Kratos Defense and Security Solutions Inc (KTOS) 2017 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions First Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

It is now my pleasure to hand the conference over to Ms. Marie Mendoza, Vice President and General Counsel. Ma'am, the floor is yours.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions' First Quarter 2017 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 everyone to please take note of the safe harbor paragraph that's 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 risk in mind as we discuss future strategic initiatives, potential market opportunities, 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. Kratos began 2017 right where we left off at the end of 2016, with strong financial performance. Deanna will speak to Kratos' first quarter financial results in her prepared remarks.

In Q1, Kratos' satellite communications, cybersecurity, technology and training division once again was the operational, financial and execution performance jewel of the company, which we expect to continue throughout 2017. This division, which is Kratos' largest, had a book-to-bill ratio of 1.2:1 for fiscal 2016, and we are beginning to see the financial results from these very solid bookings which have continued thus far into 2017.

The DoD continues to expend considerable resources into securing and managing its terrestrial digital infrastructure of interconnected systems and the related challenge of securely connecting its space base networks. The DoD and the Air Force in particular are under pressure from Congress to prepare for a potential war in space which is now being militarized by Russia and China. These are some of the challenges and threats facing U.S. space base assets and infrastructure which national focus and prioritization is currently providing a tailwind to Kratos' satellite communications business.

Directly related to this demand as related to satellite [assured] communications, Kratos' owned and operated global satellite demonitoring business, which we believe is the only commercially owned global system of its kind, continues a strong growth trajectory with approximate 61% growth in Q1 '17 revenues over Q1 '16 from both existing and new customers.

Major satellite programs Kratos supports include Wideband Global, Advanced Extremely High Frequency and Space-Based Infrared among numerous others. Kratos customers include virtually every national security-related and commercial satellite operator in the industry, with Kratos satellite communication business' products and solutions supporting approximately 85% of the satellites in the world space segment.

Kratos' training system business is coming off a very strong 2016, and we are forecasting an even stronger 2017 as this business has recently won a number of new very important contract awards, including the KC-46 aerial tanker and the marine common aircrew trainer. These 2 major program wins are just beginning, and we expect their ramp to accelerate in the second half of 2017 and into 2018. We are currently in pursuit of an approximate $75 million new training system opportunity, which we are hopeful of successfully receiving sole-source in the third quarter of this year. And the bid and proposal pipeline in this business is one of the largest in our company.

Kratos' cybersecurity business also continues to show considerable strength, and we remain one of the leading FedRAMP requirement providers in the industry.

In our unmanned systems division, which had a book-to-bill ratio of 2.3:1 in the first quarter, Kratos is the industry leader in high-performance jet-powered unmanned aerial target drone systems that will represent potential adversaries aircraft, missiles and other weapon systems.

Kratos' target drones are used to exercise and test U.S. and our allies' weapon radar and other systems. In Q1, we received from the United States Air Force full rate production Lot 13 on the AFSAT program for our BQM-167 unmanned aerial target drone system, one of the highest performanced unmanned aerial drone systems in the world.

The quantities and associated spares ordered under Lot 13 by the Air Force were greater than we had initially anticipated, and we expect production of the Lot 13 to begin to ramp up in the second half of 2017, with Q3 and Q4 being particularly strong.

Later this year, we expect to begin negotiations with the Air Force on production years '14, '15 and '16. And we understand that annual 167 quantities are expected to increase with these options beginning in 2018.

As you know, this is sole-source work as Kratos owns the data package to each of our high-performance unmanned jet aircraft, including the 167. In 2016, the Air Force's operational TEMPO usage of Kratos' BQM-167 has increased, and recent communications with our customers indicate that further OPTEMPO increases are currently expected for 2017 and 2018.

In Q1, we received a $5.6 million order from a government agency for certain of our high-performance jet target drone systems, and we expect the opportunity with this customer to increase significantly later on this year.

In Q1, we also received a $1.6 million initial contract award for a new, in-development, high-performance unmanned aerial drone system where Kratos will initially be providing system engineering, avionics, data links and ground equipment. In the first quarter, Boeing received an additional order for 18 QF-16 full-scale unmanned aerial drone system targets, for which Kratos provides command, control and communications electronics. This is the fifth option of a multi-year program for an expected 126 QF-16 drone aircraft. We recently met with our U.S. Navy customer on our SSAT unmanned target drone system program, our BQM-177 aircraft, and we are ready to begin production once the 2017 DoD budget is formalized. We expect first full year incremental revenue for production option 1 and related ancillaries to be approximately $30 million to $40 million.

We also recently met with our confidential customer, and we are ready and expect to begin production on this program a few months after the 2017 DoD budget is in place. Incremental revenue in the first full year of this confidential program is expected to be approximately $15 million to $20 million.

