Kratos Defense and Security Solutions Inc (KTOS) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions third-quarter 2015 earnings conference call. (Operator Instructions).

I would now like to turn the call over to Marie Mendoza, Senior Corporate Attorney, Acting General Counsel. Ma'am, you may begin.

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

Before we begin the substance of today's call, I would like everyone to please take note of the Safe Harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, operational outlook and financial guidance during today's call.

Today's call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information presented in compliance with GAAP. Accordingly, at the end of today's press release, we have provided a reconciliation of these non-GAAP financial measures to the Company's financial results prepared in accordance with GAAP.

With that, I will now turn the call over to Eric DeMarco.

Thank you, Marie. Good afternoon. As we've previously mentioned to you, the fourth quarter would be an important period related to the progress of certain of our unmanned aerial vehicle products, platforms and our initiatives. We are pleased to report that we have successfully completed the initial flight of Kratos' UTAP-22 high performance unmanned tactical aerial platform with additional future flights scheduled in the near feature to further demonstrate this aircraft's capabilities and evaluate potential requirements. The successful flight of Kratos' UTAP-22 is the most important milestones that our company has achieved to date in our tactical aerial systems strategic initiative.

For competitive, confidentiality, and other considerations, at this time, we will not communicate more than what was included in today's earnings release related to this successful initial flight, though we have received preliminary positive feedback from certain potential customers we have been meeting with. We are all very excited about the present future prospects for Kratos' UTAP-22, and we hope to communicate additional positive developments with you over the next few months.

A key element related to Kratos' returning to sustain organic growth is the subsonic aerial target or SSAT program, which remains on track to begin low rate initial production in late 2016 with Kratos executing another successful flight during which we achieved all of our flight objectives. The SSAT 177 is Kratos' unmanned aerial target platform that we are under contract to develop and produce for the U.S. Navy, which replaces the legacy BQM-34 and BQM-74 target systems, which are no longer in production. The most recent SSAT flight demonstrated certain advanced flight performance characteristics that we have been working on over the past several years and where we are making a considerable investment. Kratos' SSAT contract vehicle includes priced options which are expected to be exercised in late 2016 for LRIP, or low rate initial production, initially of approximately 30 to 35 units to be delivered in fiscal 2017 at approximately $1 million per vehicle, and a currently estimated additional 40 to 50 LRIP units to be delivered in 2018 under LRIP II. Following these deliveries, we expect to move to full rate production, which we anticipate will reach approximately 100 units annually. Due to the increase in anticipated SSAT deliveries over the next few years, this program is expected to ultimately be Kratos' largest before consideration of other new platforms or programs that we are currently developing or responding to via RFPs.

Additionally, a separate large confidential program we are working on also remains on track to begin LRIP in late 2016 with this program also expected to become one of Kratos' largest over the next few years once it achieves full rate production.

We are also in pursuit of a number of new, unmanned opportunities in the tactical, target drone, and ground system areas, certain of which solicitations have come out since we reported Q2 and which we are currently expected to be awarded in the next few months. Certain of these opportunities, if Kratos is successful, could also become some of our company's most important programs.

With the third quarter closing of the sale of Kratos' US and UK electronic product businesses and our recent successful UTAP-22 flight, it is important to clearly reiterate Kratos' strategy and our go-forward plan. For the past two years, we have been making significant discretionary internal investments in certain potential high-growth areas, including, most importantly, the tactical unmanned aerial system area. These discretionary investments have increased as certain new solicitations for potentially high, large high-performance value unmanned aerial system program opportunities have recently come out which we see as validation of our tactical unmanned aerial systems strategy which commenced in earnest last year and is the genesis of Kratos' UTAP-22.

We have been examining our Unmanned Systems strategic plan, knowing that we have core businesses, including satellite communications, microwave electronics, defense and rocket support solutions, training systems, cyber security, and aerial target and drone systems, that generate significant profitability and cash flow. And we also believe that these businesses in our company probably valuable, as indicated by our recently completed strategic review process. The internally funded discretionary investments that we have been making in the unmanned tactical aerial systems area have significantly reduced the recent profitability and cash flow of our Company. However, we have been consciously executing this strategic plan in the pursuit of sustained, long-term and potential transformational growth.

