Kratos Defense and Security Solutions Inc (KTOS) 2014 Q4 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Kratos Defense and Security Solutions fourth quarter 2014 earnings 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, today's 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. Ma'am, you may begin.

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

Before we begin the substance of today's call, I would like to make some brief introductory comments. Earlier this afternoon, we issued a press release which outlined some 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 call conference 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 focus -- 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 CapEx financial measures as that term is defined in Regulation G. Certain of the information discussed for the quarter ended December 28, 2014 included adjusted EBITDA and the associated margin rates, adjusted EPS from continuing operations, excluding restructuring and acquisition-related items and other, amortization of purchased intangibles, stock compensation expense, costs related to pending contract change orders and contract modification adjustments, non-cash impairment charges and costs on completed contracts. 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 measure, as calculated and presented in accordance with generally accepted accounting principles. The Company's management uses these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating the Company's actual and forecasted operating performance, capital resources, and cash flow.

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

In today's call, Mr. DeMarco will discuss our financial and operational results for the fourth quarter of 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. Good afternoon. Kratos had a solid fourth quarter that generated $23 million in adjusted EBITDA and over $25 million in operating cash flow, with the cash generation being after making our biannual interest payment on our notes in November.

In the fourth quarter, we received a large number of new contract awards and our Q4 bookings were particularly strong at $320 million, with many of these contract awards being received later than in Q4 than we had originally anticipated.

Kratos's fourth quarter book to bill ratio was 1.4 to 1, our Company's highest to bill ratio in the past three years. Our backlog increased up to $1.1 billion at December 31, 2014, our backlog's highest level in 2014. And our funded backlog increased by approximately $130 million, up to over $660 million. The increased bookings in 2014, and specifically in the second half of the year, also contributed to our government solutions segment, which represents nearly 70% of our business and where we perform our DOD and other US agency work, generating sequential quarter over quarter revenue growth for every quarter throughout 2014.

Our increased bookings and backlog provides us greater visibility in the coming year's financial forecast, with many of these recent contract awards being multi-quarter or multi-year efforts which we will begin delivering on in Q2 and throughout the second half of 2015. In the fourth quarter, our qualified bid pipeline increased to approximately $7.4 billion, even after taking into consideration the $320 million in Q4 bookings, providing further confidence and visibility into the future.

Related to our increased bid and proposal opportunities, with the FY 2015 DOD budget authorization, and the recent FY 2016 budget request, we are seeing pockets of projected solid or increased DOD spending and prioritization, and we are focused on these areas where we have products, solutions, and capabilities. These include in the unmanned systems, satellite communications, directed energy, electromagnetic rail gun, electronic warfare, missile system radar, and ISR areas.

Operationally in Q4, important program contributed contributors for Kratos included AFSAT, Patriot, EA-18G, P8 Poseidon, Trident II, CWIP, Aegis, HATS, LCS, the electromagnetic rail gun, WGS Seavers, EHF, the NY MTA, the SF MTA, Chinook, Black Hawk and certain other satellite communication programs.

In Q4, we completed deliveries on production lot 10 of our sole source AFSAT unmanned aerial target drone system program, and we have now successfully received a previously delayed $73 million new AFSAT contract award, production lots 11 through 13, which we will begin delivering on in Q2/Q3 of this year. As a result of the late receipt of the AFSAT award, we will have an aircraft delivery break in Q1 of 2015, with deliveries beginning thereafter on production lot 11. The AFSAT delivery break will result in lower Q1 revenue and EBITDA, with revenue and EBITDA starting to increase in Q2/Q3 as lot 11 aircraft deliveries begin, which I will discuss further later on in the prepared remarks.

Importantly, the recent AFSAT award also includes negotiated sole sourced production options 12 and 13, providing us clarity with this program, one of our companies largest over the next three years. In Q4, we continued to make excellent progress on an approximate $30 million Patriot order we received last year, which we expect to begin deliveries beginning in Q2 and continuing throughout 2015.

In the fourth quarter, we also successfully and substantially completed work and deliveries on our initial major HATS program orders, with additional significant orders expected from our US government and certain other customers.

Programmatically, since our last report, Kratos supported the successful United Launch Alliance Delta II patient mission, which delivered the soil moisture active passive -- or SMAP -- satellite to near circular orbit. SMAP is one of the four first-tier missions recommended by the National Research Council's committee on earth sciences and applications from space. Additionally, Kratos product solutions and equipment also recently supported the aural spatial structures probe mission, which was successfully launched on a NASA aureole, Aureole 4 sounding rocket.