As we have mentioned previously, once production ramps up over time on the Navy SSAT and the confidential program, we expect our unmanned systems business to approximately double in size. We believe that we are now in final negotiations with a new international customer for Kratos' high-performance target drone systems for an initial contract value of approximately $14 million. Importantly, new contract awards for Kratos' unmanned drone systems include a substantial customer investment amount for related ground equipment, launch and recovery systems, command, control and communication gear. The substantial initial investment vests Kratos and our customers typically into long-term strategic relationships.

We are in a solicitation process with a U.S. government agency for a number of high-performance unmanned aerial drone systems, with current contract award expected for this competitive solicitation in the second half of the year. This potential opportunity could be for several tens of millions of dollars.

In the tactical unmanned aerial system market area, as you know, the vast amount of UAVs today are propeller aircraft designed to perform their mission where the United States owns the sky and there are no threats, for example, over Afghanistan, Iraq, or Africa.

Kratos is developing, demonstrating and flying high-performance jet unmanned aircraft that address a significant existing capability gap, the ability of the UAV to successfully perform its mission in a contested environment and survive. We believe that we are the industry leader in this high-performance low-cost jet UAV market area.

In Q1, we learned that Kratos' team partner, Dynetics, was selected to advance to DARPA Gremlins Phase 2, along with General Atomics, as the program down-selected from 4 Phase 1 awardees to 2 Phase 2 awardees. The DARPA Gremlins program envisions large unmanned aircraft releasing swarms of multiple jet UAVs in the air. And then after the UAVs perform their mission, they are retrieved in-flight by the mothership or a flying aircraft carrier, if you will.

I can now formally disclose that of the original 4 Gremlins Phase 1 winners, Kratos was on 2 of the Phase 1 winning bids. Our own prime position [and] also teamed with Dynetics. Kratos' Gremlins teamed position with Dynetics was the confidential tactical opportunity I previously referred to as we were under an NDA. We believe that Kratos being selected and included on 2 of the DARPA Phase 1 winning Gremlin teams is testimony to our being the industry leader in designing, developing, demonstrating and rapidly fielding low-cost, affordable, high-performance unmanned aerial drone systems.

We are very excited to be advancing to Phase 2 with Dynetics, where Kratos will be designing, developing and producing prototype Gremlin unmanned aerial vehicles. As this remains a competitive situation, we will not be providing any further information related to Gremlins.

On Kratos' contract with the Defense Innovation Unit Experimental, or DIUx, we remain on schedule and on budget for a number of Kratos UTAP-22 UCASs now formally named Mako to participate in a major military exercise in the second half of this year.

We continue to work very closely with the DIUx as well as STRATCOM and the Strategic Capabilities Office on this initiative, including what the next steps will be after successful demonstrations. Also very encouraging, Secretary of Defense Mattis recently publicly reiterated his and the Trump administration's support and commitment to the DIUx and the DoD innovation initiatives, which Kratos is a key participant.

We remain on track on our Air Force Research Lab LCASD contract, being both on schedule and on budget, which was confirmed with a very positive recent customer program review.

We are tracking towards a Q2, Q3 2018 demonstration flight for this large tactical unmanned combat aerial system. And finally, we have now had initial customer meetings regarding a new low-cost, high-performance, jet unmanned aerial system Kratos has developed, what I will call our secret, special programs group. We have had several successful demonstration flights with a government agency with this new UAV which, in my opinion, is our most capable aircraft developed to date.

In summary, Kratos' Unmanned Systems business is performing very well. Our core targets drone business is now entering a multi-year period of expected significant growth, and we continue to make progress in the tactical UCAS area [where] Kratos [has] low-cost, high-performance UAVs.

Kratos' Microwave Electronics business had an outstanding first quarter, including a book-to-bill ratio of approximately 1.9:1. Our microwave business now has a record backlog of approximately $90 million on which we expect the delivery ramp to begin in Q2 and continue through the end of 2017, with Q4 looking particularly strong.

Additionally, in Q1, we received some very good news, with India announcing a $1.6 billion deal with Israel Aerospace Industries for Barak-8 missile systems, an advanced medium and long-range missile and air defense system. We understand that this initial order will include 600 Barak-8 missiles, and Kratos' content per missile is approximately $35,000.

We expect that Kratos will begin deliveries of our Barak-8 products in 2018, which include solid-state power amplifiers, frequency up converters and the RF front-end. Also in our Microwave Electronics business, we expect to receive an order later on this year on the Gripen fighter program where we support the electronic warfare system. Kratos' content per Gripen aircraft is approximately $200,000 to $250,000 per plane, with initial quantities currently being estimated at approximately 100. As I indicated before, at this time, the production and delivery schedules for our Microwave Electronics business indicates a strong Q3 and a very strong Q4 similar to 2016, with the potential growth step function in 2018 as a number of these new programs for Kratos enter in ramp production.

