Kratos Defense and Security Solutions Inc (KTOS) 2014 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions second-quarter 2014 earnings conference call. (Operator Instructions). As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer, and Secretary. Please proceed.

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

Before we begin the substance of today's call, I would like to make some brief introductory comments. Earlier this afternoon, we issued a press release which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos corporate website at www.kratosdefense.com. It is also available on the SEC's website.

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

During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives, and expected future performance and the potential impact of sequestration, 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, 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, loss on extinguishment of debt, 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 second quarter of 2014. He will then turn the call over to Ms. Lund to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business, and then we will open the call up to your questions.

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

Thank you, Deborah, and good afternoon.

In Q2, we continued to make progress on our strategic focus areas and in transitioning the Company to a more product-centric business where Kratos technology and intellectual property provide us a differentiator in an extremely competitive environment.

Since we last updated you, there have been a number of positive developments with several major Kratos-supported programs. These include Boeing being awarded production of 21 EA-18Gs for the U.S. Navy and 12 for the Royal Australian Air Force; Sikorsky winning the Presidential helicopter award for 21 aircraft; Qatar announcing that they will be acquiring 10 Patriot batteries; Raytheon resuming production of GMD warheads; Northrop received an award for 25 E-2D Advanced Hawkeyes; Lockheed received an award for completion of two additional space-based infrared satellite missile warning satellites; and Northrop being awarded production for additional APR-39 electronic warfare systems.

Additionally, the Navy successfully launched two Trident II D5 submarine-launched ballistic missiles in a test. A Kratos ballistic missile target successfully supported a confidential mission. And the Iron Dome system is performing extraordinarily well in Israel, with President Obama last week signing and approving a $225 million emergency supplemental Iron Dome funding bill.

In Q2, Kratos won a large production contract with a DoD customer with initial delivery scheduled to begin in the second half of this year, which was subsequently protested by a competitor. This has prevented us from beginning work until the protest is resolved.

There have also been a number of programs where Kratos products, solutions, or IP are already designed in or have been selected where we are expecting contract awards in Q2 that have been delayed until later this year or early 2015. These include in the satellite communications, software, target drone, and BMD areas.

Also, a very large international missile system program, where Kratos electronics and systems are designed into the missiles, with the potential program value to Kratos of tens of millions of dollars, has had the systems' acceptance flight test delayed until the second half of this year.

We were also informed last week that a team Kratos was on was not successful on a multiyear classified opportunity we were hopeful of winning.

In Q2, our PSS business grew sequentially 30% from the first quarter. As expected, new business starts occurred and projects were awarded, including security deployments in the mass transportation, municipality, oil and gas, energy, education, healthcare, and financial services market verticals.

With PSS' current backlog and record level bid pipeline, we are expecting a strong second half of the year, and in particular, the fourth quarter, and we are forecasting increasing EBITDA margins for this business in Q4, continuing into 2015, primarily through aggressive management of our vendor and supplier base.

We continue to make significant IR&D and other investments in the unmanned system, electronic warfare, and satellite communication areas, primarily due to a number of large new industry programs, with the objective of significant and increased designed-in positions for Kratos' products. The number of new platforms and program opportunities for Kratos has increased substantially over the past few months, including in the EW, radar, and missile systems areas and an aircraft platform, all where we have the chance to be designed in, which we are pursuing.

As a result, our current expectation is that these elevated internal investments will continue through the third quarter of this year.

In the unmanned systems area, during the second quarter we achieved all expected contract milestones across each of our programs. We had a number of successful flights with our high-performance aircraft and we experienced no major flight anomalies. We continue to make progress on the largest current program opportunity in the Company, an aerial drone program we are currently under contract on with a DoD customer, and we have a number of additional contractual milestone flights scheduled later this year and into 2015.

Kratos' UCAS initiative also continues on track, with our three UCAS or UTAP unmanned tactical aerial platform aircraft currently in production and flight tests with our government sponsors scheduled for Q3 next year.

This month, we will be negotiating with a US DoD customer an approximate $70 million unmanned drone system order, which we expect to have under contract by the end of this fiscal year, September 30.

