these bookings occurred in the latter part of the fourth quarter and due to the long leadtime to produce and ship a number of these products, these shipments and deliveries are not expected to generate revenues until the latter half of 2014.

As we have stated on prior calls, we expected our book-to-bill ratio to be stronger in the second half of 2013, which did occur; however, not quite at the level of our original expectations due to the budgetary environment impacting our industry, which we experienced throughout all of 2013. Operationally, we continue to remain focused on cost reductions and efficiencies and in the fourth quarter, we reduced our headcount by an additional 89 personnel, or another 2.3% of our total workforce, down to a total headcount at year-end of 3,815. This compares to a headcount of 4,317 at the end of 2012 for a total annual reduction for fiscal 2013 of 502 personnel, or 11.6% of our total workforce.

Similarly, we have continued to take actions on additional cost reductions in the first quarter of 2014, including in the personnel, excess capacity and facility areas. This cost rationalization will be a continuous process that we are focused on to enhance efficiencies and operating margins. As a result, in the fourth quarter, we have recorded nonrecurring charges and credits related to legacy acquired businesses, excess capacity caused in part by the delays in procurements and awards, changes in accruals for unused excess facilities, severance, legal settlements, refinancing costs and the contract design retrofit costs previously discussed in the third quarter.

For instance, certain of the more significant items include a charge of $1.5 million during the fourth quarter related to the cost of these personnel reductions, as well as due to the excess capacity and rate variances, a charge of $800,000 related to acquired businesses and $900,000 of costs primarily related to our refinancing efforts in November. These amounts were partially offset by a net $2.4 million credit primarily related to a favorable legal settlement of a contract dispute with a former subcontractor of an acquired business. In addition, an adjustment in total estimated additional future costs related to the contract design retrofit resulting from the aircraft flight test failure that occurred in October was recorded of $2.4 million, along with an increase of $2.1 million to our excess office space accrual.

Similar to previous reports, we exclude such nonrecurring or non-forward business credits and charges from our adjusted EBITDA. Our adjusted EBITDA of $24.6 million for the fourth quarter is from continuing operations and excludes the charges and credits I highlighted.

From an operational segment perspective, our government solutions segment generated $180.1 million in revenues and $20.9 million in adjusted EBITDA or an 11.6% adjusted EBITDA margin. Our public safety and security segment generated $55.6 million in revenues and $3.7 million in adjusted EBITDA or a 6.7% adjusted EBITDA margin. This is up sequentially from $51.8 million and $2.9 million, or 5.6% respectively in the third quarter.

On a GAAP basis, net loss for the fourth quarter was $7.4 million, which included a loss from discontinued operations of $500,000, $8.9 million of expense related to amortization of intangible assets, as well as a $2.9 million income tax benefit. We continue to believe 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 change in excess unused office space and excluding the change in future estimated contract design retrofit costs, utilizing the estimated average quarterly cash pay income tax provision of approximately $700,000 was $0.06 per share for the quarter.

Moving to the balance sheet and liquidity, our cash balance was $55.7 million at December 29 plus $5 million in restricted cash. For the fourth quarter, we generated $11.6 million in cash from operating activities after payment of the semiannual interest payments on our senior notes of $31.2 million in December. The free cash flow generated for the fourth quarter was $7 million after taking into consideration capital expenditures of $4.6 million.

Our DSOs decreased five days from 108 days at the end of the third quarter to 103 days. For fiscal 2013, our DSOs have increased nine 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 a shift of certain contractual billing milestones into 2014. The increase in nine days is equivalent to approximately $23 million in impact to our cash flow as each day's turn is equivalent to approximately $2.5 million in cash. We continue to target DSOs of approximately 90 days on a long-term basis, which we believe is achievable in a stable budgetary environment and as we expect that as 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 product-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 fourth quarter was 80% of revenues generated from fixed-price contracts, 14% from cost-plus fixed fee contracts and 6% from time and material contracts. Revenues generated from contracts with the federal government were approximately 64%, including revenues generated from contracts with the DoD of 60% and revenues generated from non-DoD federal government agencies of 4%. We also generated 7% of our revenues from state and local governments, 18% from commercial customers and 11% from foreign customers. Backlog at quarter-end was $1.1 billion with $540.7 million funded. Backlog at the end of Q3 was $1.1 billion as well.