In Q1, we also saw strength in other areas of Kratos' business, including Ballistic Missile Defense, where a Kratos advanced medium-range ballistic missile target successfully supported a standard missile 3 intercept test. Kratos is an industry leader in providing ballistic missile target systems to test missile defense and radar systems, and we are a key strategic partner to the Missile Defense Agency and to the United States Navy.

We have a number of additional BMD-related target missions scheduled for 2017, and we are in pursuit of a very large opportunity in this area, potentially several tens of millions of dollars, which we are hopeful of receiving in the second half of 2017. Kratos is also a major equipment provider for the terminal high-altitude area of defense, or THAAD, missile defense system, a number of which are currently being deployed to South Korea. We believe that the current global ballistic missile threat environment, including as related to North Korea and Iran, is contributing to the strength in our missile defense-related business areas.

Recently, the U.S. Army awarded a $1.6 billion contract to an OEM for a counterfire target acquisition radar systems, which Kratos products and systems support. Accordingly, we are hopeful of receiving a multimillion dollar order related to the system in the next several months. We are also expecting equipment orders this year totaling tens of millions of dollars in support of an over-the-horizon radar program, a high-altitude electromagnetic pulse-protected electronic equipment system for a certain combat system and for dozens of command and control and communication units.

All of this activity, we believe, is related to the recapitalization of U.S. strategic systems to address peer and near-peer threats, which is just beginning.

Kratos' Public Safety & Security business financial performance improved in Q1, and we expect financial performance and profitability to increase throughout 2017 as we wind down the last few lower-margin large MTA deployments, which we have not bid on since the end of 2015 and higher-margin programs replace this work.

We expect to be substantially complete with these lower-margin programs in the third quarter of this year. Bid gross margins on KPSS security system deployment contracts we have received over the past 15 months have approximated 30%, and we are expecting a particularly strong Q3 and Q4 from our PSS business based on current backlog and the bid pipeline.

For 2017, we expect Kratos' legacy Government Service business to continue to contract as a result of the continued low price technically acceptable, or LPTA contract award environment, and as we deemphasize this product area and focus on our specialized and differentiated product businesses.

In summary, Kratos' primary markets continue to improve, with defense spending increasing across the globe, driven by the increased threat and risk environment. The company is successfully executing its business plan, and we feel very good about the growth trajectory for the business and ultimately achieving our base business model of $800 million in revenue and $80 million in adjusted EBITDA.

Also, importantly, every Kratos business unit is expected to be operating cash flow-positive in 2017 except Unmanned Systems where, as you know, we are making major investments in our tactical UAS initiative and, primarily, LCASD, where Kratos will own intellectual property and data package rights. We expect the majority of our tactical unmanned investments to be complete by the end of 2017, and we expect every Kratos business unit to be cash flow-positive in 2018.

Additionally, with our investments in the LCASD UAV being substantially completed by the end of this year, the commencement of SSAT and the confidential program's production and expected continued growth in Kratos' satellite communications, microwave products, cybersecurity and training businesses, we are expecting significant revenue profitability and free cash flow increases in 2018.

Even though it appears that we may have 2017 DoD budget imminently, we do not at this time. And accordingly, we will be patient, prudent and conservative until it is a done deal as related to our current 2017 financial forecast. If a 2017 defense budget is agreed to, this will be very, very good for Kratos. And once we have circled up with our customers to be certain that we fully understand the SSAT and confidential program timing, production and delivery schedules, we will be reassessing our 2017 financial guidance accordingly.

Deanna?

Thank you, Eric. Good afternoon. Kratos' first quarter 2017 revenues of $167.8 million were at the high end of our expectations of $158 million to $168 million for the quarter. Year-over-year consolidated organic revenue growth of 9.7% was driven primarily by our satellite communications, technology and training businesses, which were up 15.6% as a result of recent contract awards in these areas; growth of 9.9% in our Unmanned Systems business, which also was driven by recent contract awards; and 21.9% in our Public Safety & Security business, driven by Security System and related communication equipment, integration under a security system deployment program for a mass transportation authority.

Our Q1 adjusted EBITDA of $10.6 million exceeded our forecast of $6 million to $8 million due to stronger-than-expected performance across each of our business units within our Kratos Government Solutions, or KGS, business segment, with a favorable mix of higher-margin work in our satellite communications, technology, training and cyber-related businesses and new awards in our Modular Systems business.