And in Q4, Kratos products and solutions supported a certain BMD target mission in the Pacific. And also importantly, and representative of the strategic national security programs Kratos supports, just a few weeks ago, three Kratos BMD targets supported a critically important MDA test off the East Coast of the United States, which we will be able to more formally announced next week.

Over the past several months, since our fiscal year end, we have continued to aggressively execute on the discretionary cost reduction plan across the country, reducing our headcount by an additional 100 personnel. The majority of these cost reduction actions included a significant reduction in our public safety and security division where, in Q4, we modified our business strategy and we are now focused less on revenue growth, with an emphasis on higher profit margin work liquidity and cash flow.

This business strategy change resulted in lower PSS revenue in Q4, and will result in lower Kratos and PSS revenues going forward beginning in Q1. Though with expected higher EBITDA margins, cash flow, and overall liquidity beginning in Q2, as the full effect of these recent cost-cutting actions and focus on higher margin programs begins to be realized. We made the PSS business strategy change in part as a result of the improving prospects for Kratos defense and international business, which we expect to continue going forward. And, in particular, beginning in the second quarter this year as we commenced deliveries and work on many of recent -- recently received new contracts and program awards.

Strategically, in Q4 we continue to make progress with our UCAS initiative. We have completed the first of our three UCAS aircraft and we solidified our demonstration flight scheduled dates with our government sponsor, which remains on track for the fourth quarter of this year. In December, Kratos UCAS participated in certain war games and simulation, and we have recently received positive feedback from the customer on our UCAS's performance.

Successful participation in this war-game is another important step in our unmanned combat aerial system strategy and initiative as we build towards the demonstration flight scheduled for later this year and future production of the aircraft. We also recently reached agreement with our UCAS government sponsor, which includes a onetime $3.5 million Kratos investment, along with certain government-provided systems equipment, access use of government facilities, and government personnel and services.

Importantly, this agreement was structured so Kratos will retain 100% ownership of the intellectual property, technology, and data rights to Kratos's unmanned combat aircraft. This IP ownership was a critical strategic objective for Kratos, as owning the IP will protect Kratos's future production right of the UCAS platform. As you know, Kratos owns significant intellectual property and data rights on all of our unmanned aerial platforms, which, for example, is the reason Kratos's sole source on the AFSAT program.

In 2015, we will separately identify and exclude from our continuing results this onetime $3.5 million nonrecurring IP related investment and we will keep you informed of our UCAS initiative progress.

Also in the unmanned systems area, since our last report, we successfully completed another contractually required milestone flight under our SSAT program, achieving seven of eight major of our primary flight criteria, with additional flights scheduled for this year and into 2016. We remain on schedule for SSAT to go into LRIP in the second half of 2016, which is an important element of Kratos's expected return to year-over-year organic growth beginning next year.

We have also been recently informed that a separate Kratos UAS program is now being accelerated or pulled forward with LRIP of this program now planned also begin next year. Additionally, we recently had a number of successful flights with our 178 Firejet unmanned aircraft for a US government customer, which has now ordered 20 of these systems which we begin delivering later this year. And, since Q3, we successfully executed and unmanned drone system demonstration flight for a new international customer opportunity, and we believe that we will be successful with an order with this new customer in the second half of 2015.

As of today, we have received orders and are under contract on all of the major unmanned aerial system program and contract opportunities we had previously discussed with you, except one international program, which we now expect to receive in the next few weeks.

In Q4, we also continue to execute on our approximate $40 million unmanned ground and seaborne system contract we were awarded last year, which will continue throughout 2015. And we have recently initiated the capture process on two additional new and large unmanned aerial platform opportunities, one a tactical UAS field opportunity and the second an aerial target drone system opportunity.

We are making significant investments in our unmanned systems business. We are seeing the results of these investments, and we believe that we are positioning this business for sustained growth in this area beginning next year.

Related to the protests, all of the protest situations we discussed in our third quarter call have been successfully resolved in our favor, except one. The successful resolution of these was not unexpected, as only 13% of all protests decided on the merits are actually decided in favor of the protester, according to the GAO's most recent report.

Unfortunately, the still unresolved protest, where Kratos was originally awarded a new, approximate $50 million contract in Q3 of 2014, is now back in a re-procurement situation by the customer. Accordingly, we have excluded this opportunity from our first half 2015 financial plan with positive resolution expected hopefully in the second half of this year.