Now moving on to our financial guidance, in January 2014, President Obama signed a $1.1 trillion spending bill to finance the US government and DoD through September 30, 2014 after previously approving a US federal funding deal that provides some clarity to expected defense spending for the next two years. As a result of the President signing the spending bill into law and the increased clarity to the 2014 DoD budget, we recently provided and today are affirming the Company's fiscal 2014 fiscal guidance. The Company currently expects full-year fiscal 2014 revenues of $920 million to $980 million, adjusted EBITDA of $92 million to $106 million and adjusted free cash flow of $25 million to $40 million. Kratos' fiscal 2014 financial guidance assumes approximately $18 million to $28 million in IR&D and other discretionary internally-funded investments by the Company with the first half and particularly the first quarter of 2014's currently forecasted IR&D spend expected to be significantly higher than the second half of 2014 as the Company pursues large, new opportunities in the UAS, electronic warfare, radar signal processing and satellite communications areas.

We are also providing fiscal 2014 quarterly revenue and adjusted EBITDA guidance consistent with our previous guidance. Revenue and adjusted EBITDA are expected to increase and ramp throughout 2014 due primarily to the following. The effect of there having been little US federal or DoD budget clarity and extended continuing resolution authorization throughout fiscal 2013, which significantly impacted and delayed expected contract awards and orders. We have just recently received previously delayed 2014 production orders on several of the Company's largest programs, including Trident, EA-18G, a certain missile program and a large confidential program with product deliveries and related revenue expected to ramp throughout 2014.

In November 2013, we announced that Kratos is a key member of a team, which received a $450 million single award Missile Defense Agency contract, which was subsequently protested by a losing bidder. The protest was just recently denied and the Kratos team award sustained. Kratos' work under this new large MDA contract award is expected to begin in the second quarter of 2014.

KPSS, which is forecasting 2014 revenue growth of 5% to 10% based on current backlog and bid and proposal opportunities, is expecting revenue to decrease somewhat sequentially from Q4 2013 to Q1 of 2014 and then increase throughout fiscal 2014 as certain large security system deployments conclude and new programs, many of which have recently been awarded, begin, the discretionary IR&D and strategic internal investments we previously discussed with a significant spend in Q1 and Q2 of 2014.

Our estimated adjusted free cash flow guidance is comprised of the $92 million to $106 million of estimated adjusted EBITDA, less cash interest of $62.5 million, less capital expenditures of $13 million to $16 million, less estimated cash taxes of $3 million to $4 million and assuming a reduction of DSOs of approximately five to seven days or $12 million to $17 million. This is equivalent to estimated cash EPS using an estimated annual cash tax pay of $3 million to $4 million, excluding annual amortization of $22 million of $0.01 to $0.15 for FY14.

From a capital structure standpoint, we remain prepared to update the documents necessary for refinancing our senior notes once the no-call period expires after June 1, at which time there will be the stated 5% take-out premium, or $31.5 million, but there will no longer be any makewhole premium, which was a significant outlay of cash and costs when we pursued a refinancing effort in November.

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 with the expectation of reducing our interest expense and extending our debt maturity profile. If the refinancing is successful, this could significantly increase Kratos' 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' equity value. With that, I will turn it back over to Eric.

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

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

Thank you. Can you share any further detail on the nature of the large UAS program you are now under contract for? And also discuss whether you have a working UCIS system today?

On the large one, Mike, that we are currently working on, as I mentioned, we just recently received a contract modification. It is now at several tens of millions of dollars over the next couple of years. We have a number of significant, very important flights scheduled throughout this year. And as I said in the prepared remarks and in the release, if we are successful on this, achieving our goals and objectives and the milestones, this clearly would become the largest program in the Company by far potentially exponentially. It is that potentially significant to us.

On the second one I mentioned, that is brand new. It has -- this initiative has just come together with this customer in the past several weeks. We are under a significant non-disclose arrangement here and I can't say anything other than I said that we are driving towards some demonstration or test flights with this aircraft, which would be a UCAS in 2015.