Our adjusted EBITDA for the first quarter is from continuing operations and excludes the following charges, which have been reflected as adjustments consistent with our prior presentation since we either believe the items are nonoperational, nonrecurring in nature or meaningful for investors to understand our financial performance. Restructuring-related items and other of $1.2 million, which includes $700,000 of related severance and terminated employee-related cost. Also excluded from our adjusted EBITDA is $500,000, representing excess overhead capacity in our Unmanned Systems division. As production is expected to ramp up when we enter into low-rate initial production on SSAT and the confidential program later this year, we expect the excess overhead capacity to decrease.

On a GAAP basis, net loss for the first quarter was $10 million, which included the restructuring-related items and other, $2.7 million of expense related to amortization of intangible assets, noncash stock compensation expense of $2.1 million, a loss of $2.1 million on extinguishment of the debt we retired during the quarter and $1.5 million tax provision.

On a last 12 months', or LTM, basis for the period ended March 26, 2017, revenues were $683.5 million, with LTM adjusted EBITDA for the same period of $51 million. We believe this is a good indicator that we are on path for our 2017 annual guidance of revenues of $700 million to $720 million, and adjusted EBITDA of $52 million to $54 million.

Moving to the balance sheet and liquidity, our cash balance was $73.4 million at March 26, plus $500,000 in restricted cash. We have 0 amounts outstanding on our bank line of credit and $10.1 million of letters of credit outstanding.

Cash flow from continuing operations for the first quarter was a use of $8.7 million, which includes approximately $2 million of internal development costs related to the LCASD program and net working capital requirements of $6.7 million, primarily related to the build of inventory in anticipation of future scheduled product deliveries. Capital expenditures of $5.2 million were primarily related to investments we are making in our satellite communications and Unmanned Systems businesses.

DSOs increased to 124 days at the end of the first quarter compared to the end of the fourth quarter of 115 days. Our DSOs continue to be impacted by milestone payments on long-term delivery projects where we are unable to contractually invoice for amount 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.

We expect certain of these milestones to be achieved in the second and third quarters of 2017. In addition, we have a number of billing milestone payments that are expected to be paid upon completion of the large critical infrastructure projects that are expected to be completed in the third and fourth quarters of 2017.

During the first quarter of '17, we completed an equity offering, generating net proceeds of $81.9 million after underwriting expenses. Consistent with the company's stated use of proceeds raised in the equity offering, cash of approximately $64 million was utilized during the first quarter to retire $62.7 million of the company's senior notes, bringing the total amount outstanding of total debt at March 26 to $374.3 million. The company's cash balance at March 26 was $73.4 million, yielding a total net debt position at the end of the first quarter of $300.9 million. The net leverage as of March 26 was 5.9x computed with LTM adjusted EBITDA of $51 million.

Over the last 2 fiscal quarters, the company has retired $77.2 million of the company's senior notes, reducing the company's annual cash interest payments by approximately $5.4 million. Our contract mix for the year was 86% of revenues generated from fixed-price contracts, 9% from cost-plus-fixed-fee contracts and 5% generated from time and material contracts. Revenues generated from contracts with the federal government were approximately 57%, including revenues generated from contracts with the DoD and with non-DoD federal government agencies.

We also generated 11% of our revenues from state and local governments, 23% from commercial customers and 9% from foreign customers, with our aggregate non-DoD revenues comprising 43% of our total revenues.

Backlog at first quarter-end was $878 million, with $616 million funded and $262 million unfunded. This compares to backlog at fourth quarter-end of $900 million, with $626 million funded and $274 million unfunded.

Kratos' book-to-bill ratio was 0.9:1 for the first quarter of '17 and 1.1:1 for the 12 months ended March 26, 2017. We are reaffirming our full year '17 guidance for revenues of $700 million to $720 million and adjusted EBITDA of $52 million to $54 million, with a 2017 sequential quarterly trajectory similar to 2016.

We're also providing second quarter '17 guidance for revenues of $170 million to $176 million and adjusted EBITDA of $8 million to $12 million. Typically, our third quarters and fourth quarters have been our strongest from a top line and margin perspective, since the third quarter is the end of the government fiscal year-end and many customers are prone to spend the funds they have before they expire, with shipments and orders occurring in the third and fourth quarters.

This trajectory also reflects the estimated shipments based on customer deliverable requirements. Specifically in our Unmanned Systems business, we expect the second half of '17 revenue and EBITDA to be significantly higher than the first half of the year, primarily due to execution on certain new target drone programs we were awarded in '16 and in the first quarter of '17. Also driving expected growth in the second half of '17 is the beginning of low rate initial production on the large Navy and confidential programs once the DoD '17 budget is in place, assuming that the 2017 DoD budget is agreed to.

We also expect that in the first half of '17, revenue and EBITDA in our Unmanned Systems business will be down from the second half of '16 due to the level of shipments and production that was completed on certain of our target programs in '16 as compared to that expected in the first half of '17.