The culmination of Kratos' unmanned initiative and the investments will be playing out over the next several quarters. With our UTAP-22 progress and the award of certain of these new high-performance unmanned tactical aircraft solicitations, which if we are successful will position our company as a leader in a new and expected to be high-growth future market area. Obviously, we understand that, in the tactical UAS area, we are competing against the most experienced, technological and well-funded enterprises in the industry.

Though we expect success in the tactical UAS area, especially with our recent successful flight, if we do not obtain or planned goals, we will dramatically reduce the discretionary investments we have been making, which would immediately and significantly improve Kratos' profitability, free cash flow, and our leverage position. We would then focus on being the world's leading provider of high-performance unmanned aerial target drone systems where we are currently under contract on two programs, which, as I mentioned before, are expected to go into LRIP in the second half of next year, and once in full rate production are expected to generate in excess of $100 million a year in new high-margin incremental annual revenue for Kratos. At that time, we anticipate that Kratos will be the primary high-performance unmanned aerial target drone system provider to the United States Air Force, Navy, Army, and multiple international customers with numerous new and updated weapon and other systems being fielded requiring operational testing driving demand.

Additionally, Kratos' microwave electronics business, where we currently have a near record high backlog and are positioned on a number of new programs, is also extremely well-positioned for future growth with recent global military emphasis on electronic warfare, missile and radar systems. And related to Kratos' microwave electronics products business, we just recently learned that Kratos expects to begin product deliveries next year for an upgrade to a certain airborne electronic warfare platforms system which is estimated to be 500 chipsets at approximately $30,000 to $35,000 per chipset to Kratos over the next few years.

And in Kratos' satellite communication business area, this is where we are the leading provider of ground, aerial, and seaborne medications, signal monitoring and intelligence infrastructure and equipment. This is seeing increased growth prospects as a result of the Chinese and Russian threats to US space assets and opportunities driven by nano and small satellites.

These three core Kratos business areas -- unmanned systems, satellite communications, and microwave electronics -- which make up over 50% of our company, are all leaders in technology, intellectual property and differentiated products and are expected to be a priority in well-funded areas of national security, as noted in the recently executed budget agreement. Accordingly, we have a very clear plan where we have thought through the potential future alternatives, and we believe that we have positioned the Company for significant revenue, profit, and cash flow growth with our existing core business with success in the tactical unmanned aerial system area potentially resulting in even greater and possibly transformational future growth for our company if we are successful.

Operationally, in the third quarter, Kratos' unmanned systems, modular systems, and microwave electronics businesses generated sequential growth of approximately 11%, 10%, and 6% over the second quarter of 2015, respectively, with sequential growth in our unmanned and modular systems businesses being driven by initial deliveries under the AFSAT and Patriot programs which are expected to continue into and throughout 2016.

In Q3, the mix of Kratos' business remained favorable, including in the satellite communications, cyber security, microwave electronics, and training solutions areas. And Kratos booked a significant number of new and large contract awards generating a 1.2-to-1 book to bill ratio in Kratos' government solutions business, which is our company's largest segment, and a 1.7-to-1 book-to-bill ratio in our satellite communications, cyber security, and training areas.

Additionally, over the past few quarters, major areas of our business had begun to firm up, representative of the sequential growth in new contract awards we are seeing. And with the two-year US federal and DOD budget agreement now in place, we are hopeful that there will be greater predictability in our industry and for business.

Since we last reported to you, we have had two disappointing areas within our modular systems and PSS businesses. In our modular systems business, we have a large program where Kratos has been under contract with a government agency where we have been delivering product. This government agency had previously communicated to us that additional significant orders under this program would be made to Kratos in 2015. These follow-on orders under the existing Kratos program have not been made to date.

Additionally, in modular systems, we had an existing contract we have been working on canceled for convenience by a separate customer, which we understand was due to funding issues.