Okay, thank you. We know that the DoD is pursuing this air/sea battle strategy and they have programs like Hydra and Integrated Topside and such to help further strategic goals. Can you talk at all about where you fit into any of these initiatives?

Yes. We have submitted bids on Hydra. We have two outstanding on that one. We are involved with DARPA in certain other areas with some additional opportunities coming out. We are also involved with some other agencies with some similar next-generation unmanned system opportunities that we are working on. So we are right now directly related to what Admiral Beaman and his team are doing right in the middle of what you talked about plus more.

And what about the existing or the pre-existing CEI targets business with the Air Force and potentially others, including MALD and Firejet, etc.

Yes, so the 2014 budget, I believe, had $27 million in it for AFSAT, then I believe in 2015 the request has $33 million in it for AFSAT. MALD is moving right along at approximately 200 airframes a year. We are still under contract on MSST and that contract -- that contract is going to go for the next several years. I am hesitating because we are under an NDA on that, but we are still working on that and then there are the -- I will use the word confidential programs that they are working on that we are still working on those.

We are delivering aircraft on a number of international opportunities right now producing and delivering them. Certain other international opportunities have been delayed for similar budgetary reasons that we are experiencing here in the United States and we are currently negotiating on a very large several dozens of aircraft opportunity that, if timing comes together, we will be able to talk about that in Q2 or Q3, excuse me.

Okay, thank you. And then final question, you can call your notes at $105 on June 1 and if you had to pick a range of 50 basis points, if it was today, where do you think you get new debt in place?

Mike, this is Deanna. I think it's in that probably 7 plus range. I don't really want to be too specific because it is in negotiation, so --.

Mike, if we do part notes like we currently have in part term debt, it will be less. If we do pure notes, again, it will be a little higher upfront, but then again it won't have amendment fees, etc. if we do anything moving forward relative to any of these programs. And so that is what we are studying.

Okay, thank you very much.

You are welcome, sir.

John Nelson, State of Wisconsin Investment.

Hi, Eric and Deanna. It sounds like you have got a very promising opportunity set ahead of you. And I congratulate you for trying to develop that potential. My question is related to an item that we've talked about many times before, but with what just happened in Crimea and the Ukraine, do you think there is much of a possibility that the land-based anti-missile systems get reinvigorated for the Eastern countries like -- Eastern European countries like Poland and Czechoslovakia again?

Yes, so -- and first of all, John, thank you for your comments upfront. We are very excited about the opportunity we have. We can see it and the fact that we are under contract, and this isn't on a drawing board, it actually exists, is very reassuring. On your questions, yes, Aegis Ashore is moving forward. The recent -- there was just a recent contract award related to that that is out there. We are involved with Aegis Ashore in many different aspects -- ground-based midcourse defense now. When the President came in, he made the decision not to increase the number of interceptors at Vandenberg or Greely, Alaska. Now he has just recently changed and that they are going to be expanding the missile field.

Just recently in the past couple, three weeks, the decision by the DoD to redesign the Exoatmospheric Kill Vehicle, which we are also on, has come out. So I think it has to do with what is going on in Russia and Crimea and what North Korea is doing and what Iran is doing and the world remains a dangerous place. So yes, sir, those are -- the ones you mentioned are all moving forward.

Thank you.

Yes, sir.

Mark Jordan, Noble Financial.

Good afternoon. A question on the R&D. If you look back at previous quarters up until the fourth quarter, you are running sort of internally at about a $4.5 million rate plus or minus. Obviously, spiked up to $6.9 million this quarter. You talk about a higher rate in Q1 and then continued high in Q2. Is the higher rate up sequentially and if so, how much? And do you see, when it settles in the second half, do you go back to that sort of $4.5 million quarterly run rate or does it settle at a higher level?

Mark, it's Deanna. So as a rate of percentage of revenue, it will be slightly higher than the fourth quarter, but from a dollars perspective, we don't think it should be higher than what we just incurred for the fourth quarter. That will probably be sustained for the first half and then we should see it drop back down, not at the levels that we have been at historically, a little higher than where we had been at just because of the investments that we see being made throughout the year.