We're also completing negotiations with an international customer for an initial order of approximately $30 million for unmanned drone systems, which we're hopeful we will have under contract by the end of this quarter, though this could slip into Q4 or early 2015. We're also in discussions with this customer for a second UAS order of similar size, which is expected to be awarded next year.

Also, as I have mentioned previously, a certain US government agency has selected a Kratos high-performance UAS for a new government program, with performance expected over the next few years, and we're still on track for Kratos' UCAS or UTAP aircraft to be an important element of a certain US government-sponsored war game at the end of this calendar year.

And in the unmanned ground vehicle area, we are working with the US Army related to an initiative to retrofit a certain portion of its tactical vehicle fleet with robotic or unmanned systems and we're working with a customer on unmanned or robotic seaborne platforms.

We are making significant internal investment in the unmanned aerial ground and seaborne areas and our entire unmanned strategy in both IR&D and CapEx, which are expected to continue for the balance of this year and throughout 2015. If we are successful in the unmanned area, we believe that the program opportunities we have can truly transform our Company a few years from now.

Approximately one year ago, Vice Admiral Gerald Beaman joined Kratos as President of our UCAS division and he and his team, including Vice Admiral Mike Malone, has made outstanding progress.

At the beginning of this month, August, we combined our UCAS and our advanced drone, ground system, sea system, robotics, and target systems businesses into a new unmanned systems division, where Gerry will be President and responsible for all of Kratos' unmanned business. We made the decision to combine our unmanned businesses to address important customer, resource, technical, and strategic considerations and requirements, and I ask all of you to join me in congratulating Gerry in his new position as President of Kratos' unmanned vehicle division.

Industrywide, the US federal government, the government contracting and DoD environment remains challenging, including delays with program starts and contract awards, as I mentioned earlier; aggressive competition; routine protest being made by companies losing competitive procurements; customer funding issues; and the threat of another continuing resolution later this year.

However, we continue to forecast the second half of 2014 to be stronger than the first half, with the fourth quarter being particularly strong, based on our current backlog and expected timing of future awards, program execution, scheduled product shipments, and higher-margin product and software sales.

Important second-half 2014 programs for Kratos are expected to include [CWIP], Patriot, EA-18G, Trident, APR-39, P8, E2D, two large mass transit authority security system deployments, a large confidential production program for a certain US government agency, and a specialized software implementation with a certain US government agency.

We're optimistic about our Company's future prospects, with Kratos products or IP designed in on a significant number of strategic national security programs, many of which are expected to go into production in the next few years, and we are particularly excited about our electronic products division opportunities in the EW, EA, radar, missile system, and aircraft areas.

The Company is highly diversified, with approximately 35% to 40% of our business being either commercial or international customer sourced, and our critical infrastructure security business is growing strongly. Accordingly, we will continue to remain focused internally with the intention of aggressively managing our cost structure, and PSS' supply chain in particular, over the second half of the year and focusing on continuing to reduce our Accounts Receivable DSOs and generating cash.

Deanna?

Thank you, Eric. Good afternoon.

Our second-quarter revenues of $229.3 million came in at the midpoint of our expected range, with strong organic growth in our specialized modular systems business unit and in our PSS segment, which generated a combined sequential growth of $23.3 million from the first quarter, offset partially by reductions in certain of our services business.

Sequentially, revenues increased from -- 14.6%, or from $200.1 million in the first quarter to $229.3 million in the second quarter. On a year-over-year basis, revenues decreased 2.5% from $235.2 million in the second quarter of 2013, with growth in our specialized modular systems and PSS businesses of $20.9 million offset by continued contraction of our legacy government services business, which declined $5.1 million, from $21.9 million in the second quarter of 2013 to $16.8 million in the second quarter of 2014.

Revenues were also impacted by the expected reduction in two sizable satellite communications projects as the scope of work completed its natural contract lifecycle, transitioning from production to sustainment, resulting in net aggregate reduced revenues of $4.4 million and the reduction of shipments of certain of our electronic warfare and aerial target products.

The growth in our PSS segment included the delivery of sophisticated security-related communications equipment, aggregating $13 million, which we expect will be subsequently integrated into our customer's command-and-control network.