In our public safety business, we have made excellent operational progress across the division with the average gross margin rate for the majority of all new projects booked since the beginning of 2015 being approximately 30% and with certain PSS regions generating direct EBITDA rates up to 18%. However, certain other PSS geographic regions have not performed to our expectations and, accordingly, we are taking appropriate actions to get these areas on track, including restructuring and consolidation of the organization and management and personnel changes. We will get this fixed, as we have demonstrated with other PSS regional performance, with meaningful impact as a result of these actions targeted for the first quarter or half of 2016. These modular systems and PSS issues have caused us to adjust our 2015 forecast to $640 million to $660 million in revenue and adjusted EBITDA of $40 million to $45 million.

In summary, as we head into the end of the year, we have achieved two of the most important 2015 objectives for our Company, a successful initial UTAP-22 flight with all objectives being achieved and with positive customer feedback, and a successful SSAT flight positioning Kratos for LRIP in 2016.

As we've discussed today, the vast majority of Kratos' business is performing well and trending positively, including Kratos' government business firming up, as demonstrated by our sequential growth, backlog, book-to-bill ratio, and our bid pipeline. There is now a two-year federal and DOD budget in place, providing the best industry clarity we have had several years, and we are pursuing a number of large opportunities, certain of which are currently expected to be awarded over the next few months and some potentially by the end of this calendar year where, if we are successful, these opportunities could significantly enhance of the future prospects of Kratos.

I will now turn it over to Deanna to discuss our financial results for the quarter in detail.

Thank you, Eric. Good afternoon. As a reminder, all financial data has been re-cast to reflect the US and UK electronic products businesses as discontinued operations for all periods presented. The third-quarter results reflect the sale of the divested businesses as well as a repurchase of the $175 million senior notes, both of which were completed during the quarter.

Our third-quarter revenues from continuing operations were $161.7 million, which sequential growth from our second-quarter revenues of $160.7 million. Although we did not provide quarterly financial guidance for Q3, our financial performance came in less than we expected primarily due to the items Eric discussed related to our modular systems and PSS businesses.

On a year-over-year basis, revenues decreased from $190.8 million in the third quarter of 2014 to $161.7 million in 2015 due to reduced revenues of $16.4 million in our KGS segment, which were a result of reduce shipment of a hardened mobile tactical facilities by a certain US government agency customer in our modular systems business of $11.3 million combined with the continued contraction in aggregate government services revenues of approximately $3.5 million. In addition, reduced revenues of $9.7 million in our PSS segment resulting from the change in strategic focus and PSS to emphasize higher margins smaller projects impacting overall sales volume, and a reduction in our unmanned systems division of $3 million as a result of the timing of awards and shipments in 2015 impacted our Q3 revenues.

Our adjusted EBITDA of $11.5 million for the third quarter is from continuing operations and excludes the following charges which have been reflected as adjustments, consistent with our prior presentations since we either believe the items are nonoperational or nonrecurring in nature. Restructuring related items of $1.5 million which includes the following: excess capacity costs of $700,000 in our modular systems and unmanned systems businesses which reflects the unabsorbed manufacturing overhead costs due to reduced sales volumes resulting from the delays in anticipated contract awards; $400,000 of restructuring related costs; and $400,000 of investments we are making in conjunction with the government agency to develop the nonrecurring IP investment we discussed a few quarters ago that we are making for an unmanned combat aerial system platform. And also included in our reconciliation to computed adjusted EBITDA are $600,000 of unanticipated contract adjustments related to certain projects in our PSS business.

On a GAAP basis, net income for the third quarter was $55.1 million, which included a net gain from discontinued operations of $50.8 million, reflecting the gain on sale of the US and UK Electronic Products business; $2.8 million of expense related to amortization of intangible assets; non-cash DOT compensation of $1.6 million; a $15.3 million tax benefit; and a $3.4 million loss on extinguishment of debt, reflecting the write-off on amortized deferred financing costs of the recently completed repurchase of $175 million of our senior notes.

Moving to the balance sheet and liquidity, our cash balance was $35.8 million at September 27 plus $700,000 in restricted cash. We utilized the net sale proceeds from the sale of the US and UK electronic products business of approximately $232 million by paying down the $41 million outstanding on our revolver and repurchasing $175 million of our senior notes, reducing our debt to approximately $450 million with zero amounts outstanding on our $110 million line of credit and approximately $36 million of cash on our balance sheet.