Okay. Eric, following up on your comments relative to the potential debt structure you may have after you call the notes, either all notes or term -- mix of term and notes. If you are all notes, would you have the ability to pay down those notes as you generate free cash flow or would you have to wait some period of years until you have non-call fixed buyers?

Mark, as long as we understand -- if it were an all-note structure, if they are senior secured, then there is the ability to pay down. When we were in the market in November, what we understood was that we could pay down up to 10% per year at $103. So we foresee that that would be the same structure if we were to go for an all-note capital structure.

Okay, thank you. Eric, you mentioned a couple major long-term naval programs being next-generation Jammer C weapon AMDR all sort of breaking loose from protests and things. Could you say how much of the revenue do you expect to get from those types of contracts in 2014 and how do they ramp in 2015 and 2016?

Okay. I expect SEWIP is going to be very strong for us this year, block 2 and that is expected to ramp in 2015. Block 3 is expected currently to be awarded this year. If block 3 is also awarded, is awarded this year, then 2015's ramp could be even more significant and beyond.

On NGJ and AMDR, Mark, I don't want to get into details on that right now for competitive reasons. But we believe we are very, very well-positioned on those. Those are a little bit behind the cycle relative to SEWIP because SEWIP block 1 was awarded a few years ago. SEWIP block 2 was awarded most recently. AMDR and NGJ both -- the development of both just came out and so production for those are a few years off. The initials on those would be design and development, which is one of the reasons we are spending. As you said, they broke free, we can't time these things and we are working to make sure we have important positions on these going forward.

Okay. Final question from me, you mentioned the Norse relationship. Looking at their materials, they seem to have some unique capabilities with regards to real-time identification of bad IP sources. What do you or what are you and Norse planning to do in terms of development or need to do in terms of development to have that, quote/unquote, point of inflection in 2015 that you've referred to?

Right. Mark, what we are doing initially, we are going after the healthcare market because that is where we have a channel of distribution and then very shortly thereafter, we will be going to the satellite communication market because we have a channel of distribution there also. What we are going to be working with Norse designing is going to be what I will call the interface that is relevant to that direct customer set. In this case, we will say the healthcare provider. Depending on the type of IP situation that we are going to be trying to proactively protect, whether it be customer-related -- excuse me -- yes, customer client, healthcare client or patient-related information and those systems we are going to be protecting, Mark, but this can also include, as you know, everything -- virtually everything now has an IP address. So for example, a heart machine has an IP address or a CAT scan has an IP address and those are literally being used as hosts by bad actors for things.

We will have to be developing a separate interface so the user who is going to be wanting to protect those and identify proactively prospectively who is coming at them can map out that system and identify where it is. So it is that interface relative to that network architecture and the specific IP items that we are going to be designing that then will connect into Norse's information and Norse's system to identify the bad actors so people can see what is happening real-time and make decisions on how to react.

Your goals for the development of that interface are midyear, fall?

Fall.

What timeframe do you --?

All fall. Right now, the plan is Q3.

Okay. Integral Systems, as you'd mentioned, has had a real string of wins recently. You talked about that that was 30% growth last year, 30% growth expected for this year. Is that a function of an increase in the number of satellites going up or are you displacing already installed systems out there where your [EPIC] system is replacing a legacy management system that is out there to upgrade the performance?

Right, Mark, it includes all of the above. It includes new satellites that are going up, new services that are required by the operators, a demand for EPIC, which, as you know, is the gold standard on command and control in the space segment and also very, very importantly, it is what we are doing in the cyber area and the radiofrequency interceptor jamming side relative to satellites where we are working with these customers on identifying what is being jammed, who is jamming them, where precisely from geolocation it is coming from so action can be taken. And that ties into KPIs and the KPIs the operators need to deliver.

Okay, thanks very much.

You are welcome.

Tyler Hojo, Sidoti & Company.

Yes, good evening. Thanks for taking the questions. I guess just firstly to go back to the UAS development initiatives, I am just kind of curious on a couple of different fronts. First would be when we should probably start thinking about moving from development into production. I'm curious what you have to say about that, Eric. And then I am also curious just in regards to the internal R&D expense. I mean it seems like interest from your customers continues to grow on this productline and I am just curious how we kind of size the risk of a spending creep in terms of your internal spend.