In Q2, PSS EBITDA margins were lower than expected, due in part to the mix of revenues, which was more product focused during the quarter, which typically generates lower margins compared to systems integration, which typically generates higher margins. In addition, EBITDA margins during the quarter were impacted by certain new program starts, which had lower initial margins, and due to cost growth on two other deployments.

However, as Eric previously mentioned, we have initiated an aggressive internal vendor and supplier cost-reduction plan, which is expected to have a meaningful impact by Q4.

The growth in our specialized modular systems business was primarily driven by growth of approximately $11.8 million in our surface combatant missile system, radar system, and hardened facility product lines.

Operationally, we continue to remain focused on cost reductions and efficiencies, and in the second quarter, we reduced our headcount by an additional 98 personnel, or 2.7% of our total workforce, down to a total headcount at quarter-end of 3,598. This compares to a headcount of 3,815 at the end of 2013.

We have reduced headcount each quarter for the last four quarters by 2% to 3% as we right-size the business to address the current industry environment and customer requirements. This cost rationalization will be a continuous process, which will also help to enhance operating efficiencies, while improving our operating margins.

As a result, in the second quarter we have recorded charges related to excess capacity, caused in part by the delays in procurements and awards, severance, and contract design retrofit costs. For instance, included in the second quarter is a charge of $700,000 related to the cost of personnel reduction actions and excess capacity charges. A charge of $500,000 primarily related to legacy-related contract costs for certain of our new aerial target platforms and a certain legacy modular systems contract.

Our adjusted EBITDA of $19.5 million for the second quarter is from continuing operations and excludes the charges highlighted, as well as the loss of $39.1 million on the extinguishment of debt related to the refinancing of our 10% senior notes that we completed in May.

As expected, our adjusted EBITDA was impacted by an accelerated level of R&D investments during the second quarter, which were at $5.9 million, or 2.6% of revenues. As a reminder, our normal R&D spend as a percentage of revenues has been historically at 1.7% to 2% of revenues.

On a GAAP basis, net loss for the second quarter was $49.9 million, which included the loss on extinguishment of debt of $39.1 million, a loss from discontinued operations of $100,000, $5.7 million of expense related to amortization of intangible assets, $2.9 million of non-cash stock compensation expense, as well as a $1.6 million income tax expense.

We continue to believe it is also meaningful to provide our earnings per share excluding the amortization expenses, stock compensation expenses, and reflecting our cash pay income tax, and excluding nonrecurring items. On a pro forma basis, adjusted EPS from continuing operations, excluding amortization, stock compensation expense, restructuring related items, excluding the contract design retrofit costs and the loss on extinguishment of debt, utilizing the estimated average quarterly cash pay income tax provision of approximately $600,000, was adjusted EPS of $0.02 per share for the quarter.

Moving to the balance sheet and liquidity, our cash balance was $26.9 million at June 29, plus $5.1 million in restricted cash. Cash flow from operations for the second quarter was a use of $12 million, resulting primarily from the $29.2 million sequential increase in revenues from the first quarter, which resulted in an increase to the Company's receivable balance of $18.3 million, despite our days sales outstanding, or DSOs, decreasing seven days from 113 at the end of the first quarter to 106 days at the end of the second quarter.

Our DSOs are impacted by the timing of achievement and/or completion of certain contractual billing milestones. 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. We believe that certain of these more sizable milestone events will be achieved later in 2014 and some into 2015, resulting in a reduction of DSOs and generation of cash flows from working capital.

Our contract mix for the second quarter was 83% of revenues generated from firm fixed-price contracts, 13% on cost-plus contracts, and 4% on time and material.

Revenues generated from contracts with the federal government were approximately 54%, including revenues generated from contracts with the DoD of 44% and revenues generated from contracts with non-DoD federal government agencies of 10%. We also generated 6% of our revenues from state and local governments, 28% from commercial customers, and 12% from foreign customers, with our aggregate non-DoD revenues comprising 46% of our total revenues.

Backlog at quarter-end was $1.046 billion, with $557 million funded. Backlog at the end of the first quarter was $1.071 billion.