Cash flow from continuing operations for the third quarter was a use of $8.2 million, reflecting working capital requirements, primarily in our Unmanned Systems business. Capital expenditures for the quarter was $2.9 million.

DSOs decreased six days from 116 days at the end of the second quarter to 110 days. DSOs continued to be impacted by milestone payments on long-term delivery projects where we are unable to contractually invoice for amounts until the completion of certain milestones and/or final delivery of products or the demonstration of certain flight parameters, specifically in our Unmanned Systems segment.

Our contract mix for the third quarter was 80% firm fixed price, 14% cost plus fixed fee, and 6% time and materials. Revenues generated from contracts with the federal government were approximately 60%, which includes revenues with DOD and non-DOD government agencies. We also generated 7% of our revenues from state and local governments, 20% from commercial customers, and 13% from foreign customers with our aggregate non-DOD revenues comprising 40% of our total revenues.

Backlog at quarter end was $961 million with $552 million funded and $409 million unfunded.

Book-to-bill was 1-to-1 for the third quarter, and for the last 12 months was 1.1-to-1.

The guidance Eric provided earlier reflects increased investments related to IR&D, bid and proposal, NRE, and CapEx in certain of our microwave products, satellite communications, and Unmanned Systems businesses, specifically also related to the Unmanned Systems demonstration flights during the fourth quarter and a bid and proposal and to these activities related to new opportunities we are actively pursuing in that business.

We remain focused on cost reduction opportunities. For instance, we recently executed a sublease expansion agreement for one of the largest lease commitments that we assumed in 2011 in conjunction with the Integral Systems acquisition. The expansion now extends through the entire term of the lease commitment of March 2020 and encompasses the entire facility. Over the expanded period and space of the subleasing expansion, our net cash flows will improve approximately $2 million to $2.5 million per year, or for an aggregate improvement of over $11 million for the remaining term of the lease commitment through 2020. We continue to pursue opportunities to reduce costs and enhance cash flows.

In closing, post Electronic Products asset sale and the bond repurchase, we believe that we are well-positioned to continue to execute our strategy of building a differentiated product and technology business with major future growth opportunities in the Unmanned Systems, satellite communications, and related cyber security businesses.

Thank you, Deanna. We will turn it over to the moderator now for questions.

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

Thank you. With the UTAP-22 flight test, did anyone try to shoot it down?

No, not in this flight.

But is that something anticipated in the future flights?

As I said, Mike, for competitive and other reasons, I am not going to get into the details of what we are going to be doing in the future flights the next few weeks.

Okay. Great. And then regarding the SSAT, I noticed in the joint Aegis ballistic missile test earlier this week that there was a Northrup target used, the Chucker, that's no longer in production. Do you know how many more of those the Navy has left in inventory?

Yes I do. Though I'm not sure, Mike, I'm allowed to say the number. But, yes, I do.

Okay. Without saying a number, is it a lot or is there more of a pressing need for your (multiple speakers)?

Right, without saying the number, based on the op tempo that the customer, the Navy, has had, and as they are projected to have, it gives us high confidence in the LRIP, in the full rate production schedules that are coming, that their inventories will be depleted, and that they will need to targets to replace those that are depleted.

Okay. Thank you. And then regarding other combat and electronic warfare opportunities you are pursuing, one I presume is DARPA's Gremlins program, which has received a lot of press lately, and there's proposal -- technical proposals look like they're due in two weeks' time. Can you discuss whether you are involved in that, or what you think of that program?

We think that that is an excellent opportunity for what we have to offer, Mike.

Okay. And there's to be four Phase 1 winners. Are you bidding as a prime or on any other teams? Or can you say?

I should not say specifically, for competitive reasons, how we are going to come at it.

Okay. I guess final question then is let's say whatever unexpected reason that all of your efforts to build combat systems are unsuccessful. And so you have to just go back to be a supplier of targets were you have this $150 million a year type of revenue increase coming down the pike in a few years. So what is the magnitude of the investment reduction you might be able to see in your operating expense and cost of revenue levels in such a scenario?