We are updating our free cash flow guidance for '17 from a use of $26 million to $31 million to a use of $23 million to $28 million, reflecting the decrease in cash interest expense of approximately $3.2 million for the $62.7 million of senior notes we retired in March.

Estimated cash taxes for '17 are $3 million to $4 million and an increase of working capital uses to fund the near-term expected top line growth, including the estimated cash spend on the LCASD investment that is not capital expenditure-related, less the total estimated capital expenditures.

As a reminder, from a cash flow perspective, we expect our total CapEx to be in the range of $28 million to $33 million for '17, with approximately $18 million to $23 million related to our Unmanned Aerial Systems business, which we believe will provide the foundation for the 2x growth we are anticipating for this business over the next 2 years.

The balance of the capital expenditures is expected to be in our satellite communications and training and electronic products businesses to fund growth initiatives in both of these businesses.

We expect our operating cash flows will be impacted by estimated investments of $7 million to $10 million we plan to make to develop the LCASD platform to maintain [an] intellectual property that are not included in capital expenditures. As a reminder, the total estimated investment that is not related to capital was accrued as a forward loss accrual in the third quarter of '16 where we were awarded the contract.

In summary, our estimated cash investment for the Unmanned Systems business in 2017, including the LCASD capital and other development costs, is $25 million to $33 million or substantially all the free cash flow use we are estimating for the corporation for the year. We expect that these investments for our unmanned tactical initiative will be substantially complete in 2017 and that we will return to free cash flow generation in 2018.

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

(Operator Instructions) Our first question will now come from the line of Mike Crawford with B. Riley & Co.

Several quick ones on the Unmanned Systems then one on the budget. First, you talked about a 2.3:1 book-to-bill in the Unmanned Systems segment, so that implies about $36 million of bookings in the quarter. Can you break that out in any manner?

The biggest part of that, Mike, was option 13 on AFSAT with the Air Force and then there was the $5.6 million one with the government agency we are unable to disclose at this time, and then there was the $1.6 million one on the brand-new -- it's a brand-new airplane, and we've got the initial contract for the aspects I mentioned. Those were the primary pieces.

Is that brand new airplane the same one that you called the world-class secret special programs group developed? That's different?

No. Yes, this one is brand new. The other one is flying.

Okay. So that was -- my second question was going to be on the secret one. So you're also saying that your investments in proprietary combat systems would be substantially [done] in 2017, and that includes this aircraft as well?

Absolutely.

And that's in conjunction with some kind of formal RFP? Or is that outside of the program of record? Or how is that being done?

I'm not going to get into it.

Okay. And then last one is on spirals, LCAS, potential $20 million spirals?

Yes, we have received 2 to date.

Okay. That's great. Then, finally, in your 10-Q, [your] very up-to-date language on the budget, including the fact that the House passed the budget bill, the Senate today approved the bill, it was required to be signed by the President tomorrow. But you say you're going to be prudent on guidance until the budget is in place. So if we get a budget tomorrow, does that mean that we would see a different guidance? Or do you intend to wait a few more months until you change guidance?

Well, no. As I said, Mike, what we will -- if the President signs it, our plan is to -- [post pay] system, is to communicate with our customers on how quickly these options that we have on the contracts that we have will be exercised. Once they're exercised, what the production schedule under those options will look like and, most importantly, what the delivery schedule will look like. We've got -- we're going to have a lot of wood to chop because, obviously, we have the 6 months' CRA between now and the end of our calendar year, and we just want to make sure that we understand all those parameters and what work we can get done between contract execution in the end of 2017.

Our next question will come from the line of Ken Herbert with Canaccord.

Just wanted to first -- LCASD, I know, obviously, you're on track for the test flight, I think you said second or third quarter or mid-next year. Can you just provide an update on how that schedule is going? And have there been any changes, either positive or negative, to the schedule in the last 3 months?

There have been no changes, positive or negative, to the schedule. However, in the last 3 months, as I mentioned in the prepared remarks, we had a program review, very detailed, multiple days, with the customer. And it went very, very, very well. And we are more excited than we've been since we were awarded this contract on what the potential will be for this aircraft once we demonstrate it and get it flying.

Okay. And at the risk of getting too far ahead of ourselves on this one, assuming a positive flight test next year, what might be the next steps or what should we look for in terms of next steps or major milestones on that particular program?

Ken, I'm going to agree with you. And I'm not going to get too far ahead of myself on this one. I -- God willing, it's tracking. We are on track and things are looking good. And as we get closer, I'll talk about that, but it's too soon.

Okay. I can appreciate that. Let me try again, a similar question, but on UTAP-22 and the Mako program. Obviously, you got a major exercise coming up here it sounds like later on this calendar year. Assuming that goes well, what might be the outcomes we should expect, either in terms of milestones or sort of the next hurdles or gates on that particular program that it would move through?

