Kratos Defense and Security Solutions Inc (KTOS) 2014 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions first quarter 2014 earnings conference call.

At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions).

As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer, and Secretary. You may begin.

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

Before we begin the substance of today's call, I'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 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 Report 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, 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, stock compensation expense, contract design retrofit costs, and other, 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 first quarter of 2014. He will then turn the call over to Ms. Lund, who will 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. Good afternoon. Many important positive developments across the Company to update you on this afternoon. We're glad you could join us.

In the first quarter, we saw strength in certain of our higher technology and value-add product areas, including unmanned systems, electronic products, satellite communications, and signal intelligence, with some delays with certain PSS new business starts, which resulted in us achieving the higher end of our adjusted EBITDA forecast, and coming in just under the low end of our revenue range.

We have now received and started work on a number of new, large critical infrastructure security system deployments, many of which we have been able to publicly announce over the past several weeks, and we expect to see approximately 10% Q2 over Q1 sequential PSS revenue growth, and 5% to 10% growth year over year for this business.

Kratos' Q1 book-to-bill ratio was one of the strongest we have seen in the past five fiscal quarters, which we believe is a direct result of a DoD budget being in place for the first time since 2012, and the Company's last six month book-to-bill ratio is now approximately 1.0 to 1.

Bookings have remained strong thus far into the second quarter, as you have seen with the number of contract awards we have been able to publicly announce, including important EA-18G, P-8 Poseidon, and unmanned system awards, and a large amount of work is now underway, with delivery scheduled beginning in Q2 and into Q3 and Q4.

Additionally, we just recently received a $35 million C4ISR contract award that our customer approved this week for public release, and which we will be formally announcing shortly, and just yesterday we received another large mass transit authority security system deployment contract award.

We have also in the past few weeks completed negotiations for a large sole-source radar and missile-system-related product order of approximately $44 million, which we expect to commence work on in the May and June timeframe.

In Q1, Kratos' proposal pipeline increased approximately 25% from year end, up to $6.5 billion, as we are pursuing a number of new, large opportunities, including in the unmanned systems, electronic warfare, training solutions, and SATCOM areas.

Accordingly, as a result of our large number of recent contract awards, growth in our proposal pipeline, and overall improving industry conditions, we have reaffirmed our fiscal 2014 annual guidance, with expected approximate 15% sequential Q2 revenue growth over Q1, and continued growth throughout the year.

As you know, in the first half of 2014 we are making important IR&D and other investments in the electronic warfare and satellite communication areas, in part due to a number of large, new industry programs being recently awarded, including SEWIP, NGJ, AMDR, and the AESA upgrades, with the objective of significant and increased design-in positions on these programs. A large portion of this incremental IR&D spend is expected to conclude or end at the end of Q2, which will result in increased EBITDA and cash flow for the Company in the second half of the year.

In Q1 we continued to aggressively manage the Company's cost structure, as we have committed to you on previous calls, reducing our headcount by an additional 120, eliminating and consolidating facilities, streamlining operations, and restructuring the business. Proactive cost management will continue going forward, including expected substantial reductions in our real estate lease cost, with the expiration of a major lease later on this year, which will not be renewed.

Additionally, in 2015 we will eliminate another significant lease cost, as a second major facility lease expires, and which we also do not plan to renew. The reduction of our cost base will result in increased future cash flow and EBITDA.

And now, very importantly, since our last update, we have had a number of successful flights with Kratos' newest unmanned aerial aircraft, and we have successfully achieved some very important platform and programmatic-related milestones. This new UAS platform, and the related large contract we are performing under, is expected to become the largest production program in Kratos in the new few years, at approximately $1 billion or more.

Additionally, we are currently completing negotiations with a customer for an approximate $70 million unmanned aerial drone system order for a different Kratos UAS platform, which we expect to receive in the third quarter. This order would be sole-sourced to Kratos due to IP and data rights ownership positions on this aircraft.

We are also in negotiations with a potential new customer for an initial buy of 20 unmanned aircraft, including a third Kratos UAS platform, and related support equipment, and we expect to receive this initial order of approximately $30 million in the second half of this year. This order would also be sole-sourced to Kratos. There could also be a potential follow-on order of approximately equal size in 2015 from this customer.