Right. I think somewhere around approximately $5 million in expense, maybe a little less, maybe a little more, $6 million to $7 million in CapEx right off the top. And those are the low-hanging fruit, Mike. And there will be significant leverage on the overheads and the rates once those go into production, which will further increase profitability. So this is several and several millions of dollars if we are unsuccessful, both on the P&L side, the cash flow side, and the CapEx side.

Okay. Great. Thank you.

Mark Jordan, Noble Financial.

Eric, you talked a little bit about obviously a very robust bid pipeline of $7.3 billion. Could you talk about what, of that pipeline, what has been submitted, and what do you expect would be solicitations will be going in, say, in the next six to 12 months?

Right. So submit, Mark, submitted right now, approximately $1.5 billion of that has been submitted. The vast majority of the rest of it is being tracked to be submitted within the next 18 to 24 months. And, Mark, what was the other part of your question, please?

It was, again, what -- when would you expect those to go in? In your experience, have you seen any change in regards to your customers' willingness to plan and start to commit funding schedules? Again, it's awfully soon, so we've got sort of a break in the financing end of things. But have you detected here in the last three months any change in customer behavior and any feeling as to the response to the budget list that has emerged?

Right. So, Mark, in certain areas, yes, absolutely. So specifically in the satellite communications area where, in the past three months, for example, 60 Minutes ran a show talking about the space threat and an incremental $5 billion that was being earmarked immediately to safeguard the space assets. And that relates directly to us, and we are absolutely seeing an uptick in that area. And that ties into the 1.7-to-1 book-to-bill ratio we just experienced. That's area number one.

Area number two in our microwave electronics business, on surface-to-air missile platforms, air defense, both low, mid, and high, we are to signed in on a number of platforms. There is a test coming up in November, this month, that, if it is successful, we will begin production with the prime to start delivering. And it's thousands of missiles beginning next year. And this is an area that we've seen significant strength.

And the third area that we've seen this year is in our cyber security business, particularly on the government side. And what we are doing in that area, a lot of which I can't get into here, we are seeing particular strength there. So in those three areas, we are seeing a lot of strength. And as Mike alluded to, in the past couple, few months, just as we talked about on the last call, there have been a number of solicitations released in the tactical unmanned aerial system area. We are pursuing several in the tactical ground Unmanned Systems area, several of which are very large. That is picking up as well.

When you are talking about the microwave surface-to-air missiles, would that be your Israeli subsidiary that was retained out of (multiple speakers)?

Yes. Yes, sir. And the subsystems we are providing are both of the ground radar and on the missiles themselves.

Okay. The 1.7 book-to-bill on the satellite, that's a lot more impressive number if it was relatively short duration contracts versus, say, a five year -- a couple of five-year contracts. Could you give a little bit of feel for are these just a plethora of shorter term tasks, or were these book prices longer in nature?

Yes. So we have got a mixed bag in there. So in the quarter, we received a contract, a $50 million contract. We were funded $20 million up front. We have already received the funding and the payment on it. That is a five-year one. That will burned fairly ratably over five years. However, there was another $40 million or $50 million one we received. The way that one is burning, I would not be surprised, Mark, if the majority of that is shipped next year. And that is specifically in the satellite communication area.

Okay. And a question from me for Deanna. In your Accounts Receivable, it has been a pretty high number for quite a while. What is in there that is, in essence, unbilled waiting for a specific milestone to occur to be billed?

Yes. So there is a fairly sizable amount of milestone driven collections in our Unmanned Systems area where until we either hit final delivery and/or flight demonstrations upon final delivery, we are not able to bill until that time. So that is impacting our DSOs. We have some similar type of milestones in some of our other modular systems business area, as well.

Mark, in that unmanned area, there's one international customer in particular. It is between 10 and 20 aircraft. And the aircraft are now complete, virtually substantially complete. There are some modifications left. And the flight schedules are not for a while. And once those flight schedules are successful, as Deanna mentioned, then we can bill it out.

Okay. Any way to just say and put an absolute dollar figure on that unbilled portion of the $195 million?