Also recently, the 3DELRR contract, a large multibillion dollar radar system upgrade program, was awarded to Raytheon, which award was subsequently protested by the non-winning bidders. The Air Force has now announced that they will be reconsidering the bids and potential award of 3DELRR, which the Air Force is currently expected to take approximately 4 months. 3DELRR is a major program Kratos expects to support in the future. However, we have excluded this opportunity from our 2015 forecast, due to the ongoing program protest and program delay situation.

We have also excluded from our 2015 financial forecast a large, new directed energy opportunity we are pursuing and that we expect to win. And we will wait until the contract awards are finalized and any potential protests cleared before we incorporate these back into our forecast.

Moving on to our initial 2015 guidance, based on the factors we have discussed today, including the previously mentioned AFSAT, Patriot, HATS program award delays and related delivery schedules, a revised profitability and growth strategy for PSS, where PSS will be generating lower revenue going forward than previously expected as we focus on higher margin programs, the delay in the international unmanned system opportunity I mentioned, and the continuing program protest situations.

At this time, we are currently forecasting full-year fiscal 2015 revenue and adjusted EBITDA to be approximately similar or slightly lower than 2014 with fiscal 2015 free cash flow exceeding 2014's. For the first quarter of 2015, due to the temporary break in AFSAT and HATS program deliveries, the Patriot program deliveries which are scheduled to begin in Q2, and the planned future reduction in PSS revenue as a result of our change in strategy, we expect Kratos's Q1 to be the lowest of fiscal 2015 with revenue and EBITDA of approximately $180 million to $190 million, and EBITDA of $10 million to $12 million.

We expect revenue and EBITDA to begin increasing sequentially in the second quarter as we begin deliveries and execution on AFSAT, Patriot, Hats, and large also under contract satellite communications programs we were awarded in Q4, as we realize the full effect of the cost-cutting actions we made in Q1. We expect revenue and EBITDA to increase in Q3, driven by increased deliveries and execution on each of these under contract programs I just mentioned. And we currently expect Q4 revenue and EBITDA to approximate Q3's, bringing full-year 2015 revenue and adjusted EBITDA approximately at or slightly below 2014.

Important 2015 programs are expected to include AFSAT, Patriot, HATS, CWIP, Block, P8, Aegis, BMD, Trident II, EA-18G, certain satellite communications programs, and certain unmanned drone system programs, substantially all of which are currently under contract. Lastly, Kratos's Board of Directors is continuing our previously announced business's strategic alternatives review, which, based on progress made to date, we expect to have initial results to report to you no later than the end of the second quarter of this year. Also related to our strategic alternatives review and Kratos's insider trading window policy, at this time, Kratos's insiders are prohibited from buying or trading in Kratos's stock.

With that, I will turn it over to Deanna.

Thank you, Eric. Good afternoon. Our fourth quarter revenues of $221.5 million came in below our expected range, due to delays in contract awards and shipments of unmanned targets to an international customer that are now expected to commence in Q2, which Eric mentioned earlier. Shipments have hardened mobile tactical facilities in our modular systems business, which are now expected to occur in Q2.

In addition, shortfalls in our public safety business resulting from the large national account delaying the deployment of new systems and, to a lesser degree, due to the change in focused higher margins and foregoing larger, lower margin opportunities. In the fourth quarter, we have begun to report two separate segments within our KGS businesses: one which includes the historical KGS businesses of our electronic products, satellite communications, missile defense rocket support, and modular systems businesses, and a new separate segment representing our unmanned systems business.

We have begun to separately report our unmanned systems business as a separate segment due to the expected growth potential in the next several years for this business, driven in part by the expected 2016 commencement of low rate initial production of our SSAT program, moving to full rate production thereafter, the expected acceleration of low rate initial production into 2016 on another unmanned system program we are under contract on, and expected continued progress with our UCAS initiative and other opportunities we are pursuing.

On a sequential basis, revenues increased for our KGS segment from $151.4 million to $159.3 million for Q4 over Q3. The fourth quarter sequential increase of $7.9 million or 5.2% in our KGS segment was offset partially by a sequential quarter decrease of $1.8 million in our US segment from $22.9 million to $21.1 million, and a sequential decrease of $1.7 million in our PSS segment from $42.8 million to $41.1 million.

The US segment decrease was primarily due to the completion of AFSAT production lot 10 deliveries in Q4, which Eric mentioned earlier. And we are now under contract for production lots 11 to 13, which we will begin deliveries on lot 11 later on in 2015.

As mentioned earlier, PSS revenue was down in Q4, in part as we began the transition to focusing on the higher profit margin opportunities. As a large amount of PSS quarterly revenues are smaller programs that are booked and executed in a given quarter, which can present challenges in forecasting revenues especially when larger contracts awards, which typically provide more visibility due to the associated backlog, are delayed.