We are also working on a new UCAS program with a government sponsor, with three aircraft just beginning production, and test flights for this platform currently scheduled for next year. Additionally, we have also recently been notified by another, separate, government customer that there is an additional potentially important opportunity for a certain Kratos UAS platform under a new program, which we are currently exploring.

And finally, we have just been informed that a Kratos UCAS platform and aircraft will play an important part of a major exercise in the second half of this year.

In summary, we have made significant progress in our strategic unmanned systems initiative and the investments we have been making in this area are creating real opportunities for the Company. Additionally, including making significant platform, programmatic, and customer-related progress, our recent flight successes could also mean the potential for a significant reduction in our currently IR&D and investment spend, going forward.

Nearly 20% of Kratos' business today is related to unmanned aerial systems, ground systems, and robotics. This area is growing and is expected to continue to grow in the future. As a data point, in fiscal 2014, we are currently planning on producing approximately 275 unmanned drones, systems, or aircraft, all of which are jet or turbofan powered and high performance.

In closing, we believe that Kratos is well aligned with US national security priorities, including unmanned systems, electronic warfare, missile systems, radars, and ISR, all as described in the FY '14 budget, the QDR, and the FY '15 DoD request. We are under contract and working on a number of potentially transformational UAS opportunities for Kratos for the mid and long term, and we are making excellent progress.

Kratos' PSS business, which is approximately 24% of our Company's revenue base, is expected to continue to solidly grow in 2014, and this will be the near-term growth driver of the Company. Accordingly, we are focused internally with our emphasis on realizing the organic growth potential we have, maximizing EBITDA, and achieving the cost reductions that we have outlined, and we expect to use the cash flow we generate to de-lever the balance sheet.

With that, I'll turn it over to Deanna.

Thank you, Eric. Good afternoon.

Our first quarter revenues of $200.1 million came in below our expected range, primarily as a result of the wind-down of certain contracts in our PSS segment, and the delay of expected awards and the commencement of critical infrastructure deployments later than expected. A number of these awards have now been received and work has commenced.

Our revenues decreased year over year 21% from $252.8 million in the first quarter of 2013, reflecting the impact of fiscal 2013's DoD budgetary situation, which caused certain delays in orders and awards, the related impact of timing of product shipment, the expected reduction in two sizable satellite communications projects as the scope of work completed its natural contract lifecycle, resulting in net aggregate reduced revenues of $5.1 million, and the continued contraction of our legacy government services business of approximately $6.5 million, or 29.3% compared to the first quarter of 2013.

Operationally, we continue to remain focused on cost reductions and efficiencies, and in the first quarter, we reduced our headcount by an additional approximate 120 personnel or another 3.1% of our total workforce, down to a total headcount at year-end -- from year-end of 3,696. This compares to a headcount of 3,815 at the end of 2013.

We've continued to take actions on continued cost reductions in the first quarter of 2014, including in the excess capacity and facility areas. This cost rationalization will be a continuous process which will help to enhance operating margins and efficiencies, while improving our operating margins.

As a result, in the first quarter we have recorded charges related to excess capacity caused, in part, by the delays in procurements and awards, changes in accruals for our unused excess facilities, severance, and contract design retrofit costs. For instance, included in the first quarter is a charge of $500,000 during the first quarter related to the cost of personnel reduction actions, as well as excess capacity charges of $500,000, a charge of $1 million related to contract design cost for certain of our new aerial target platforms, along with an increase of $200,000 to our excess office space accrual related to facility contraction actions we have taken.

Similar to previous reports, we exclude such recurring or non-core business credits and charges from our adjusted EBITDA. Our adjusted EBITDA of $17.1 million for the first quarter is from continuing operations, and excludes the charges highlighted.

As expected, our adjusted EBITDA was impacted by an accelerated level of R&D investments during the first quarter, which were at $5.2 million or 2.6% of revenues. As a reminder, our normal R&D spend as a percentage of revenues has been historically at 1.6% to 1.9% of revenues.

