Kratos Defense and Security Solutions Inc (KTOS) 2017 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Kratos Defense & Security Solutions Fourth Quarter 2017 Earnings Conference Call. (Operator Instructions)

I'd now like to turn the conference over to Senior Vice President and General Counsel, Marie Mendoza. Please go ahead.

Good afternoon, everyone, and thank you, for joining us for the Kratos Defense & Security Solutions Fourth 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'd 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, 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'll now turn the call over to Eric DeMarco.

Thank you, and good afternoon. Kratos' fourth quarter and full year 2017 financial performance clearly demonstrated the continued successful execution of the strategy we began a few years ago to build a technologically differentiated product, intellectual property based business focused on the rapid development, demonstration and fielding of affordable systems for national security.

Today's announcement of the pending sale of our Public Safety & Security system integration business for approximately $70 million in expected in net cash proceeds continued the successful execution and it positions Kratos for the significant organic growth trajectory we are forecasting for our company over the next several years.

The divestiture of PSS will further reduce Kratos' net leverage, improve our financial flexibility and financial matrices going forward, including Kratos' growth rates, margins and adjusted EBITDA rates, and position Kratos as a pure play, high-growth defense technology product and systems company.

We believe that the business we have built in Kratos and the portfolio of systems and products we offer positions our company for future, year-over-year revenue, profit and cash flow growth, irrespective of temporary or quarterly bumps, resulting from the recurring DoD budgetary delays.

The success of Kratos' business model is also demonstrated in a number of unmanned drone system contract awards we have recently received, including a $93 million, an $81 million, a $24 million and a $23 million reward, each of which are sole or single-sourced to Kratos.

Importantly, and similar to Kratos' AFSAT program for the United States Air Force and our SSAT program with the United States Navy, each of these recent awards are expected to be multiyear, multi-decade programs in length, with significant future increases in value expected, with hundreds and potentially thousands of Kratos drones ultimately delivered.

And additionally, a government agency has recently issued an intent to award Kratos an additional sole source unmanned drone system contract, which we expect to receive in the near future.

We clearly believe that our strategy over the past few years of making internally-funded investments so that Kratos owns the intellectual property in our systems and products has been successful, and has differentiated Kratos in the market space as most recently represented by these sole-source contracts we have received.

Also important to the extremely bright future we see for Kratos, global defense budgets, and in particular the U.S. DoD budget are significantly increasing. And Kratos is positioned in well-funded mission-critical DoD priority areas including high-performance unmanned aerial drone systems, satellite communications, Missile Defense, Training Systems and Microwave Electronics.

Each of these markets where Kratos is an industry leader are expected to experience solid growth and continue to represent long-term high priority, national security focus areas, providing us additional confidence in the future expectations for the company.

Kratos' Unmanned Systems division Q4 performance was particularly strong with increased production, decreasing investments, a very favorable product mix and solid execution by the Kratos Unmanned team.

In addition to the recently received contract awards that I previously mentioned, we continue to expect to receive production year 14 of AFSAT with the U.S. Air Force, with increased quantities and production Year 2 of a confidential program later this year. Though the extended continuing resolution has pushed the expected award dates of these programs out until the second half, after we have a 2018 budget.

We continue to be on-budget and on-schedule with each of our tactical drone programs, which number has increased since we last reported to you with our Valkyrie UAS now currently scheduled for demonstration flight in late Q3 of this year. Kratos' Mako UAS program is expected to receive increased funding with the 2018 budget and numerous Makos continue to successfully perform their missions and customer-funded exercises.

Also, tomorrow, we will be formally announcing that the Kratos Mako is the 2018 Aviation Week Laureate Award winner for the defense Unmanned Systems category.

Aviation Week's Laureate Awards honor extraordinary achievements in aviation, aerospace and defense and recognize leaders in the industry for their vision and their innovation.

We are all extremely proud of the Kratos Unmanned Systems teams in receiving this truly outstanding recognition.

Additionally, on another high-performance jet unmanned aerial drone system platform, as was recently reported, Kratos is under contract on the new 5GAT UAS.

We are now currently in contract negotiations with a new customer, for a multiyear $100 million plus high-performance UAS drone contract and we are now in the capture process for an additional new high-performance jet powered UAS, which could be one of the largest opportunities for us to date if we're successful.

As you can see, the number of opportunities for Kratos' high-performance unmanned aerial drone systems is both increasing and accelerating, which is exactly what we envisioned when we set our tactical UAS strategy approximately 6 years ago, when we analyzed the strategic UAS road map.

Also extremely importantly, we remain hopeful for a successful announcement of a Gremlins program Phase 3 award, with our outstanding partner prime and teammate, Dynetics. If we are ultimately successful in winning Phase 3 of Gremlins, we believe this will be a game changer for our company, based on the information we have most recently received.

To handle the expected significant increased drone productions, we envision over the next several years we recently announced the opening of a new engineering and production facility in Oklahoma, where we have outstanding state, local and congressional support.

Our planned Oklahoma UAS facility is another important step and key element of Kratos' strategy to rapidly provide affordable products and systems for our customers, which we believe is a significant differentiator of our company.

Our Oklahoma production facility with a lower cost of living, ample pool of highly skilled labor and an overall friendly business environment is also expected to be a key element of Kratos' profit margin improvement initiatives.

In summary, Kratos' unmanned aerial drone system business continues its outstanding execution, and we expect this business to generate approximately $150 million in revenue in 2018, achieving the goal we had previously set of doubling our 2016 UAS revenues in 2 years, and with increasing year-over-year margins anticipated.

For 2018, similar to 2017, we expect the second half of 2018 for our unmanned business to be much stronger than the first half as a result of the existing extended CRA, which as you know, delays new and increased production quantities until the 2018 DoD budget's in place.