On a year-over-year basis, Kratos revenues decreased 6% or $14.2 million from $235.7 million in the fourth quarter of 2013, with a year-over-year decrease in our PSS business of $14.5 million from $55.6 million to $41.1 million, primarily due to the delay of system deployments by a large national account mentioned earlier, as well as delays in other expected larger awards, a year-over-year decrease in our unmanned systems segment of $7.6 million from $28.7 million to $21.1 million, partially offset by an increase in our KGS segment of $7.9 million from $151.4 million to $159.3 million.

The year-over-year comparison for our KGS segments include the following. Our legacy services business continued to decline due to competitive pricing pressures and commoditization, which decreased [$5.7 million from $19.4 million to $13.5 million]. The legacy services business revenues are approximately up slightly sequentially, $100,000, from $13.4 million from the third quarter.

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 $2.5 million. The changes in our unmanned systems business was impacted by the reduction of shipment to certain of our aerial target products, which has been impacted by the delays of certain expected awards of unmanned drone systems for domestic and international customers and the completion of deliveries of the AFSAT production lot 10 in Q4, which we mentioned earlier.

These year-over-year declines were offset partially by increases of work performed in our training business of $5.8 million, driven primarily by increased work in our aircraft/aircrew trainer business, increased shipment in our specialized modular systems business of $4.4 million, driven by growth in our surface combatant radar and missile system and hardened facility areas, and increased specialized work performed on government weapons ranges of $2.2 million.

As Eric had mentioned, we have made significant personnel reductions in the first quarter which we should start seeing the full impact in the second quarter. In addition, we should also start seeing the impact of the cost negotiations with key suppliers that we have made in our PSS business.

Our adjusted EBITDA of $23 million for the fourth quarter is from continuing operations and excludes the following charges, which have been reflected as adjustments since we either believe the items are nonoperational and/or nonrecurring in nature. Acquisition and restructuring related items and other of $5 million, which includes employee termination and excess capacity costs of $700,000 in our US business, as we continue to rightsize the business; a $1 million net nonrecurring credit related to the settlement of a litigation matter; $1.9 million of non-cash charges and costs primarily related to a write-down of the carrying value of inventory assets and certain receivables, and $3.4 million of costs related to pending customer change orders related to scope increases in additional work performed in our PSS business.

We have submitted or are in the process of submitting change orders for two sizable PSS projects, both of which have very recently been completed. We believe we will be successful in obtaining customer change orders to reimburse us for additional work we have performed at our customer's request, based upon our historical experience. However, for accounting purposes, we have recorded all the costs we have incurred on these two projects without reflecting any of the anticipated change orders we have submitted or are in the process of submitting until actual receipt of the signed change orders.

As expected, our adjusted EBITDA was impacted by the continued increased IR&D investment during the fourth quarter, which were at $6 million or 2.7% of revenues. On a GAAP basis, net loss for the fourth quarter was $2.2 million, which included $5.5 million of expense related to the amortization of intangible assets at $3.8 million credit related to non-cash stock compensation expense, as well as a $1.4 million income tax provision.

Moving to the balance sheet and liquidity, our cash balance was $34.7 million at December 28, plus $5.4 million in restricted cash. Cash flow from operations for the fourth quarter was a generation of $25.9 million, resulting primarily from a reduction in DSOs from 107 days at the end of the third quarter to 102 days at the end of the fourth quarter. As expected, the net working capital requirements in the third quarter primarily related to production of certain combatant hardened facilities were converted to cash as these sizable milestone billings were collected in the fourth quarter.

As we have discussed previously, our DSOs can fluctuate due to milestones and shipments on our production type contracts, and will likely continue to impact our DSOs and cash flows from operations in the future.

Our contract mix for the fourth quarter was 85% of revenues on fixed-price contracts, 11% on cost-plus contracts, and 4% on time to material contracts. Revenue generated from contracts with the federal government was approximately 62%, including revenues generated from contracts with the DOD and non-DOD federal government agencies. We also generated 5% of our revenues from state and local government, 19% from commercial customers, and 14% from foreign customers, with that aggregate non-DOD revenue comprising 38% of our total revenues.

Backlog at quarter end was $1.1 billion with $662 million funded. Backlog at the end of Q3 was $1 billion. Now on to the financial guidance that we are providing at this time.