In addition, included in our cost of sales is approximately $500,000 of investments related to blue sky initiative, in which we are internally funding flights of our newest unmanned aerial system platforms.

On a GAAP basis, net loss for the first quarter was $15 million, which included a loss from discontinued operations of $100,000, $5.6 million of expense related to amortization of intangible assets, as well as a $2.3 million income tax expense.

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 non-recurring items. On a pro forma basis, EPS from continuing operations, excluding amortization, stock compensation expense, restructuring and related items, excluding the change in excess unused office space, and excluding the contract design retrofit costs, utilizing the estimated average quarterly cash-pay income tax provision of approximately $700,000, was a loss of $0.06 per share for the quarter.

Moving to the balance sheet and liquidity, our cash balance was $53.6 million at March 30th, plus $5 million in restricted cash. Cash flow from operations for the first quarter was $1.7 million, and free cash flow was a use of $1.4 million with a net reduction in accounts receivable generating a $17.8 million source of cash flow from operations, despite an increase in DSOs or days sales outstanding of 10 days. The DSOs increase primarily resulted from previously forecast lower first quarter revenues, as well as certain expected missile system program milestone receipts being delayed due to a subcontractor-related issue. The subcontractor issues is expected to be resolved and the milestones achieved in the second and third quarters of 2014, the first of which was resolved and collected in April.

The increase in DSOs is primarily a result of continued delays in funding stemming from the recent budgetary environment, as well as the shift of the expected completion of certain contractual billing milestones into future quarters of 2014. The increase in 10 days is equivalent to approximately $25 million in impact to our cash flow, as each day's turn is equivalent to approximately $2.5 million.

We believe that certain of these more sizable milestone events will be achieved later in 2014 and some into early 2015, resulting in a reduction of DSOs and generation of cash flows from working capital. As our revenue mix is more product-focused now, our DSOs fluctuate due to the timing of shipments and satisfaction of billing and contractual milestones.

Our contract mix for the first quarter was 81% of revenues generated from firm, fixed-price contracts, 14% from cost-plus fixed-fee contracts, and 5% from time and material contracts. Revenues generated from contracts with the federal government were approximately 58%, including revenues generated from contracts with the DoD of 55%, and revenues generated from contracts with non-DoD federal government agencies of 3%.

We also generated 6% of our revenues from state and local governments, 24% from commercial customers, and 12% from foreign customers, with our aggregate non-DoD revenues comprising 36% of our total revenue.

Backlog at quarter end was $1.1 billion, with $534 million funded. Backlog at the end of Q4 was $1.1 billion.

Moving on to financial guidance, the Company today affirmed its previously communicated full-year fiscal 2014 financial guidance of revenues of $920 million to $980 million, adjusted EBITDA of $93 million to $106 million, and free cash flow of $25 million to $40 million. Revenues and adjusted EBITDA are expected to increase and ramp throughout 2014, due primarily to the timing of expected deliveries and shipments in the second half of the year, and EBITDA is also expected to be impacted by internally funded investments by the Company with the first half, and, in particular, the first and second 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.

Our estimated free cash flow guidance is comprised of the $93 million to $106 million of adjusted EBITDA, plus cash interest of $62.5 million, plus capital expenditures of $13 million to $16 million, plus estimated cash taxes of $3 million to $4 million, and assuming a reduction of DSOs of approximately 5 to 7 days for a generation of $12 million to $17 million.

As we have discussed previously, from a capital structure standpoint, we remain prepared to update the documents necessary for refinancing our senior note, as we are closer to the period in which the no-call expires at the first of June, at which time there will be the stated 5% takeout premium, or $31.5 million. 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 up-front costs various current market condition, and the benefits associated with the refinancing, with the expectation of being opportunistic and to reduce our interest expense and extending our debt maturity profile.

Our goal remains to increase Kratos' free cash flow, and we plan to use the additional free cash flow to further de-lever our balance sheet, with the goal of increasing Kratos' equity value.