Just for that business, it is probably around $20 million related to the flight parameters that need to be hit.

Okay. Thank you.

John Nelson, State of Wisconsin Investment Board.

My question is related to what's going on in the PSS, public safety and security, markets. Are the revenues from that division coming in in line with your expectations and your profitability targets?

Right. So, John, the first answer to your question on what's going on in that area, there are numerous opportunities. There is a robust opportunity set in that area. No doubt about it. As you know, we have been focused on going after higher margin stuff. Some of the highest margin stuff, as I mentioned in my prepared remarks, we have, year-to-date on the majority of the opportunities that we go after in the book and burn area, it is over 30% gross margin. So that has impacted the revenue, and it has impacted it more than I had anticipated, so we are enhancing -- part of the plan we are doing is we are enhancing the sales force to expand it so we can go after even more of these because we are passing on the low margin ones. We still have a pretty big nut. I think, John, it is $20 million or $30 million a year of very large deployment projects, security system deployment projects, we are working on. Two big ones drop off in 2016. Another few drop off in 2017. And then we are basically done except for one big one. Okay?

As I said in my remarks, in several of our regions -- and I talked by region because that's how we organized -- we are knocking the cover off the ball. In one region, John, we are generating direct EBITDA for that region, approximately 18%. In another one, we are generating like 11% or 12%. We're doing great.

There were two regions, very candidly, that during the quarter -- there were some jobs that were terrible and they impacted the entire division. And that is where we have made personnel changes. We have made management changes. We are doing some reorganization. Because if you look at the other regions, we can execute this, which means it is people. And so we are fixing it and, as I said, our plan is to get this fixed Q1, Q2 of next year.

Okay. Let's see. Is the sales force expansion going to be, would you say, large, small?

20%.

Okay.

Up 20%.

Okay.

Absolutely. And we are probably 5% into that 20% increase. So we have increased it 5%. We've got another 15% to go to hit the target that we have set by the end of the year, January. We want to make sure we get the right people; just don't bring in people and they turn out to be the wrong people.

Okay. And the pipeline for the projects that meet your kind of margin targets, would you say it is growing slowly, leveling off? I know you are increasing your sales force. But is it -- I guess is it broadening out to a lot of different businesses that you had not expected before, or is there any significant change in the customer profile?

Let me bifurcate it into opportunities and the pipeline. The number of opportunities, John, are significant. Security system deployment, whether it be access control, basic video cameras, infrared cameras, CBRNE, facial recognition, it is an in-demand business in this country. And it has to do with any type of new construction -- office building, mass transportation, energy, energy transport. Across the board it is growing. So the opportunity set is there.

Our pipeline has not been growing as fast as I would like for two reasons. Number one, we have set some very high parameters, bounds, on the profitability we are willing to accept because the business has got to make an acceptable margin for us. Number two, it is the sales force size I believe that I mentioned to you where we believe that if we can expand this sales force along the lines that we discussed, that we can capture more of these high-margin opportunities, which will drive the business forward.

Okay. Terrific. Thanks very much.

Kevin Ciabattoni, KeyBanc Capital Markets.

Just starting big picture, Eric, does the two-year budget deal signed help you get more comfortable with your expectations around 2016? If there is any kind of particular areas within your business that might see the biggest benefit of this in the near-term? Any color you can give there?

Right. I think the areas that we are going to see benefit in the near-term is in the satellite communications area, the training system area, we are seeing significant strength there. And the budgets, if you dig into them, if it turns out the way that it is expected, is going to be significant force in the training area, especially in the aerial vehicle, manned aerial vehicle training system area.

The target drone area -- I think the target drone area is going to be very strong and very predictable for us starting now for the foreseeable future not just because of the contracts that we have because of what's going on with OPTEMPO out there relative to certain platforms. That is looking pretty strong. Based on the most recent ballistic missile test schedule, I think our ballistic missile target area will be very predictable. We have booked a significant number of work there recently and we are expecting some more in the near future that will play out -- that we will be able to build, ship, and launch over the next couple of years. That looks pretty strong right now.