As Eric stated, we are expecting FY 2015 revenues and EBITDA to be approximately at or slightly below FY 2014 levels, with stronger free cash flow reflecting a full year's impact of annual cash interest savings of over $18 million as a result of the refinancing. EBITDA is expected to continue to be impacted by internally funded investments by the Company, with IR&D and other investments now expected to continue at higher than normal levels as a percentage of revenues throughout the year as the Company continues to pursue large new opportunities in the UAS, electronic warfare, radar, signal processing, and satellite communications areas.

As Eric mentioned earlier, we are continuing to make investments from IR&D and CapEx prospective in certain of our electronic product satellite communications and unmanned systems businesses. Our total estimated CapEx for 2015 is $15 million to $19 million, with the most significant invest in investment being in our unmanned business as we will be manufacturing an increased number of aircraft where expected customer presentation requirements and includes production of UCAS aircraft. I would now turn the call back over to Eric.

Great. Thank you, Deanna. Operator, we will now open it up for questions.

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

Thanks for giving all the color on the unmanned systems and breaking it out of government solutions. Can you talk a little bit about what margin you might expect from that business as you enter full rate production on things like SSAT and lot 10, 11, 12 -- or I'm sorry; 11, 12, 13 of AFSAT, as well as UCAS, and whether that margin changes depending much on the actual mix?

Okay, first piece, on the new program on SSAT under contract right now, we have two production options. They are both LRIP options. On those spelled LRIP options, the margin we expect to be similar to maybe slightly above what KGS is. And then, after we get through LRIP and we get into full rate production and we are down the learning curve, we would expect them to increase from there. What was the second part, Mike?

That is interesting on SSAT. And then, what about if you are successful in your demonstration on the unmanned combat system?

We would expect -- we would hopefully expect those to be somewhat higher than that on those.

And, let's say we are down the path at some point in the future without getting to a specific year, but let's say that business is running somewhere closer to, say, $200 million in revenue. Is that something that could be a high teen margin business, or would it be less than that, you think?

It would be mid to high teens at that revenue rate.

Okay. Great. And then, you mentioned the Lockheed and Northrup protest of Raytheon's 3DELRR win. So you and Raytheon partner -- are you partnered with the others as well?

We will -- I will answer that question generally, Mike, because of the NDAs we are under. On most of the large procurements, our strategy, as we have talked about before, is, we are strategic partners with strong partners with all of the OEMs except BAE. We do not have a very strong position with be a BAE. So our strategy is to have content or to be in a position -- be positioned to have content with each team.

And more often than not, the content position with one will be higher -- can be higher than the other. And that is typically our strategy. So, if a Raytheon is involved in a large program where Northrup is involved in a large program, or a Boeing, we typically expected to participate in that because we have participated on their past programs and we have strategic relationships with them.

Okay, thank you; just one final question. On your strategic process, you seem confident in being able to discuss some progress in the second quarter on that. Is that, do you think, limited to non-core businesses such as maybe training, modular systems, PSS? Or could it also include something more that you would define as more core?

Because of where we are at in this progress -- process, right now, Mike, I really cannot say anymore than I said in the prepared remarks.

Mark Jordan, Noble Financial Group.

Could you talk a little bit about the UCAS market with regards to what your other players in the marketplace may or may not be doing? I mean, this is a major opportunity, so people have tremendous vested interest in things like the Reaper and Predator platforms. What are they doing to potentially compete with you, or are they being quiet at this point in time?

I will tell you what I know. What I know is that, four of the biggest players -- Boeing, Northrup, Lockheed, and GA -- are all focused on the UCLASS opportunity, which is going to be coming out in RFP very, very soon now. And so on the UCLASS opportunity, that is where they have been focused.

There are -- there have been some RFIs that have come out, primarily from DARPA, including very recently, on some other types of next-generation unmanned combat aircraft that we are pursuing and I understand that certain of they are pursuing. So we obviously expect this to ultimately be very, very competitive, which is why it was so critical for us to maintain our intellectual property position on our aircraft for the niche area that we are going for.

And the niche area that we are going for -- and when I say a niche, that sounds small, but, for us, it is very, very big because we are a small company -- our understanding right now is we are the primary player there today, Mark.

Okay. Of the $7.4 billion pipeline, what of that has been submitted or will be submitted within -- by midyear 2015? And how much of that do you expect to be awarded by the end of the current year?

Right. Roughly, Mark, approximately $1.6 billion of that has already been submitted. It is submitted already. I would imagine probably another $1.5 billion or so will be submitted between now and the end of the year, and then the balance of it waterfalls in 2016 and into 2017.

Do you have any guesstimates as to what amount of that $3.1 billion that you will have submitted to the government by the end of the year will actually be adjudicated?

Mark, when I don't know something I will tell you. I don't know that off the top of my head. I do not know.