We also announced today that Standard & Poor's revised its Kratos outlook to stable from negative and affirmed Kratos' B rating yesterday. S&P noted that clarity regarding the US defense budget has improved in recent months, and S&P's view is that there is less potential for disruption in demand and volatility surrounding its base case forecast for Kratos than in the past, due to a more certain outlook for near-term US defense spending, and that it should stabilize near-term demand for Kratos' products and services. S&P also noted that the stable outlook reflect its view that Kratos' credit metrics will gradually improve over the next few years due to a combination of debt reduction, improved cash flow and modest earnings growth.

I will now turn the call back over to Eric for closing remarks.

Thank you, Deanna. Operator, we'll turn it over for questions at this time.

Thank you. (Operator Instructions). And the first question is from Mike Crawford of B. Riley & Company. Your line is open.

Thank you. On your unmanned platforms, particularly the combat platforms, how similar are these different prototypes you're building for these different customers, and to what extent does stealth play into any of the products you're working on?

Mike, to be clear, when you ask, how different are they, how different are they from what, sir?

From each other?

Oh, got it. They are very similar to each other. The performance characteristics and the payloads are primarily what are different, and they're fairly similar across the customers that I referred to, as well. And that's part of the beauty of this is that they're proven systems that there's a logistics tail, there's an inventory tail, and -- which means lower cost initially and lower cost over the long and mid term.

So, stealth wouldn't really come into the equation, then, for what you're offering. And would some of these --

Let -- yes, Mike, on that, Mike, let me be very clear. I have been -- I cannot talk about that in any way, shape, or form.

Okay.

So, that's my answer. I cannot talk about it.

And what about ability to -- for mid-air refueling?

Mike, these aircraft are designed to fly in contested air space, not uncontested air space if that helps answer your first question, and these aircraft, if required -- if required, because of the endurance on them, it may not be a requirement -- would be able to be refueled.

Okay, thank you. And then, just switching gears, can you talk a little bit about some of these new, major programs, if you can, that I believe Kratos will be working on, such as SEWIP and AMDR?

Yes. So, we are under contract on SEWIP. It's an LRIP. We're delivering product, and we're expanding our position on that literally. We're gaining additional content on that Block 2, as we speak. That's what I was just talking to.

On Block 3, Block 3 SEWIP is scheduled to be released -- I think it's been delayed a little bit. Now I think it's September or October. That will also be another very important program for us.

We are under contract and in production on APR-39, which is a helicopter and fixed-wing aircraft warning system for incoming threats, primarily missiles. That program will be ramping over the next couple of years. That program is going to be very significant to us, tens of millions of dollars over the production period.

We are under NDA on AMDR and NGJ, so those -- with the people that we're working with, so those I cannot say too much about other than we are working with long-term strategic partners and those will also be very important for us, though they are a little bit behind SEWIP Block 2, SEWIP Block 3, and APR-39.

And we're also on -- we're under NDA, but we are involved with the AESA upgrades on F-16.

Okay, thank you. A final question relates to if you were able to go to banks today to refinance your balance sheet, what rate range might you expect to get? Thank you.

Mike, because we -- as we've been talking about on our normal calls, we are so close now to the no-call date falling off, et cetera, that's something I'd rather not speculate on at this particular point in time.

Okay, thank you.

Okay.

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

Thank you. Eric, what -- you seem to clearly be more positive on your UAS initiative now than you were a few months ago. What have you demonstrated and/or what has been communicated to you that gives you this enhanced sense of excitement about the program?

Yes, you've sensed correctly, Mark, and I typically try to be reserved on these things, but we have had a number of flights with a new supersonic aircraft that have just knocked it out of the park for us, knocked it out of the park for us.

In addition to that, what Admiral Beaman and his team are doing, literally in the last three or four months we have several new customers for our aircraft, for demonstration, for war games. It is moving far faster than I ever could have imagined.

Because of some of those recent flight tests, I mentioned we are -- we have basically completed negotiations on a new $30 million order for aircraft, the one that I mentioned. We have virtually completed the negotiations on a $70 million order for aircraft for a different platform -- and the $30 million is a different platform, as well.

So, it's -- things are -- the plan that we put together is happening, and it's coming together for us, and that's what you're sensing.