Yes, yes, very fair. If everything, Tyler, goes correctly and goes well, it is possible that in 2015 we could go to LRIP.

Wow, okay.

If it does not, it will be 2016. Everything would have to go correctly to go to LRIP in 2015, but more likely 2016.

Okay.

So that is on that. On spending creep, that is an excellent question. As I mentioned, we currently have an agreement with this customer. This is the second program now to do demonstration flights in 2015. And it is middle to Q3 of 2015. If we are successful getting to there, we are going to know a lot when we get there. I don't believe outside of the ranges that we gave today, I don't believe, unless something really unforeseen happens, that we would have spending creep outside of those bounds. I just don't. We have identified the aircraft, we have the aircraft, it is not a brand-new aircraft. It is going to be a derivative of an existing aircraft that is heavily modified, of course and I think we have it scoped out.

Okay, that is certainly helpful. Okay, great. And I guess maybe one for Deanna. I think you provided your cash EPS guidance. Was it $0.01 to $0.04? Did I hear that correctly?

$0.01 to $0.16.

$0.01 to $0.16. And could you maybe just walk us through the restructuring and the amortization expense that is included in that range?

Sure. So the amortization is about $22 million and no restructuring is assumed in that guidance. And cash taxes are $3 million to $4 million.

$3 million to $4 million. Okay, great. And then I guess just lastly from me, I just want to talk -- I just want to touch briefly on the margin profile within the PS&S business. Certainly it was nice to see the sequential improvement in Q4. How should we think about kind of profitability ramp in 2014?

We spent a significant amount on sales and business development in Q4 in that business, Tyler. It was significant and we have had a lot of wins recently. Most of them we are not allowed to disclose for -- we don't have approval to disclose them. So Q4 and thus far into Q1, it has been very heavy sales commissions, wins and related business development. As these jobs come online and they ramp up, the revenue ramp against that spend will spread. We'll get leverage off of it and we are expecting the margins to increase.

Okay, great. Thanks a lot for all the detail.

Yes, sir.

Sheila Kahyaoglu, Jefferies.

Good afternoon, Eric and Deanna. Just a quick follow-up on the CBM program. You mentioned task orders are in the upcoming weeks. When do you expect potential awards are awarded and has that been pushed to the right at all?

There have been -- I believe that there have been a couple, three awards on the continuous monitoring, which went to some off-the-shelf software that certain of the other prime holders have access to at discounts that we do not and so we did not participate in those. Those were I believe straight from -- those were DHS awards. The next several task orders that are coming are coming from civilian federal agencies. They are coming up instead of down where the requirements on these on I think three of the four are right in our sweet spot where hopefully now our advantage with Microsoft and Dell, one of the other advantages was with, for example, HP will give us a favorable position. And so these are coming out in the next month or two. These are ones that we are again in our sweet spot, so we are going to bid on those and so as soon as they award them after that. So the next three or four months, we are going to know on this next slew of task orders, I believe.

Okay, got it. And then in terms of just sticking on in terms of your trajectory for upcoming orders for PSS. In the past, you've mentioned there are several big contract awards. Have they been awarded yet or is that part of the Q4 pipeline that you have been working through?

It is part of the Q4 pipeline and I was briefed just yesterday by the division president who came in and saw me that one of those large ones is slowly moving forward relative to a procurement. So they are still there; they are coming, but it was part of Q4 as you mentioned.

And just the size of them for scope is about $20 million. Am I recalling them correctly?

$50 million to $100 million.

Over a few years though?

Yes.

Okay, got it. And then in terms of your cost-cutting efforts, you mentioned you are continuing a few reductions in Q1. How do you think about the appropriate size of the business given that you think it sort of bottoms out in 2014 and 2015?

Right. So the number one thing that we have been doing is as our facility leases have been coming up relative to the acquisitions we made over those number of years, we are doing everything we can to consolidate our footprint where we have multiple facilities in a certain geographic region to get into one facility and typically, it is a brand-new facility that is totally -- that is much less costly than what we had before. So that is continuing. That is part A.