Okay. That rail gun, I thought I saw or read somewhere that there is now talk that that initiative may actually be deployed on a DDG-1000. And the evolution of that from -- not a laboratory, but from its development phase to actually being put to sea, is that a positive event for you from a revenue standpoint as you have supported that program?

Yes. That would be -- this is -- what is happening there is a very positive for us. We are involved in the electromagnetic rail gun in several different areas under several different programs. So this is -- this, over time, as this continues to move forward, will become a significant program for us at various divisions throughout the Company.

All right. Final question from me, the services revenues declined 6% sequentially, down to $91 million in the fourth quarter. Given your comments -- and should we assume that that services line for the full year will be closer to kind of annualizing that fourth quarter run rate than what you had for the full year?

Mark, this is a Deanna. The way we actually dissect it is looking at -- so what we report from -- on our earnings release with services is not necessarily our traditional services revenue, because services at a wrap with products are also included in that number. So what we look at more carefully is the actual traditional legacy services revenue, which is at about a $13.5 million run rate per quarter. So it is running just under $60 million currently. That is down from last year's annual run rate of about $85 million.

We did see, sequentially, from Q3 to Q4 that that $13.5 million was about the same as it was in the third quarter. So we don't expect that to continue to decline at the rate that it has on a year-over-year basis, especially just given what we have seen in the most recent two quarters.

Okay. Thank you; one last question. You did note that the strategic review was ongoing. Do you have a sense that a timeframe at which it will -- things will happen or it will be completed and nothing will happen?

Yes, sir. You may not have heard it, Mark. In our prepared remarks, we believe that before the end of the second quarter we will be able to report on progress made.

Eric Selle, SunTrust.

I see that you guys have changed the manner in which you are estimating guidance. Should we see the current guidance as more conservative and achievable as we have seen in the past?

We definitely, Eric, have changed it because of what has been happening with the environment and what we envision is going to continue to happen with the environment. Our absolute plan is that this is a more conservative approach for us, yes.

Okay, good. And then, given the lower Q1 guidance in EBITDA, should we -- and slightly -- or close to slightly down over 2014, should we expect year-over-year growth in the back half?

Oh, yes, sir. Yes. Absolutely. And most of -- a good portion of that, as I mentioned in the remarks, is under contract and that is when the deliveries begin and start to ramp up.

And they cannot be protested.

We have won them. They cannot be protested.

Okay. And that is offset by we're going to keep R&D higher.

As Deanna mentioned, we are going to keep R&D higher and we are going to keep some other investment areas higher, particularly in the unmanned area.

And then, what are the key drivers/press releases that could cause you to meet or beat it? And kind of laden in your answer: assumptions on the budget, the size of the cost savings, and then the potential for some of these protests to come back.

Right. So I think the biggest question mark out there is October 1 of this year, federal fiscal 2016 begins. As we all know, there is a very large disconnect between the Pentagon and the President's request and what the Budget Control Act says and what sequestration and the law says. And so we will just have to see where all that plays out and what that does or does not mean come October 1. That is probably the largest question mark that is out there.

Would that impact 2015 or 2016?

It depends. So it is obviously in our fiscal 2015. And, let's say, for example -- I don't expect this, but let's say, for example, that there is not an agreement and the government shuts down again, or there is not an agreement and there is an extended continuing resolution. That should not impact us materially in 2015, but if it were to go in Q1, it would impact us in 2016, which is very similar to what happened to us in 2014.

Okay, and then Deanna, you guys said that, despite flat to slightly down revenue in EBITDA, that free cash flow is going to be up in 2014. Two questions on that. One, is that all due to interest savings? And then, secondly, what number are you guys using for 2014 free cash flow?

Our 2014 free cash flow is actually a use of $7.7 million. So the comment that we made that we expect free cash flow to be greater in 2015, it is driven somewhat by the interest savings as well as expectations from a working capital perspective.

And that 101 AR days, can we assume that you guys stick to that for the year -- I mean, as you see it right now?

So we are actually at 102, and what I had mentioned in my prepared remarks is that, because we are so product-centric now and delivery-based and shipment-based, those DSOs can vary from quarter to quarter as we saw during 2014. And that was something that we remarked that we expect that type of variability in the future. It is down from 107 in the third quarter to 102 in the fourth quarter. But, there could continue to be variability just because of the way our shipments and milestone contractual billing terms are negotiated with our customers.

Because of the timing, you just don't know when exactly they come?

Correct. Correct. Yes.

And then, I know you can't say a ton about asset sales, but absent an asset sale, could you guys still pursue buying back bonds?