So, those $30 million and $70 million contracts that are coming, would they be for 2014 deliveries? And with these positive moves, is -- you haven't changed your overall guidance for the year. Is this building conservatism into your expectations?

Right. So, based on the current expectation, the $30 million one we would start building this year, and so that would be -- there would be revenue events for that this year. On the $70 million one, that's expected later in this year, so that would probably not be this year, but it would probably be the beginning of '15, just on timing to get going on that.

And we are -- as you know, as Deanna mentioned, we're product based, and some of our work, as I just indicated, is percent complete, and a lot of the other work is based on deliveries. And we try to build some -- we try to build conservatism in, based on initial indications of production schedules and delivery schedules, but in this environment, and the environment is much, much better than it was in '13. '13 was a disaster, six months of continuing resolutions, a government shutdown, furloughs, blah, blah, blah. It was just terrible.

This environment is much, much better, but it's still -- things can still move around a little bit. It's just the case.

Mark, I'll give you an example. We are -- we have negotiated and we have been approved for an approximate $40 million order for some very specialized hardware that we fully expected to get in Q1, and now it looks like it's all going to happen in Q2, and we'll build it out and we'll deliver it over the balance of the year. And it's -- and we're designed in. We're sole source. We've been given the documentation, the data package, it's just moved. And so, we haven't lost anything -- that's what's critical -- but things are still moving around a little bit, sir.

The Air Force has announced their intentions to retire the U-2, which was really the only thing that could fly in contested air space. Also, I think the capabilities of the Global Hawk was documented, where I guess one was shot down over the Crimea a little bit ago. Is there any platform that is being worked on, to your knowledge, that with -- could be delivered within the next two to three years that could provide UAV capabilities that would be able to fly in contested air space, other than yours?

That would be deployable in the next couple three years?

Yes, that could be -- that are within a reasonable time horizon or could be relevant to your customer.

Nothing, Mark, that -- nothing that I'm aware of, and that excludes anything that could be on the dark side.

Okay. Final question online. I think that I read in the S&P report -- and congratulations on being upgraded in a time that still things are pretty dicey -- they stated that there was no intention on the Company's part to make any acquisitions for at least the next two years. Is that a firm commitment with S&P and an understanding of the Board's?

We -- it is -- we have made that comment and commitment since we made our last acquisition in the middle of 2012. We have zero intention of making any acquisitions of any size at all going forward. If something comes along, or it's a group of engineers, five or 10 guys that might make sense, that could add a capability, and we want to bring them in with some IP they have, they might be an option.

But acquisitions that we've been making in the past, absolutely not. We have some incredible opportunities that we're working on that are under contract and that are programs where we have sponsors. And we would be remiss if we went off and did anything to dilute these opportunities.

Okay, thank you very much.

Thank you. And the next question is from Sheila of Jefferies. Your line is open.

Good afternoon. It's Sheila Kahy Aouglu.

I just wanted to follow up on the unmanned opportunity. Is that an incremental $100 million inflow, Eric? So, the way we should be thinking about your unmanned and missile target platforms being about -- potentially about $200 million next year?

Okay, which -- Sheila, is which part an incremental $100 million? I want to make sure I understand.

Sure, the two contracts you mentioned, the $70 million drone order, and the additional -- the other 20 aircraft, unmanned aircraft, order.

Right.

Those two contracts, would they be an incremental $100 million in sales next year, so the way to think about your total unmanned platform could be $200 million next year?

Right. Sheila, depending on deliveries on the $70 million, that $70 million will probably deliver out over '15 and '16.

Okay, got it.

The $30 million, definitely, and the potential follow-on to that $30 million, that would also be a '15 event. So, there are really two potential $30 millions in there, and then the $70 million. The $70 million would be out over two or three years.

And this is new customers?

The first two are new and the other one is an existing.

Got it.

Two new, one existing.

Okay, thank you. And then, in terms of PSS, this is one of the first disappointing quarters. Growth has been really great. Do you mind elaborating on the infrastructure contract push-out and what gives you confidence for the remainder of the year?

Sure. So, on the confidence on the remainder of the year, I'll answer that first, because we've now won the contracts, and we've started working on them.