Now moving on to our financial guidance. The Company today affirmed its guidance within its previously communicated range of full-year fiscal 2014 financial guidance of revenues of $920 million to $960 million, adjusted EBITDA of $93 million to $100 million, and adjusted 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, with an expected favorable mix of higher-margin product shipments and software sales expected. And EBITDA is also expected to be impacted by internally funded investments by the Company, with IR&D now expected to continue at higher than normal levels as a percentage of revenues through the third quarter as the Company pursues large new opportunities in the UAS, electronic warfare, radar signal processing, and satellite communications areas.

We expect PSS to continue to grow organically year over year compared to 2013 performance. However, we do not currently expect sequential quarter growth from the Q2 levels, due to the sizable delivery of the communications equipment during the quarter.

As we have not had a conference call since the refinancing was completed, we thought we would take the opportunity now to go over more of the details at this time. From an interest expense perspective for 2014, the approximate savings resulting from the refinance is approximately $8.5 million, after taking into consideration the $1.5 million monthly savings of interest resulting from the 3% reduction in rate for 6-1/2 months since the refi closed at May 15, less the increase in interest on the borrowing we made of $41 million on our line of credit to fund a portion of the refi. Our intention is to pay down the borrowings on the revolver with cash generated from operations.

However, as we had to pay double interest for the one-month period from May 15 when we closed the new bond deal and we were paying interest on the new bonds and the old bonds through June 13, when we closed the process to redeem the old bonds, we paid double interest of $5 million.

Therefore, for 2014, the net cash interest savings is approximately $4.5 million, computed as $8.5 million net P&L interest savings, plus $1 million of the amortization deferred financing costs, but less $5 million of the duplicate interest for that one month.

On an annual basis, beginning in 2015, Kratos' yearly cash interest payment due as a result of the refinancing has been reduced by approximately $18.75 million, as compared to our previous 10% note.

As Eric mentioned earlier, we are continuing to make investments from an IR&D and CapEx perspective in certain of our electronic product, satellite communications, and unmanned systems businesses. Specifically, we are making additional investments in our unmanned systems business, where we are pursuing two business models, the first model in which we are selling our unmanned aircraft and the second model in which we are building aircraft to be used for presentation purposes to customers, whereby we are paid for the presentation and if and when the customers shoot down our targets.

Our total estimated CapEx for 2014 has increased from our initial estimate of $13 million to $16 million to $18 million to $19 million, with the most significant increase being in our unmanned business as we will be manufacturing an increased number of aircraft for expected customer presentation requirements.

Our estimated free cash flow guidance is comprised of the $93 million to $100 million of estimated adjusted EBITDA, less cash interest of $58 million, which includes the duplicate one-month interest payment of $5 million, less capital expenditures of $18 million to $19 million, less estimated cash taxes of $2.5 million to $3 million, and assuming a reduction of DSOs of approximately four to eight days, or $10 million to $20 million cash generation.

As a reminder, we reduced DSOs by seven days from 113 to 106 days in the second quarter. We expect that as we achieve certain contractual milestones that we will be able to continue reducing our DSOs in the second half of 2014.

Also, as our modular systems business had record bookings in Q2 and we are building a large, complex missile system, surface combatant, and hardened facility structures and systems, we expect a number of these milestones will be achieved for this business in the fourth quarter, but it is expected to cause a near-term use of working capital in the third quarter due to these milestones.

We are increasing our adjusted EPS estimates to $0.20 to $0.35, reflecting earnings from continuing operations, excluding amortization costs, excluding stock compensation cost, excluding the loss on extinguishment of debt, excluding contract design retrofit costs and restructuring and acquisition-related items, computed using a cash tax pay rate of that $2.5 million to $3 million for the year.

Our adjusted EPS estimates were positively impacted by the reduced interest expense resulting from the refinance.

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

Great. Thank you, Deanna. We will turn it over to the operator to take questions at this time.

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

Thank you very much for all the detailed information. Regarding the one pushout on the test scheduled for unmanned system -- I think it's targets, when is that now to be scheduled again, and this is for a potential $70 million program, did you say?