Very candidly, we have not put any thought into that path at all right now.

You are focused on the outset sale asset.

We are focused on executing the strategic alternatives review that our Board has set for us.

And then, finally, your change on strategy on PSS, does that change its attractiveness to suitors?

In my opinion, it definitely should, because the margin and the liquidity presentation of the business has already begun to improve. However, hypothetically, there are some people that like lots of revenue growth and then they will figure it out later. There are other people that like high-margin revenue growth, so it would be hypothetically the eye of the beholder. But this is the right -- in our opinion, the right way to run the business and that is what we are going to do.

And then, I'm sorry. I lied, but just one more. Could you guys -- do you guys disclose what that business did in profit? And then, how big are these cost savings you guys are putting through?

Yes. So we do disclosed that, Eric, so it is in our press release. So if you look at page 2 of our financial tables, the public safety business for 2014 full year generated revenue of $196.4 million in revenue and adjusted EBITDA of $7.1 million.

And then, do you have any -- like how many people are you guys letting go? Is there any way to calculate what the cost savings would be going forward?

As Eric had mentioned, he said that we have made over 100 headcount reduction since the beginning of the year with a significant piece of those reductions related to the public safety business.

And is there any cash severance that will hit free cash flow? I guess that is in your free cash flow guidance. So it would be in that.

Yes. Yes.

(Operator Instructions) Tyler Hojo, Sidoti.

Just to kind of stick with public safety for a second, I get the strategy -- get that it is going to be a headwind in terms of the top line in 2015. I was just hoping that maybe you could called quantify how big of a headwind we are talking about as it relates to the flat to slightly lower revenue guidance for the whole Company.

I would look at it, Tyler, as a similar quarter to what we just clicked off in Q4.

Okay.

In that ballpark, maybe a little less because we initiated the plan of focusing on higher margin work there, so maybe that to a little less is how I would look at the run rate.

Okay. That's good. And, in light of current run rate, could one assume that there are going to be additional cost savings actions taken in 2015?

Absolutely.

Okay. Okay. Got it. And then, just in regards to the conversation around IR&D, it is going to be a headwind. I think it was like six-point-something-million-dollars in Q4. First, what was it for full year 2014 and how big of a headwind are we talking about for 2015?

Yes. Tyler, for 2014, it was $23 million. It has been -- the last three quarters have been about $6 million per quarter. That compares to 2013 at $21.5 million.

Okay. And what are we talking about for 2015?

We haven't given specific guidance on that, but I would say it would be in the -- about that same ZIP Code.

Around $23 million mark?

Yes.

Yes.

Okay, so just to dig into that a little bit more, we are talking about increasing spending on UCAS. What is going down to kind of offset that?

There are some reductions in some of our satellite business and a little bit in our electronic warfare business.

Okay. Fair enough. And then, just on free cash flow --

Tyler, let me make another comment on it.

Sure.

In addition -- importantly, because I see how you are trying to analyze this. In the unmanned systems business, in addition to the IR&D and the way you are framing it up as a headwind, there is also a significant amount of other costs that are not in IR&D that are related to this business. For example, we have a number of executives, including on the consulting side, that are working with customers at very, very high levels. Okay?

Okay.

And, in the overhead area, whenever we do test flights that we pay for, we have to rent the (technical difficulty) for the team -- our team to go out there and do it. Those costs always typically fall in cost of sales or overhead, in that line. Like, for example, the demonstration flights that we are going to do in the fourth quarter of this year. Okay?

Yes.

That piece is not being sponsored, so that piece we will be paying for that to happen.

Okay. Understood. And those expenses are fairly significant.

Yes, sir. They are in the millions.

Okay, very helpful. I appreciate that color, Eric.

Yes sir.

And then, just on free cash flow, I get improving -- and, obviously, really nice performance here in Q4. But, improving on a full year basis on a negative number, I mean, can you give us a little bit more? I think in the first half of last year you guys were talking about $25 million to, I think, $40 million in free cash flow. Are we in that ZIP Code here for 2015? Or any comments there, Eric, please.

Tyler, this is Deanna. I would say our expectation is that we will be positive and that is really what -- I am limited to saying that, since we did not provide that specific guidance in our prepared remarks.

Okay. But we are going to be free cash flow positive this year.

Correct.

Okay. Got it. And, last question for me; there has been a lot of talk from you guys just in regards to the impact from protests in 2014. And I guess it is nice to see them resolved, but could you maybe just talk high level, like what was the sales impact in 2014 and, in context with the impact in 2014, why wouldn't we be better in kind of the base business, ex-public safety, in 2015?