That's easy.

So, that's gives us -- that's what gives us confidence, and that's been a number of the releases we put out over the past month, and keep in mind, most of their work we can't disclose because of the customer side or the nature of the work, et cetera.

When we gave our Q1 guidance when we reported Q4, we did indicate that Q1 would be down a little bit, because we knew we were coming off of some, and we knew we had a bunch of new ones that would be starting. The reason it was off a little more than we thought, the new ones that we thought would start didn't start as quickly as we had initially planned, but, as I said, they're going now. It appears right now Q2 will be particularly strong for our PSS business.

And then, just on the margins in that business, how do you think about that? I know you don't provide long-term targets. But could we see that become a 6% to 8% margin business? How should we think about that, over the next two, three years?

Sheila, this is Deanna. So, 6% to 8% from an EBITDA margin perspective should be the range that we expect. If we look at where PSS was operating at in 2013, it closed the year just under 8% EBITDA margin and for the year they're at 7.3%. So, that is clearly in the range of our expectations.

Yes, our plan, Sheila, because approximately 15% of that business is either maintaining the systems or operating the systems after you deploy them, and that annuity stream -- my word -- that annuity stream that once you're designed in you get the maintenance or the operating contract, those margins are typically better than the deployment contracts. And so, our plan, all along and it's been working, has been we win the work, we get designed in, we have the schematic, then we operate and we maintain it and slowly increase that percent of operating and maintaining them, which is a higher margin.

Okay. We've had a good problem the past year and a quarter. The good problem is, we've been winning so much deployment work, the deployment piece is actually growing faster than the service and maintenance piece, if you know what I'm saying, because we're winning it and -- which is good, but it will catch up, because the vast majority of these, once we deploy them, we maintain them.

Okay.

And that figures into our mid- and longer-term margin objective.

That's very helpful, and then I guess on the EBIT margins, but I understand, the EBIT margins could be slightly better, I guess.

Yes, Sheila, there's not a lot of DA in PSS, so it's pretty close to EBIT.

Okay. Okay, I got it. And then, one cleanup item. I don't think you mentioned the Department of Homeland Security contract in the opening remarks. Do you mind commenting on where the task order stands on that?

I -- yes, I -- what's happening with that is the second -- they've come out. So, the DHS has indicated what the next set of task orders are going to be. They're going to be between $50 million and $150 million each. And they -- I think some of them are out, or they're coming out right now, and there are several of them. It is going to be very, very large. This is phase two.

They've already also started talking about phase three for next year, with task orders of equal size. As I think I indicated before, we have or we will be bidding on virtually everyone of the task two -- phase two, excuse me, phase two task orders that are coming out now and over the next few months. So, it's happening. It has begun.

Okay, thank you very much.

Okay.

Thank you. And the next question is from Tyler Hojo of Sidoti & Company. Your line is open.

Good evening, everyone. Just going back to the UAS initiative line of questioning, Eric, in the prepared remarks you indicated, I think, that there was a $1 billion contract opportunity if certain development milestones were hit. And I guess I'm kind of curious if you could give a little bit more color in regards to what those development milestones are, and, also, I mean, you also talked about kind of this becoming, potentially, the largest single program in -- for the Company. What kind of timeframe are we talking about?

Right. So, Tyler, on the first part of your question, on the milestones, there are additional significant and important flight milestones that need to be achieved over the approximate next year, and right along with those are technical milestones that relate to those flight milestones and performance milestones with specific objectives for the aircraft to do, which it's not appropriate for me to get into publicly, but they're flight milestones. That will be for the next year, into 2015.

If things go according to plan, starting in 2016 we could, hopefully, start building on this, and then in 2017 we get into production. And we are looking at somewhere between around 50 to 100 aircraft a year for an extended number of years.

Like on our AFSAT program right now, Tyler, we're finishing production year 10 and we're negotiating -- we've just negotiated productions year 11 through 13. So, we're going into the 11th, 12th, and 13th years of production. This would be something similar to that. It's not that program. It's something similar.