Services area looks weak. Modular systems area in missiles and radars is very strong. In some of these other specialty areas where these are high-profile national security systems like this contract that we have and we have been delivering on and the customer has told us you are going to deliver 20 million or 30 million more this year, and then they said, no, we are delaying with no definitive schedule, that's lumpy because it is politically driven.

So the majority of it is good. Service is soft. Certain specialty areas, choppy.

So just looking at that modular piece, the 20 million to 30 million, I know that obviously hit the full-year guidance. Does the budget deal help kind of move that along or is it outside of --?

I have to be very careful on how I say this because we are the prime, and this is a very high profile program. The money is in the budget for it. It is there. That money can be taken and used for other things, which has impacted my confidence because you can have a program and you can have a contract, and then for reasons money can be redirected.

Okay. Okay. And then I know you mentioned the Gremlins program a little bit earlier in the call. I think the original expectation on timing for that was an award in 1Q 2016. Is that still kind of what you are thinking?

Nothing has changed in my thinking on any of those that have come out that's different than what has come out in the solicitations.

Okay. And then last one for me I guess, the PSS shortfall in the quarter, you mentioned a couple of specific regions. Was it that revenue came in light and impacted -- lighter than you thought and impacted the margins there, or was it you got the revenue you thought, but it was lower margin business that you have been kind of been trying to avoid, or a combination of, I guess?

Right. So let me frame that up for you. On the modular system program, think $20 million of revenue, that's 30% gross margin. The other piece was revenue light. And in certain regions, the execution was not acceptable.

And that compounded with the revenue light and the infrastructure that is there, that had a double impact on the EBITDA margin.

Right. I get it. Okay. On the modular piece, the $20 million, was that for the quarter or for the remainder of the year?

Six months.

In the six months? Okay. Is there restructuring impacts from PSS going to be meaningful all from a dollar standpoint?

I don't think it will be material. It depends on (technical difficulty). It's not going to be tens of millions. A few. It's not going to be significant.

Okay. Perfect. That's all I had. Thanks.

Sheila Kahyaoglu, Jefferies.

I guess can you reconcile, put together the pieces a bit when we think about the revenue outlook with your bid pipeline, the two large contracts rolling off on PSS. The modular systems just seems to -- those two contracts seem to impact 2015 only. So can you let us know how we should start thinking about 2016?

Because of the number of things that are going on right now with us, the number of opportunities that we are pursuing, some of which that, as I mentioned in my prepared remarks, possibly could be awarded by the end of the year, and some of these are very, very large and could be very important, we are not going to get into 2016 right now. We just don't want to do that until we have more information.

Sure. Can you let us know the size of the PSS contracts?

The two that are going to be rolling off, the --?

That will be completed, I guess, in 2017.

Well, there were to there that were going to be completed in 2016. And I think, Sheila, there are like -- it's like, combined, it is $5 million to $10 million of revenue.

Okay, so smaller than I thought.

Yes.

And then I guess on government solutions, within that businesses, is it just all the impact from modular systems where the margins are impacted?

Yes. Sheila, yes.

So, is there -- I guess how should we think about the moving pieces there, because the profitability does swing around a bit.

Typically, our satellite, communication, and training and cyber area is one of the highest margin areas. That is strong. Our microwave electronics business is extremely strong. We are sole-source on virtually everything that we do. Or services business areas is weak, as you would expect a services business area would be. It is weak in there. Modular systems, when the volume are right, is average, an average type of a business, 8% to 10%, when the volumes are there to leverage off of the fixed overheads.

The Unmanned Systems area right now is hard to gauge because of the massive investments that we're making. Historically, though, if you look back a couple, three years, it made 15% to 20% EBITDA margin. That's just on the target business. And so that's kind of how you should think about that. I believe we are going to be successful in the [S] and the tactical area. I believe that, especially now with the success of our aircraft and the customer feedback that we've gotten, which has been much stronger than I thought in such a short period of time.

But, heaven forbid, if we are not successful, and we have to make some changes there, head targets business in the past has made 15% to 20% EBITDA margins.

Got it. Okay. Thank you. That is helpful color. I think that's all I have for now.

Eric Selle, SunTrust.