Right. So the impact of 2015 that we are going to get in 2015, that we did not get in 2014, think in the $15 million range.

Okay.

Okay? The one that is still unresolved, I believe -- I think it is a four- or a five-year contract. So that is $10 million a year that -- excuse me, $10 million to $12.5 million that we are still not getting because it has been protested. Okay? We have taken out this directed energy opportunity, I think, is another $40 million opportunity over a few years that we have excluded.

Okay.

So it is -- there is an electronic warfare one -- a program; I don't think I can mention the name of it. That has been protested. That is probably $3 million a year.

Okay.

So it is significant. When you add them up, it has been significant.

And, just rough order of magnitude, if you added up everything kind of you are expecting to not get in 2015, would it be kind of similar to what the impact was in 2014?

Yes.

John Nelson, State of Wisconsin.

It is nice to hear, I think, a more positive tone coming from you two than previous -- the last few calls. And, I mean, it sounds like the pipeline is quite exciting. For both of you, I am curious as to what you think of the -- if there is going to be much change in that new defense budget on antiballistic missile systems, given the problems with Russia and Eastern Europe, and then, whether or not there is a treaty with Iran, that either way there becomes a greater focus again on anti-ballistic missile systems.

Right. John, thank you for your initial comment on that. We have routinely said that we thought 2014/2015, from an industry standpoint, and for us, would be the trough and that we would see us turning out of it in second half of 2015, 2016. And that is what we are seeing.

And we are seeing it in the orders, which is why our funded backlog has gone up so much, and we are seeing it in the pipeline and the opportunities. So your sense of a little more confidence as we see us coming out of this in the second half of this year and growing from there as a number of these programs that we have won ramp up. And the other ones that we are going after -- which a lot of them are sold source and if they are not, it is us and one other guy -- we are going to get them. So thank you for that.

Now, on your comment, absolutely in the BMD -- the ballistic missile defense area -- we are seeing a significant amount of that, of increased activity in the BMD area. As I mentioned in my prepared remarks, we are going to be able to put out a formal announcement, I believe, on Monday, where, just a few weeks ago, we had three of our ballistic missile targets fired within seconds of each other in a raid format at the fleet.

We are working on some very interesting things very recently with the Missile Defense Agency that is specifically related to some of the things that you mentioned. Aegis Ashore, this is taking the Aegis missile defense system from the Aegis platforms and putting them onshore in Eastern Europe -- excuse me, Western and Eastern Europe, that is moving forward. We are involved in that.

We are seeing specific activity related to our ballistic missile defense work relative to the Mideast -- significant. So each one of those areas you touched on, yes, sir. Ballistic missile defense, because of the proliferation of missile systems, is a high priority area right now.

Okay. Good. And you have talked often about the UCAS program and this being a significant part of the future of the Company. Have you -- can you give us any sense of the size of the UCAS market versus kind of ex-ing out that portion that would be UCLASS versus UCAS?

Right. So John, let me say something relative to the first part of your question. We are definitely making a big investment in our unmanned combat aerial system initiative. However, a very big part of our future that is under contract is our SSAT program.

And, today, for the first time, I was able to mention that we are on another very large program that is confidential. But I was able to mention it today. That LRIP on that is being pulled into 2016 as well. And full rate production will begin after that.

So, our targets work. Our unmanned aerial drone target business is going to be a very, very big part of our future and most of that is under contract. And we are heading into production on what will be the largest production program in the Company, and the second one will be right up there with it.

The unmanned aerial system market is very, very large and there is a lot going on. It is multibillions. There have been $5 billion numbers thrown around. There have been $7 billion numbers thrown around. It is very large. There is a lot going on within those pockets -- in those budgets right now where -- and that just has to do with the move away from asymmetric warfare, and flying in uncontested airspace to nationstate or near peer, peer warfare and flying in fully contested anti-access aerial denied airspace and that takes a different type of vehicle.

And it has been a lot of RFI and RFP activity out there for next-generation types of unmanned aerial systems that can perform their mission in those contested environments. We believe that this is going to be -- this is and is going to be -- this is outside of UCLASS, outside of that. This is going to be a multibillion-dollar budget funded area because of the mission requirements. And if we can get a small piece of this, this could be a few hundred million dollar a year business for us.

This concludes our question and answer session. I would now like to turn the call back to Eric DeMarco, President and CEO, for closing remarks.

Excellent. Thank you very much for joining us today. We will obviously speak with you when we report our first quarter in May, unless there is a need to call a meeting prior to that. Thank you very much.

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