Okay. That's helpful. And I was also looking for a little bit more clarity in regards to the IR&D. I think you said under a certain circumstance that could track lower than you're currently guiding, and, one, is that the case, and two, what kind of downside driver could that be?

Tyler, it's Deanna. So, what Eric has said in his prepared remarks is it could potentially lead to a reduction in R&D spend, and that applies to both '14 and '15, because some of the plans to develop some of these aircraft actually extend through mid-2015. But regardless of that potential reduction in R&D, we are planning on reducing R&D in the second half of 2014, and what his comments referred to is that it could potentially decrease that more than what we were expecting, plus also reduce the level in '15, as well.

All right. Thanks for that. And, I guess lastly, Eric, I get you're not a buyer of properties at this point, but I guess I'm just curious on what your perspective is on the M&A market. We've seen some loosening up, I guess you could say, and are there any particular assets that are kind of part of the portfolio today that you might consider being a seller of?

So, on the first part of your question, Tyler, in the past three months the activity in the M&A area in small and mid-sized companies has increased significantly. It's just increased significantly.

And I think part of it, I think, is Ryan-Murray, and we know we've got a $496 billion spend for '14 and '15. We've got a budget and we have a '15 request, and we have a QDR, so people kinda sorta think they know what's going to be funded. Additionally, some of the big OEMs, which have been buying back a significant amount of their stock and paying dividends, well, they're -- which has been great for them and great for their shareholders, but they are seeing some very significant revenue reductions, and so they are coming back into the market, and they are showing some interest and, in particular, related to specialized product companies.

So, that is heating up, and we are right in the middle of it, right in the middle of it.

There is -- our business is -- as you know, it's two segments. It's the defense business, which is about 75% of the Company, and it's our critical infrastructure security business. The defense business is substantially integrated. Let me give you an example so you can understand.

We build composite aircraft. We build the electronics and avionics to go in that composite aircraft. We build the ground control and flight controls equipment that fly that composite aircraft. We build the command and control shelters that that equipment is in. We build the transport shelters that they're in.

We're going to be at a show in Orlando. You're going to see all of this down in Orlando in a few weeks.

So, our defense business is very heavily integrated, for the most part. So, there's that piece.

The critical infrastructure security business, that, as I talked about before, and I talked about today, that has been and will continue to be our near-term organic revenue grower in the current environment. We are very fortunate that we started building this business when the Obama Administration came in and he changed those procurement rules and policies, and I think this business grew 10% or 15% last year, 13% last year.

And I think it's going to beat 10% this year. It's looking good. The book of business is very strong.

And so, looking at those two pieces, Tyler, no, there is -- I don't see an opportunity for us to do anything like that, based on our current strategy and the current environment.

Very helpful. That's all I had. Thanks a lot.

Okay.

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

Hey, good afternoon, guys, or good evening. Thanks for taking my questions.

Eric, maybe you could just elaborate a little bit on not so much the M&A, but you've been talking about a lot of the end markets. I don't think you've really mentioned kind of the cyber markets. I know you guys have some interesting products and applications. Maybe if you can sort of quantify what percent of the overall revenue streams are coming from cyber? What do you think the opportunities are there right now?

Yes. So, approximately $100 million to $150 million of what we do is related to cyber or information assurance, and that includes cyber on the satellite communications side and the terrestrial network side, all right?

So, our cyber business includes our software products that we sell and we integrate or design into certain customers' or agencies' networks, most of which we are not available to talk about. We do that same thing on the commercial side, and we have software and products on the satellite communications side.

The growth area for us, putting aside the DHS contract we won and those task orders, which are very binary. That's why I'm not even assuming those in our plan, is on the SATCOM side, and the ground equipment side, and our Monics software and NeuralStar and dopplerVUE and identifying cyber threats that are trying to be injected into satellite networks.

Got it. Okay. And then just separately, looking at the defense business, you mentioned kind of the budget in place. Can you kind of comment on what you're seeing in some of your shorter-cycle businesses, whether it's spares or services, some of those contracts that had really gotten delayed? I mean, are you seeing a pickup in that business?