The DIUx's charter is within 24 months of contract award to begin fielding units that have been successfully demonstrated to the field. We received this contract award at September 30, 2016. I am extremely comfortable that we are tracking to the DIUx's strategy and their charter. And I -- once we are successfully demonstrating what we're going to be doing with these sensors at this exercise, the next steps are either going to be another exercise, that's already being looked at, with the potential that maybe we will -- we could sell some airplanes. I don't want to get ahead of them, I don't want to get ahead of us or Raj Shah at the DIUx.

Yes, okay. Well, that's fair enough. And then just finally, you obviously had a really nice -- the AFSAT came through. It sounds like SSAT is on track. Is SSAT -- that's really about getting the fiscal '17 budget in place. And obviously, coming out from under the CR and when should we look for the next major milestone on the SSAT program?

So I met with the admiral very, very recently. And the plan is within 60 to 75 days after we have a budget that our contract option is exercised. And we have already ordered long leads, we've gone ahead on this. We've ordered the engine, we've ordered a significant amount of the composites. I believe we've also ordered some of the avionics and electronics. So we've -- we primed the pump, we've gotten ready. And so the next data points will be is exercise the contract, the option, and begin production. And as I mentioned, I believe, that's going to happen within 75 days.

Okay. Well, that's great. And just finally, really nice to see the step-up, obviously, in the free cash guidance for '17. I know you've said several times that the vast majority of the investments to support the growth largely are done, it sounds like, this year. Is there any risk either if any of these new programs that you win or schedules could change that you could see some of this investments spill into '18? Or we could see any sort of incremental investments in '18? Or is it really at least with what you've identified now that you're pretty well scoped for completing most of that investment, if not all, in '17?

So as we sit here today, I do not see any additional incremental investments at all. We're funded now on every program except on the cost share on LCASD for the data rights. As Deanna said, we expect to be substantially complete with that by the end of '17. It is possible that some of that could go into Q1 of '18, it's possible. But as of right now, I do not see that being material if it were to happen. And so back to what we said in our prepared remarks, we don't envision any material, if at all, discretionary investments in '18 and we envision getting back to -- every business unit will be cash flow-positive, they all are now, obviously, except Unmanned, and we expect significant cash flow generation from Unmanned in '18 from delivery of AFSATs, from delivery of a certain customer we're delivering on that I haven't been able to disclose yet, delivering SSATs to the Navy and delivering to the confidential.

Our next question will come from the line of Michael Ciarmoli with SunTrust.

This is actually Les in for Mike. On the Public Safety, can you talk about some of the growth drivers and sustainability in that segment and also why the drag on margins? Essentially, just give us a little more color on what's happening here.

Yes. So let's talk about the growth drivers first. I like to talk about those. The number of security deployment opportunities continues to increase. And the verticals that it's increasing for us are: Energy, so think pipeline and refineries. Education, schools, from grade school up to colleges, are deploying significant amounts of security systems on their campuses right now. Health care. Health care is ripping right now for us. And certain metro transportation, think of buses and trains. Those are the growth drivers right now where we have been booking for the past 15 months, as I mentioned, were up over 30%. The margin drag that we have -- we've had that is coming off is we are finishing up 4 very large security system deployments underground, for the most part, for a massive mass transit authority. And we're going to have -- I believe, we're getting 2 of them done in Q2 and the other 2 are done in Q3, and then we're done. Tied with those are several millions of dollars of receivables we're going to collect that are retentions to wrap them up. And so we've taken some reserves on these as we finish these up to make sure that we bring these in this year without any more losses. Or I should say, margin degradation is probably the better way of saying it. So that has been the drag, and that's why we're so confident that the margins there are going to be turning around because as those low or no margin deployments finish, they are being replaced by very high-margin deployments that we've been booking for the past 15 months.

Got it. On the -- a little bit further on the budget, I guess, is there quantifiable upside risk to your guidance regarding to the budget passing as is? And also any thoughts on the $15 billion shortfall from the initial proposal?

Right. I -- there is absolute upside to us for a budget getting signed, whether the budget was equal to last year's budget or where it is this year, including the $18 billion supplemental, and the total budget, obviously, being $598 billion, including the OCO. There is potential upside to us. If the budget was not signed -- as you know, we have 2 programs that were dependent on that happening. So that's why we're being cautious here. I know, as you mentioned, the Senate signed it today, it's going to the President. I hope the President signs it tomorrow or the next day, and we're off and running.

Our next question will come from the line of Mark Jordan with NOBLE Capital Markets.

Looking at (inaudible), what percent of that $30 million to $40 million that you expect in the first release could be realized as revenues this year? And then secondly, what is 2018 expectation for production on that line?