No, so the $70 million, Mike, is we're in negotiations right now with a US government customer. The customer has indicated to us they want the negotiations complete and the contract let by the end of the federal fiscal year, September 30, and we're pretty confident right now we will have that done, so that's an order with a US government customer, approximately $70 million.

The test that I mentioned that was pushed out has to do with a weapons system, a missile system, where our electronic products are actually on the tactical missiles themselves. The test had been scheduled for the first half of this year. It is now scheduled -- I know the date. I can't give it exactly. It is scheduled for the second half of this year.

This program, because we're actually on the tactical missiles, is worth north of $50 million to us.

Okay, thank you, Eric. And then, the large target opportunity that could be 50 to 100 units a year --

Yes, on that one, Mike, we've had successful flights in the quarter. We have additional flights scheduled for the second half of the year and into 2015.

As a reminder, we are under contract. The contract that we are under goes all the way from development through LRIP through initial production orders. And that's the contract that we are operating under.

Okay, I know it's a bit early, but given all these moving parts, the record bookings in modular and the PSS business, offset by the headwinds, is it fair -- how would you characterize the probability of having higher revenue in 2015 versus 2014?

That is going to depend solely on, right now, if there is another continuing resolution and how long it goes.

So if a resolution -- if we get a budget in place, say, by December 31.

Then as we sit right now, 2015's revenues should be higher than 2014's.

Okay, thank you very much.

Mark Jordan, Noble Financial.

Eric, you mentioned both the $70 million drone contract that should be signed by the end of the quarter and an international relationship of $30 million you are building. What would be the -- when would production start under those orders and what would be the duration of the delivery schedule?

Okay. On the first one, Mark, right now it's forecast that the production would begin at the beginning of 2015 and it would go for somewhere between 30 and 36 months.

On the $30 million one, that production would begin immediately and it would be complete 12 to 15 months.

And then the follow-on would just literally follow on after 15 months?

It is possible the follow-on could be let during the production of the first one.

Okay. In the last call, you talked with some potential optimism about the continuous monitoring ID/IQ that you had received. Could you give us an update of what success or what you see happening in that area?

Right. Mark, there are four task orders out right now under that program at the $100 million to $200 million each level. Those four, we are going after all four. They are in our area. Two of them are right in the sweet spot.

This program, if you have been following it, things have been delayed. It has been pushed. There are two reasons I haven't talked about this much, because things have been delayed and pushed, and these are binary events. If in the next six months we hit one or two of these, it's a binary event for us and it's a step function.

So they're out. We will be bidding on them over the next several months. They are currently scheduled to be awarded later this year. That may be delayed, and it is very possible that once they are awarded, the losing bidders could protest them.

Probably likely.

Exactly, I know. It's a terrible situation. But that's the current status.

Mark, as I mentioned in the prepared remarks, it's very frustrating. We won a large production quick burn program with one of the four branches in Q2. It was protested and now it's all gummed up. We are under a stop work until it's resolved.

Was that the series of modular systems that you --

No, no. Every one that we announced was not protested and we're moving forward. The one I am talking about, we did not announce because right after we got it, it was protested.

Okay.

We never announced it.

Of your Q3 and Q4 revenues, what is in funded backlog right now?

We have $557 million funded backlog right now, Mark.

And as what percent of those projected revenues for the quarter are currently funded?

It is roughly about half of that is expected to be burned in the rest of the year.

Okay. And then, I guess, while you talked about 2015 in aggregate being better, assuming we get a budget around year-end, I think it is clear that at least the early quarters of 2015, given the awards that you have received and the pushouts that you've had that would fall from 2014 into 2015, should mean that you would have a better start to 2015 than you suffered through this year?

To some degree. So some of the awards, the pending awards that Eric was talking about, it depends on the type of revenue recognition we have on each of those programs. Some of them are on units of delivery, so revenue is recorded as shipments are made. and others are on percent complete. So, it's both.

Okay. And finally for me, the unmanned vehicle division that you have set up, does that -- the businesses that went into that, was that CEI and microsystems?

Those were two of them, yes.