No. No. The services business is terrible. It has been completely commoditized. Virtually everything is low price technically acceptable, virtually everything. If you do win, it's protested, and then it's delayed for another six months. It is -- Deanna and I talked, we thank God that in our services business we don't have any major recompetes coming up for the next few years, because the incumbents win the work, I think, less than 20% or 10% of the time now.

Right.

It's just terrible. On the shorter cycle product side, okay, we are doing very well with Patriot right now. We are doing well with Aegis. We are doing well with THAAD on the shorter cycle side. All strategic systems.

Okay.

The tactical systems, Army and Marines, command post platform, things like that, have gone to zero.

Got it. Last one for me, regarding the refinancing, what are the steps? I mean, you're going to have to call your bonds that are out there. So, I mean, and it's -- I'm not sure how long the notice is, but, I mean, what are kind of -- what's the timeframe that that's going to have to take? I mean, if you were planning to refinance as soon as your kind of prepay penalties are over, I mean, I would imagine that the paperwork's got to get filed pretty quickly. Am I under the right assumptions there?

You're correct, Michael. So, we could either call or tender them or redeem them. So, it's a couple-week process. So, it's not as time-consuming as you would think, and that no-call does end on June 1st of this year.

Okay. All righty. That's all I had, guys. Thanks.

Thank you, sir.

Thank you. (Operator Instructions). And the next question is from David Okavetski of Jefferies. Your line is open.

Hey, guys. Thanks for taking the question.

My first one, obviously, relates to the refinancing. I don't want to throw a wrinkle into the plan, but I'm not quite sure exactly what you guys are looking to do in terms of a structure. But you've got all this tremendous EBITDA growth coming down the pike in '15 and '16. Why not do a -- structure a deal where it's something like half term loan, half bond, so that you in -- after a year you can take out the term loan with a small prepayment penalty of 1 of 2 points? I mean, is that something you guys are considering with your underwriters?

Yes.

Okay, good. Good. And then, you mentioned that the -- there's some leases that are rolling off in '14 and '15.

Yes, these --

What's the dollar amount of that.

These are corporate headquarters from some of our --

The previously acquired companies.

Previously acquired companies that have been significantly under-utilized. They're not utilized at all by us.

And this is one with Haverstick that we acquired. This is our ballistic missile target business. Their corporate headquarters was in Indiana. That's rolling off in the next several months, and it's -- that's relatively significant to us. It's how much annually in cash?

It's about, I think, $200K a month.

A month. So, $2.5 million a year that will go away right there. And then, I think it's in the middle of '15.

Yes.

Another significant one.

A fairly sizable one in Maryland.

Rolls off in Maryland.

And that was one acquired from Integral Systems.

And those dollars --

That was their previous headquarters.

And those dollars are a couple of few million dollars a year, also.

They're fairly sizable, David.

Okay, perfect. I mean, that's great to hear.

Yes.

Because that's going to be pretty darn accretive. So, these are really just corporate headquarters? There's no production coming out of these facilities, right? So, you're not --

These were administrative facilities where we have long since consolidated out the corporate infrastructure, the back office, all that stuff.

Okay, good. And then, so, that actually leads perfectly into my next question. On the acquisition and also maybe spin off front, are there any small, little businesses, business units, that might have been rolled up through the various acquisitions that now you're considering non-core, and, therefore, looking to sell off?

No, sir.

Nothing? Okay.

Nope, nothing.

Okay, good. And just to clarify your earlier comment, Deanna, so the minimum call notice, I believe, is 30 days. So, presumably you could issue that tomorrow. And do I understand correctly that that is not your plan?

Well, we could do it tonight. We could.

As I said, David, we continue to work with our financial advisors as very similar to what we've said in the past. And so, we continue those discussions.

Okay. Well, thank you very much for taking the questions, and best of luck.

Thank you. Thanks, David.

Thank you. There are no further questions at this time. I'll turn the call back over to Eric DeMarco for closing remarks.

Great. Thank you again, all, for joining us this afternoon. I think -- I believe our next scheduled quarterly call will be in July or August.

It'll probably be the last week of July, first week of August.

Last week of July, first week of August. Thank you very much.

Thank you.

Thank you. Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day.