Part B, the mix of our business of certain areas of our business is changing significantly. Let me give you an example. In our modular systems business, we were previously building specialized tactical modules for the Humvee. This is when it was more of an asymmetrical warfare position than a (inaudible). Now we are moving more towards modules for Patriot, modules for THAAD, modules for Aegis Ashore, the electronic module enclosure for DDG-1000. These are much larger and much more sophisticated, but there are a lot fewer of them. So we need fewer people to build them, but they are larger and higher value. So it is offsetting some of the revenue decline.

So in that case right there, as that business continues to transition, for example, we are just going to continue to rightsize it through the product mix that we have and that is both on the personnel side and on the facility side. I could see over 2014, I'm speculating, maybe another 100 headcount across the entire 3,700, 3,800.

Do you have to add headcount in PSS?

Oh, yes. We do, but it is a mix. We do both. It is a rightsizing in certain areas, but you add in others.

Okay, got it. And then just a last one for me, please, if you don't mind, what is the risk to the low end of 2014 guidance on the revenue side?

Well, it is a lot different as we sit here this year than last year because we do have a budget, so we know we have a budget through September 30 of 2014. In addition to that, we have a spending bill, the bipartisan spending bill that the President signed that outlines spending for 2014 and for 2015. That is a good data point. So the risk I see as we sit here today is we get to October 1 of 2014 and even though we have a spending bill, Congress and the President don't come to an agreement on a defense budget even though they know the spend is supposed to be $496.6 billion and we go into a continuing resolution into Q4. So that is the risk, the one risk factor I see right now as we sit here.

So it is more the short cycle business? Not --

Yes.

-- a program type of thing? Okay.

Yes, well said. Yes.

Okay, I understand. Thank you very much.

You are welcome.

Michael Ciarmoli, KeyBanc.

Hi, good afternoon. It's actually Kevin on for Mike.

Hi, Kevin.

Most of my questions have been answered; just a couple here. And Tyler started to go into this, but I was wondering if you could give us some color on the kind of bid and proposal environment in the PSS business, maybe kind of by -- I know you mentioned you couldn't talk about specific customers, but maybe by kind of broader end market and then an update on kind of the timing of task orders against the new C4 specialty contract.

Yes. In the PSS business right now, the bid and proposal pipeline is extremely strong in healthcare, healthcare facilities, educational facilities and mass transportation. It is extremely strong and procurements are moving very, very quickly and where we have experience and where we are a known entity in some instances, we are getting plussed up or we are getting sole-source add-ons because of speed of execution. And that is because of the breadth perception right now with public venues in this country for the reasons that we know, because of the stuff that continually happens. So those three areas are very, very strong.

Also very solid is energy. And that is both in the transport area, the refinement area and the production areas. So those are the ones that are -- all areas are strong. Those are the ones that are the strongest right now.

Okay, that's helpful. And then in terms of the SeaPort actually, any shift I guess from what you see on that versus the old contract?

As I mentioned, that is an incredibly important vehicle for us where we do a significant amount of work, including in some of the areas I mentioned that are priorities coming out of the 2015 request on the QDR in the directed energy area and in the railgun area, for example. We have a fairly significant railgun bid out right now we are expecting to hear on in the next 30 days, for example. So that is -- it is very important and as I said, we have got literally hundreds of millions out there with one or two big ones supposed to be awarded in the next month or two.

Okay. And then you talked about a lot of the positives from the budget release last week. And just kind wondering from your perspective if there were any real big negative surprises. I mean I assume LCS might fit into that category. Anything else out there?

Yes, so upfront, in my prepared remarks, so the negative, AEHF, there are two satellites that are either being pushed or truncated. Good news on P-8, which is a very important program for us. It is going into full-rate production. The bad news on P-8, the quantity has basically been cut in half for the next year or two. LCS, that is one I fully expected. It has actually turned out better than I expected. I thought that that procurement would be cut at 20 ships and I think it is cut at 32, I think.

EA-18G, EA-18G plussed up in the 2014 request, in the 2014 budget, currently not in the 2015 budget. Though I saw this morning that it is going to be added on with Congressional approval, so that has a question mark on it. As I said, there were some puts and calls. We had some good puts and those were some of the calls.

Okay, that's helpful color. And then last one from me, you mentioned a couple areas where that kind of increased R&D spend was targeted. UAS, obviously, EW satellite, just kind of wondering if you could maybe be a bit more granular in terms of how that actual total amount of R&D is split up, maybe looking at it by a percentage towards UAS versus EW?