So you've gone through some of it, but basically the EBITDA guidance is down $10 million versus the last guidance. And the disclosure you gave on the modular business I think compromises about 60% of that miss. And so basically, second-, third-, and fourth-quarter EBITDA is going to be pretty flat sequentially. Despite the headcount cuts, despite the better bidding and PSS, and despite the delivering of contracts that were paid upon delivery that you incurred costs in the first half, is that how we are supposed to look at it? Because we didn't get the ramp in the back half. Is this a one, lumpy, modular loss that is comprising 60% of the loss, and masking all of those savings? It's just hard for me to look at this. You explain this.

Right. I want to be clear and reiterate. The modular area, we didn't lose anything. We have a program. We have a contract we have been delivering on. We have been delivering tens of millions of dollars worth of product over the past few years on this. We had a delivery schedule from the customer where we have this program for 2015. The customer came to us and said, no more deliveries this year. We do not have a delivery schedule for 2016, so we didn't lose anything. We have a program and a contract with the customer where we are the prime. That's on that one. As I said, that's -- as you said, that's about 60%.

In the PSS area, the two areas that Deanna mentioned, number one, we came in light of revenue for two reasons that I talked to John about. Number one, I think it's because we are being very aggressive in what we are going after. That 30% gross margin is the target. That really has limited the opportunities. Because of that, we are going to be expanding the sales force to make sure that we are seeing every opportunity out there so that we don't miss any. So we were revenue light because of that. That's my opinion.

And number two, in two geographic regions in particular and on just a few projects, programs, the performance was terrible and it impacted the margins significantly. So we lost the leverage on the revenue and we had the impact on the execution and that was the shortfall. You add those together, that is the guidance.

So basically 60% of it was a -- versus the guidance was a sudden change in a long-term customer (technical difficulty) was it PSS? I guess it begs my question of PSS. PSS had a rough 2014. It's not been -- despite the margin change, it sounds like you guys are increasing prices and maybe missing some contracts.

My question is why invest in sales? Why put more money in PSS if it's been so disappointing the last 18 months? I understand it is growing. I understand the industrial demand. But can you possibly compete against a Cisco, or is this something that probably belongs in someone else's hands?

Right. So, on your question of why invest in the sales, because the salespeople should pay for themselves. And as I mentioned to John, the target set -- we believe the target environment is rich. We have demonstrated we can generate, as I indicated in my prepared remarks, up to 18% gross margin in certain regions. I mentioned one that was 11% or 12%. So it can be done. So, we believe that it is a low investment on the sale size to bring in the people, to try to capture more of that high-margin revenue, get leverage on the G&A, and then hit our 8% to 10% overall EBITDA target rate. That's our plan.

Okay. And then on the unmanned drones, you said you are testing in the next couple weeks. Do you guys expect to make an announcement on winning or losing that by year-end?

It depends. I don't know right now. And the reason I'm saying that is I'm not sure exactly what we will be able to disclose, when we will be able to disclose it, or if we will be able to disclose it.

Okay.

I don't want to say because I don't know.

Now, the customer always dictates that, and I definitely understand that.

And I guess my final question is if you look at your -- how much capacity and willingness do you guys have to buy back bonds in open market? I know you have some excess proceeds from the (technical difficulty) sale. (technical difficulty) talked to bankers, looked at covenants and all that, how much excess cash could you go after more bonds in the open market?

That is something we would obviously need to study from a working capital perspective, Eric, so not really prepared to respond to that at this point.

Okay. Thank you.

Kevin Ciabattoni, KeyBanc Capital Markets.

A real quick follow-up. I just want to make clear that the lowered EBITDA guidance doesn't reflect any changes in expectations around R&D for the year.

As Deanna mentioned, in Q4, in the R&D area, in the B&P area, and in certain NRE areas, primarily all related to the unmanned area, those are up.

Versus prior expectation?

Correct.

Okay. Thanks.

Thank you. I am showing no further questions at this time. I would now like to turn the call back to Eric DeMarco for any closing remarks.

Excellent. Thank you for joining us this afternoon, and we will keep you updated as we can, as we continue to move forward with some of these initiatives. Thank you.

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