Right. So Mark, right now, we're envisioning, say, $15 million to $16 million, $15 million to $18 million in this year. But this is why we're being cautious on not taking guidance up at this time because we want to make sure that we get the contract, we understand it all because we've been in a holding pattern under a CRA because, as you know, no new contract starts. So let's say it's -- this will make round numbers easy for Eric, let's say it's 15, let's say the number is 35, that means that 20 would move over into 2018. Right now, the fiscal 2018 buy is looking like that number, all in, could be $50 million to $55 million. Part of that, assuming we have a budget -- a 2018 budget, let's say in January or February of '18, the majority of that would fall in '18, along with the $20 million of '17 that we didn't generate in '17. And then we would head into -- and then we'd head into full rate production in '19.

All right. Even if it was extended CR next year, since you [already] have been initiated this year, you would be allowed to continue at the fiscal '17 rate.

Absolutely. Yes, sir. Yes, absolutely.

Okay. The second question relative to Lot 13. You're talking about OPTEMPO. Could you quantify what the 13 level is versus what you saw in the prior couple of years? And what are the implications for 14, 15 and 16?

Right. So the past few years, the quantities have been $20 million to $21 million per year. It went to $25 million this year. And I don't want to get ahead of the customer, but for '18 and '19, they're looking at quite a bit more than $25 million.

Okay. A question on the microwave business. Given the programs that are starting and you talking about [a step function], (inaudible) which was $55 million last year, could that be -- by 2018 be a run rate that could be double what you did in 2016?

No, no, no because these would be ramps. It is production and then deliveries and the vast majority of what we do on our Microwave Electronics business, Mark, we book on deliveries, not on percent complete. And so I don't want to give 2018 guidance right now. But our full anticipation as we head to the end of this year, and we're turned on, on these, we have the build plans and, most importantly, the delivery plans, we're definitely going to signal that and then, obviously, we'll incorporate that. But I don't to get ahead, but you heard the numbers, $35,000 for Barak-8, we've got 600; $200,000 to $250,000 per Gripen. There's 100 under order right now. You saw last week, Belgium has said they're going to go with the Gripen. They've said that. They've been -- the Gripen has been down-selected in India, it's down to 2 planes. It's the Gripen and the F-16. The initial quantity is 200 Gripens there. So we're -- and we're designed in and sole-source so we're feeling pretty good about this program near and midterm.

Okay. Final question. Do you -- should the second quarter share-based be about 86.5 million shares?

Yes, that's correct.

Our next question will come from the line of Eric Selle with SunTrust.

Eric, you're making me look smart, that's hard work. I wanted to dovetail on some of the question on PSS. You guys obviously did a wonderful job fixing it, you refined it, you focused it, and we're seeing results. And awesome work from your whole team. As you look at this because we've -- you've had different feelings on this, is this a fix it and keep or is this a fix it and sell?

We are going to, this year, increase and refine our focus on our core businesses, which is Unmanned Systems, satellite communications, Microwave Electronics. And I got to tell you Training, Eric, is ripping. It's just ripping. And this has to do with readiness, and the money that's pouring into readiness. I don't want to specifically address selling businesses, any businesses. I don't think that's appropriate. But we are going to focus on the core.

That's great. And the second question is, I mean, because when you put out good results, I don't really have that many questions, you leave us flat. But your CapEx jumped a little bit. Is that going to be sustained at that level for the year? I mean I guess it's a high-class problem, you're [on] a lot of these programs, you going to have to spend the money. But $5 million on a quarterly basis is a pretty big jump. Is that sustainable? Or will it taper off towards the end of the year?

It will actually increase. So I don't know if you've heard all the prepared remarks, Eric, but the CapEx that we're forecasting for the year is $28 million to $33 million. So there will be substantial increases from that $5 million run rate in Q1. That's primarily all related to -- a significant portion is related to the Unmanned Systems initiative, specifically on LCASD where it's approximately $15 million to $19 million of CapEx that we're building our own capital targets, 2 targets, 2 aircraft as well as ground support equipment. And then the balance of the CapEx is related to investments we're making in our satellite communications business. So it will continue at that level and actually increase.

Our next question will come from the line of Josh Sullivan with Seaport Global.

Can you just expand on some of the investments you're making in satellite and training? I think -- you've obviously had some nice wins recently. And I think you just mentioned training's ripping. What kind of technologies or opportunities are you investing in those segments?

Without getting into specific companies that we're partnered with, a lot of it has to do with virtual reality and the operators being inside the systems. And with their helmets on, they're seeing virtual reality of, say, a mission, that's going on. But when they look around them inside the system, let's say, they have 2 other operators next to them, the virtual reality goes away and now it cuts away into the system. And so now they're inside the helicopter or they're inside the airplane or they're inside the tank and they can see real, real reality, what's right next to them. They turn their head back, and it switches back over to virtual reality and the threats that are coming at them. And so we are making a significant investment in that virtual reality realm and the algorithms related to it.