Okay. Are there other distinct units that we would know that went into them?

There are. A significant portion of our electronic products division supports that division, and a portion of our modular systems division. We build ground control structures and flight and transport -- UAV transport structures in there. They support it as well. Those are in separate divisions.

Okay. Thank you very much.

John Nelson, State of Wisconsin Investment Board.

Eric, can you tell us anything more about the internal UCAS program as far as progress and potential, without divulging anything that is classified?

We are working with a US government agency that is our sponsor. We are -- we have begun production on three aircraft. One is a ground test aircraft and two will be flight aircrafts.

These are derivatives of one of our high-performance unmanned aerial drone systems, so these are not new drawing-board aircraft. These are aircraft that exist. They fly. There is a logistics tail that is in place. There is an inventory that is in place. There is a spare parts inventory that is in place, so it's not an off the drawing board type of a thing.

We expect to have those three -- the first plane, the ground test aircraft, is supposed to come off the line first. The two combat aircraft are supposed to come off the line next, by the end of the year or early next year. Then we are going to be integrating specialized systems, including some weapon systems, into them and we are currently working with our sponsor relative to the range, time, for Q3 of next year for the flights.

We're looking -- we compare this to our target drone business. If we could ultimately annually sell 50 of these a year at $2 million or $3 million each, that would be fantastic.

Okay, very good. Is it possible -- or I should say, is it possible that as you run through this program and reach several of your -- if you reach your internal milestones, that the sponsor comes in and picks up more or all of the funding of the program? Is that anything in the -- is there anything in the plan for that or is that not possible?

That's a very important question you have asked, John. We are funding it because -- so we own the IP. And we own the data rights to the aircraft.

It is possible that the sponsor may pick up certain additional elements, but it will not be all, so long that we need to ensure that we own the data rights to the aircraft.

Okay. Good. Second question is related. Can you tell us anything more about the sea-based program and its potential?

Yes. The sea-based program is related to command-and-control systems, and I call them little robots that were sea-based, small sea-based boats -- think fast-attack boats, are being converted to unmanned systems.

The larger opportunity, John, is the conversion that is being initiated by the Army and, I also believe, by the Marines. I believe it is up to one-third of their tactical -- the Army's tactical wheeled fleet where they will be converted from manned to either robotic or unmanned or dual source, where you would put a kit or -- I liken this type to a terminator. You put a terminator in the driver's seat and the terminator drives it.

That, we are under contract. We have a contract. We are under contract. We're working with an agency on this. If it goes into production and we are involved in that, this could be tens of millions of dollars to us.

Okay. And last question is related to the PSS division had lower margins than estimated -- earlier estimated, due to the mix with more hardware. Going forward, should we expect that to bounce up and down depending on the mix or is there any kind of a shift that is occurring where hardware is going to be bigger component of the overall contracted sale?

It is in the near term, John, and when I say the near term, I'm going to say the next two, three, or four quarters. It will probably remain somewhat bumpy because the system integration work is much higher margin when we actually system integrate the security products that we deploy.

Now, I believe approximately 13% or 14% of the business today is a recurring revenue stream, where once we have deployed the security systems, we get a multiyear contract to maintain it or run it. That part of the business is obviously much higher margin. That part of the business we had targeted a couple years ago to get up to 20%, which would have significantly lifted the entire business's margins.

However, over the last few years -- I think two years ago, this business did like 185. Last year, it did like 210, and this year, we are looking at like 225 or 230. So the deployment part is growing and the maintenance and the annuity stream hasn't been able to catch up to it. Do you understand what I am saying?

Yes.

So over the longer term --

It is a catch-up.

I would love to say we are going to continue to grow the business like we did last year at 13% or 15%, then we wouldn't catch up, but I have to be realistic. And as you get bigger, it is harder to continue to grow at 13% on 230 or 250. So as that slows down, and as we catch up on these big deployments, hopefully that maintenance dream will start -- our target was to get it up to 20% over time. That will lift the margins of the entire business.

Okay. Very good. Okay, thanks very much. Appreciate it.

(Operator Instructions). Michael Ciarmoli, KeyBanc.