No, no, sir.

Okay. All right. That is all I had.

Okay, thanks.

(Operator Instructions). David [Okavetski], Jefferies.

Hey, guys. First on a lighter note, I was on the subway in Manhattan at 51st and Lex the other day and there was a Kratos sign. I was just wondering if that is you guys.

Absolutely, it is, sir. It's a very important account for us, the (inaudible).

What are you guys doing down there?

We are deploying some very interesting security assets down there.

Okay, fair enough. Good, so you are keeping me safe. Thank you. I appreciate it. And I was going to ask about Poseidon, but it sounds like we just went over that. Can we go over the backlog a little bit and just remind us approximately what percentage of that you are designed in on, so to speak?

Right. I would -- take the midpoint of our range of 950, take out our critical infrastructure security business of say 220 or 230, take that piece, the remaining piece. We are designed in on that piece I am going to say 60% to 70%.

Okay, so in other words, and correct me if I am wrong, that business is not going away functionally, correct?

Unless something else happens with the budget or a program gets terminated or canceled, that business is not going anywhere.

Great, okay. And then I am not familiar with Norse. Did you mention how big they are? Are they a possible acquisition or merger target?

No, sir, no, no, no, no. They are one of those companies -- first of all, they are private and so I can't get into their size, but this is one of those companies that is or is going to be worth hundreds and hundreds of millions of dollars based on valuations for what these guys are doing right now. This is like a Mandiant kind of a thing, that kind of -- that is kind of what this is. And so no, there is not a chance for us to acquire something like that. We are very fortunate that their principal shareholder is our largest shareholder and it has given us the ability to team with them on some interesting, very interesting opportunities that I said could be very beneficial for us if we are successful next year.

Okay, I guess I am just wondering if there would be any synergistic benefit between the combination of the two businesses. I don't know --.

There would be. I am not talking about an acquisition type combination, but a combination like we are doing strategically. It is the channels of distribution that we bring in certain areas where we have significant cyber footprints and customer relationships like credibility already and that is where we are starting out in healthcare and that is a big cyber area for us and satellite communications.

Got it. So like revenue synergies is essentially what we are talking about here, right?

Yes, it is revenue, but it is also, and this is no slight to them at all, they are a technology company, but we have been working with these customers for years and years and years, so it is credibility and critical mass if you are going to do a large multimillion dollar deployment.

Okay. And then, Deanna, I think you said that there was a $900,000 charge for the attempted refi in November.

That's correct.

So I guess the question is I mean what was that -- it didn't get done, right, so what did the bank make you pay for exactly?

So it is comprised of a couple things. A portion of that is related to the bank. There were some deposits that they required us to provide for estimated fees. There is a fee related to one of the rating agencies because they did rate the Company. Albeit the opinion was pulled after a day when we had pulled the transaction. The good news is we should be able to use that fee when we do go back out in the market. So it is not lost, but from an accounting perspective, we are required to expense it. And then the remainder of the fees was related to legal and accounting fees.

Okay, great. And then also you went through your free cash flow bridge. I apologize; it was a little bit quick for me. Would you mind doing that one more time?

Sure, no problem, no problem. So if you use the adjusted EBITDA of $92 million to $106 million, subtract cash taxes of $3 million to $4 million, interest, cash interest of $62.5 million, so this assumes no refi, and CapEx of $13 million to $16 million, that comes to about $13.5 million to $23.5 million before any type of working capital changes. So we are assuming we will be able to reduce our DSOs from five to seven days, which would generate $12 million to $17 million to achieve that $25 million to $40 million of free cash flow range.

Okay, perfect.

Assuming no refi at this point.

Right. But we are assuming there will be a refi, right?

Correct. But it is when it will happen and obviously, we don't want to get ahead of ourselves. So that is our focus and we continue to discuss with financial advisors to determine when the right time is.

Okay, perfect. Thanks so much, guys. I appreciate it.

Great. Thank you.

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

Very good. Thank you for joining us this afternoon and our next scheduled update will be related to our Q1 announcement. Have a good afternoon.

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