Have you had program wins associated with that?

Absolutely.

Okay. I guess just one, switching over to the drones. On the international customers that you mentioned, I think you said activity was conducive to a long-term relationship.

Yes.

Is there any way to quantify their potential long-term needs, maybe how many drones they currently use or potentially would need on an annual basis?

Absolutely. So currently they are using no drones that represent 4 or 4.5 generation threats. So think of a 4.5 generation fighter aircraft or a 4.5 generation or a fourth generation cruise missile, they are not using them. This country, they have developed and they are about to field a number of new weapon systems, including surface-to-air missile systems and air-to-air missile systems. So they want to exercise these new weapon systems that they have indigenously developed against the highest performance unmanned target drones in the world, which are ours. So think of the launch equipment, the ground equipment, the command and control equipment, the equipment to clear the range, electronically, of course, and maintain clearance on the range, all of that equipment goes in, and it's all custom-designed for our target drones. And so once that investment they've made is in what we have seen, I am not aware of any customer that has switched to any other competitive drone system once they have made that investment and they have flown our drones. We're going to be looking at this, in addition to the initial buy, every 1 or 2 years depending on shoot-downs, several millions of dollars additional every year or 2 to replenish their drone inventory.

(Operator Instructions) Our next question will come from line of Sheila Kahyaoglu with Jefferies.

Just a few cleanups, if that's okay. I know the microwave backlog was up in the quarter, and I was just wondering if you could give the growth rate for that business as well as maybe the Defense & Rocket Support subsegment, if you can. I don't know if you mentioned it earlier.

We don't break them out because they're part of our Government Solutions segment. And so we have not broken -- we haven't broken them out. But dovetailing to what Mr. Jordan asked, as he said that -- he rightfully said that in 2016, the Microwave Electronics business was $55 million, and he said what do you expect that to happen, and I said I expect that to -- assuming we actually get these production awards on these platforms that have been awarded, we expect that to do a growth function going forward. And in the second half of this year, once we get those awards, God willing, we will give specifics on that growth.

Okay. And then in terms of the PSS business, I know you mentioned you're working on 4 major subsystem deployments. How do think about a return to profitability? Would you expect that in 2017?

I am fully expecting a return to profitability in Q2, and I'm expecting that profitability to increase significantly second half of '18 -- '17, excuse me, Sheila, over first half of '16. So I am expecting full clean profitability in Q2 and that increasing into the second half.

Is that sort of a revenue run rate we should consider going forward for that business?

Yes. I would use that number, and here is why. Because those 4 programs are rolling off, 2 in Q2 and 2 in Q3, so revenue is going to come off from those, say, $5 million or so. And it's going to be backfilled by higher-margin revenue. So right now net-net, [what] we'll think, we'll think flat, but actually there's some growth in there because those ones are falling off.

Okay. That's make sense. And then just in terms of -- sticking on profitability for the overall business, gross margins were up over, I think, 300 basis points in the quarter versus last year, Q1 '16. Just thinking about the mix, what drove that? Was it like government systems, was it the satellite...

Yes, it was primarily -- so government systems clearly with organic revenue growth of over 6% across the segment. I think I've mentioned that the overall financial performance was above our expectations across the board in each of the KGS segment. So it was -- the revenue growth and the favorable mix on certain of the areas as well.

Okay. And then, Eric, one more for you, if you don't mind, with the Mako, what is the first flight expectation? Is that -- when is that for? The demonstration flights are in the second half, would the first flight also be in the second half?

Right. So it's the Mako like the shark, I understand it's a killer shark. It's a killer UAV. Yes, it's -- the expectation, Sheila, it would be a series of flights by a number of our aircraft, and they're currently scheduled for the third quarter. And they would occur over the period of a week to 10 days. And they're going to be specifically related to a loyal wingman type of a scenario with manned aircraft and ground systems and other systems taking control of them and then sending them out on a controlled semi-autonomous and an autonomous mission with very sophisticated sensor and other packages integrated into the UAVs.

Got it, okay. And this is the last one, actually, I promise. In terms of Lot 13, the profitability of that business, would it -- do you also, as you see a step-up in revenues, do you see a step-up in profitability in the second half?

Yes. Absolutely. Yes.

There are no further questions. So now it's my pleasure to hand the conference back over to Mr. Eric DeMarco, President and Chief Executive Officer, for closing comments and remarks. Sir?

Thank you all for joining us this afternoon. And we will be circling up with you end of July, early August for our Q2 call. Thank you.

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude the program, and you may all disconnect. Everybody, have a wonderful day.