Thanks for taking my questions. Eric, could you just elaborate a little bit? The unmanned opportunities, you mentioned, obviously, you are spending the R&D money to own the intellectual property. What other -- are there any other defense contractors from your perspective that have similar capabilities? I almost look at unmanned right now maybe more on the commercial side as -- they're almost becoming commoditized products. Everyone has got some sort of unmanned capability.

Can you maybe elaborate in terms of what is still proprietary about the systems you are developing and why has the customer selected you guys?

Sure. It starts back with the company we acquired several years ago now, which was CEI, and back at that time, the big, high-performance unmanned aerial drone or target drone player was Northrop Grumman.

And CEI made the decision -- and we knew them because, as you recall, Hurley builds the electronics and the avionics and the ground control stations that fly their planes, which is one of the reasons we acquired them. They made the decision to go to a composite aircraft versus an aluminum or a steel aircraft and to invest their own money, so not take the government money, when the government solicitation came out.

And they won. They won that procurement. They won a procurement with the Air Force; they won a procurement with the Navy.

We are in negotiations with the Army, and in the current financial environment, especially over the past several years, companies would have to make a significant investment to get into this area. In the current environment, Michael, the government is moving more towards they want to own the IP.

The reason the government wants to own the IP is because if the government pays for the development either directly or now they are even trying -- they are looking at through the G&A rate. So if you incur IR&D, you put it in your G&A rates and that G&A is paid by the government, they come knocking. If the government owns the IP, they take the design and then they will bid it for production and they will put it out to bid.

So, why do I believe we are sitting where we are today? It is a number of factors. After 9/11, the US national security position went almost primarily from strategic warfare to asymmetric warfare and terrorist warfare.

Somewhere over 90% of all the aerial drones in our inventory today are propeller planes. They are tactical. They are small. Many of them -- most of them, probably 80% or 90% of that, 90% are handheld and they were designed for asymmetric warfare, fighting terrorists, boots on the ground, et cetera.

And there was easy money there. And I'm not saying that detrimental in any way, and that's where a lot of companies, they focused, because there was easy money there.

We focused on high-performance aircraft that can fly in contested environments. And now, there is a pivot going on. And there is a shift. We are seeing it in world events.

Some people are doing it reluctantly, but it's happening where we are going from asymmetric warfare to nation-state warfare where the country is getting ready to take on a peer or a near-peer adversary, and that will be a denied environment or a contested environment, and this is why there is the UCLASS program that Boeing and Northrop and Lockheed and General Atomics are bidding on, a very sophisticated unmanned aircraft to fly in fully contested airspace.

So, it has been a convergence of items that is why we believe we are positioned where we are today, and taking these existing target drones, which, as I mentioned before, they actually fly. They are in inventory. There is logistics tail. There is spare parts. All that cost is already incurred. It dramatically reduces the cost of turning it into a tactical vehicle.

Okay, okay, that's fair. No, that's helpful.

How about two other quick ones? I believe someone asked on the continuous monitoring contract. How about the other big one you got last year? I think it was maybe earlier this year, the SeaPort-e contract. Can you maybe give us an update as to what's happening there?

Yes. We are not allowed to announce everything, but that is a very important contract for us, and we are doing weapon systems work, directed energy systems work, railgun work underneath that vehicle.

Okay. Can you give us a magnitude of what (multiple speakers)

Okay, so historically, we have done hundreds of millions of dollars of work under that vehicle. We do several tens of millions of dollars of work under that vehicle annually, and that number we expect to increase. It is increasing at a certain area that we are in, because we are, as you know from the announcement, under every element. We won every element of that vehicle.

Okay, so it sounds like you are taking some share there on that contract on a go-forward basis?

Yes, taking some share. We are winning work in new areas.

Okay, and then just the last one for me, missile defense, you mentioned Iron Dome. It's obviously front and center on the news. The Ground-based Midcourse program had a successful test. Do you see increasing foreign military sales helping out your business and helping to accelerate topline growth? How do you view the opportunity for FMS sales?

I believe, based on the current environment and saying that the two big production programs on the drone side we are working on go into LRIP either late next year or into 2016, and we don't go into production after that, that our FMS and our international business is definitely going to increase.

And it is going to increase in missile systems and the electronics that go on the missile systems. It is going to increase in the radars, the electronics that go on the radars, the ground equipment, the command-and-control ground equipment, and the radar ground equipment.

We just received an extremely large Patriot order, and Patriot is, if you look at the Patriot OEM, they are looking at significant international opportunities. We think that's going to continue to grow for us and it will probably continue to be a bigger piece over the next couple of years.

Okay, okay. Perfect. Thanks, guys. I think that's all I had.

Sheila Kahyaoglu, Jefferies.

Thank you for taking my question. I just wanted to follow up. I know the quarter was modestly disappointing from a topline perspective, but it declined only 2% year over year. Are you seeing some of your businesses starting to trough? Could you maybe comment a little bit about that?

Frankly, for me -- it may have been disappointing for you, Sheila, but for me, we hit -- I think we were square in the middle of our range, so it was on track from my perspective.

We saw -- other than our traditional government services business, which is in the low price technically acceptable realm and which has been contracting -- which has been contracting the last few years, I believe -- you can't say everything, but the business troughed in Q1. It troughed in Q1 because in 2013, we had no defense budget. We had two three-month continuing resolutions and the government shut down, blah, blah, blah.

We got a defense budget signed at the beginning of this year. Very importantly, our LTM book-to-bill ratio was back to 1.0 to 1. That's outstanding, considering if you go back a few of those quarters in the LTM period what was going on.

We -- not just in the numbers, but we can feel the business is solidifying and is gaining traction. Barring something very unforeseen, the second half will definitely be much stronger than the first half. I went through a number of OEM contract awards that all were awarded in the second quarter, every one of those, Kratos builds product that supports them.

So there was a big award let of, what, 10 major programs in Q2. So it's -- right now, it continues to feel better than it did in Q1 and much better than it did in 2013.

Right, so sales should start growing in Q3, per your guidance.

And I guess I know maybe too early to start thinking about 2015 topline, but if we think about just the contract delays that you had in this quarter and assume they don't happen in 2014, and the two potential unmanned orders that you have that are $70 million and $30 million, we could see potentially government solutions grow 5% to 10% next year. Is that an accurate way to think about it, just --

I am not going to -- I'm not -- it's too soon and there's an election coming up in November and one quarter at time.

Okay, and then just again on GS, in terms of profitability, it's been swinging around. Is there anything we should be thinking about for the second half?

For the second half, that in -- right now, based on the programs that we are on, I think that the internal investments, the R&D and some of the other internal investments are going to come down, which is going to directly increase EBITDA.

Okay.

That's something we see happening. We have been making a significant investment to get on -- you know all these programs. CWIP, you know them all. We have been making a significant investment to get on all of these. And if things work out, these are going to be really, really good for us two, three years from now.

Understood, thank you. And then, I guess, just one cleanup. I might have missed it. The corporate expense, that was mainly the refinancing uptick and the restructuring, or am I not getting that correctly?

Which line item are you referring to, Sheila?

Just the corporate income line within -- on the segment line (multiple speakers) on a segment basis, that $3.6 million?

Yes, so those are costs that are not allocable as far as corporate overhead costs, so this corporate office here, it's some of those costs that are not allocable from a division perspective.

But should we see that tick down back to the $1.5 million to $2 million run rate or is it $3 million plus?

There are some increases in our SG&A from a corporate perspective that will, unfortunately, continue, so compliance costs in general, both from an IT security perspective, cyber, protecting the Company from cyber attacks.

As you can imagine, with the kind of work we do, the kind of systems and platforms that we are on, we are a big target, if you will, from a cyber attack perspective. So we have increased our cyber security efforts and that -- we don't see those costs going down, unfortunately, and the overall compliance costs have increased as a result of just the regulatory environment that we are living in.

Okay, okay. Thank you very much.

At this time, I am not showing any further questions. I would now like to turn the call back over to Eric DeMarco for any closing remarks.

Great. Thank you very much, all, for joining us, and our current plan is to -- the next communication will be related to our third-quarter release. Thank you all.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.