Kratos' satellite communication business also had an outstanding fourth quarter, exceeding virtually every one of this business's operation and financial objectives. Kratos' satellite medications business is the industry leader in its core competency areas of command, control, communications, RF interference, identification, location and mitigation. This business is the cash flow engine that has enabled us to build Kratos as it is today.

Kratos' satellite team is one of the most technologically advanced in the industry, and they are the go-to provider for virtually all of the world's leading satellite system operators, including the United States Air Force, due to the specialized products, technology and systems. The leadership team of Kratos' satellite business is second to none in the industry in my opinion.

With the increasing U.S. DoD defense budget, space and satellite communications is receiving some of the largest increases as a result of the perceived Russian and Chinese threat to U.S. space assets, and Kratos' satellite business is extremely well-positioned to continue to benefit from this increased budgetary environment.

Kratos' globally owned and operated spectrum or satellite beam monitoring business continues to be one of the fastest growing, most profitable and valuable businesses of our company.

Kratos' Spectrum Monitoring business grew approximately 35% in 2017. We continue to add new customers and aggressively integrate new capabilities and technologies into this unique and extremely valuable asset.

Our satellite business also remains focused on the new and rapidly growing nano cube and smallsat market and related low Earth orbit command, control, RF interference, and signal monitoring requirements.

Major programs we can talk about that Kratos' satellite business supports are the early missile warning constellation space based in [Veretta-Sivers], wideband global or WGS, advanced extreme high-frequency or AEHF, and multiple (sic) [mobile] objective user systems or MOUS.

Similar to Kratos' unmanned aerial drone system business, Kratos' satellite communications business supports multiyear, multi-decade programs. And along with increasing DoD budgets for space, we anticipate a long-term year-over-year growth trajectory for this business.

For Kratos' satellite communication business, for 2018, we are expecting year-over-year growth above 2017, with the second half of 2018 being significantly stronger than the first half of '17 -- excuse me, the first half of '18, due primarily to the existing extended CRA.

Kratos' training system business had a very solid Q4 as we continue to execute on a number of new programs, including MCAT and KC-46 and we expect this business where margins are somewhat lower than our other core businesses to continue a very solid growth trajectory for 2018, including in Q1 as a result of the significant international training programs we are supporting.

Along with our Unmanned Systems business, we expect our Training Systems business to be one of the fastest growing businesses in the company, as a result of the significant number of large, long-term multi-year program awards we have received, which we are now executing on.

Also similar to Kratos' Unmanned Systems business, our Training Systems management team generated a strategic plan a few years ago to be an industry leader in full fidelity aircrew training systems and grow the business to approximately $100 million in revenue and they have been tracking to this and executing flawlessly.

Kratos' microwave electronic business fourth quarter financial performance was its strongest for 2017, with significant deliveries in support of missile, radar, Missile Defense, EW, communications and other systems.

Since we last reported to you, we have now received the initial $20 million production award in support of electronic warfare suite of a new 4.5 generation fighter aircraft.

We expect to begin work on this new program in the first half of 2018, with deliveries expected to commence in 2019 and we expect the ultimate size of this program for Kratos to significantly increase over the next few years, up to several hundred ship sets.

Additionally, we have just recently been informed that we have now been selected to support electronic warfare suite on a separate tactical aircraft system. And we are hopeful of receiving initial production on this new program opportunity in the second half for 2018.

We also continue to expect to receive our initial production award on the BARAK missile, in approximately the middle or the second half of this year.

Representative programs that Kratos' microwave electronic business supports include Iron Dome, Arrow, SPYDER, Sling of David, BARAK, F-15, F-16 and Griffin.

Based on these recent and expected new production award wins and the related delivery schedules, we expect Kratos' Microwave Electronics business in 2018 to be similar to slightly increased as compared to 2017, with Q4 once again being by far the strongest quarter of the fiscal year, with an expected growth trajectory beginning in 2019, concurrent with expected new program production, execution and deliveries that I just went through with you.

Kratos supports numerous Ballistic Missile Defense initiatives, systems and programs across our entire company, including BMD targets, Patriot, THAAD, Aegis, SM-3, SM-6, High-energy laser, Electromagnetic rail gun, Arrow, SBIRS and others.

Missile Defense funding in the DoD budget as well as internationally is seeing significant growth as a result of the increased global threat environment and Kratos' Missile Defense related businesses have performed and are expected to continue perform very well in this environment.

A key Kratos offering in this area is our low-cost Ballistic Missile target systems where we are seeing significant increased customer interest due to the affordability of Kratos' targets as compared to our competitors.

Today, we reported a noncash goodwill impairment charge related to our legacy government services business, which as you know, Kratos deemphasized with our strategy change in 2000 -- in 2010, for Kratos to be a technological and intellectual property and systems focus company.

Specifically, we have been focused on building a high growth, high margin business, which we believe our fourth quarter results clearly demonstrated. Kratos' services business, though being a great cash flow generator and which has allowed us to successfully execute our strategy and build the technology product and systems company that we have today, has historically adversely impacted the company's book-to-bill ratio and our growth rates, due to our deemphasis and the related reduction in new contract awards.

The quarter had an expected decline of this business, including our loss of 2 new large opportunities in the fourth quarter that we had been pursuing has impacted our initial projections for 2018. But is ultimately expected to result in increased longer-term future margins as our core businesses continue to ramp and replace this much lower margin business.

As we begin 2018, we're focused on execution, operational excellence and improved financial performance, including most importantly, liquidity and cash flow.

We expect Kratos' investments to wind down. Our revenues and adjusted EBITDA to continue to organically grow, our profit margins to expand for the company and for the company to return to positive cash flow generation in 2018.

Additionally, in 2018, we will more aggressively manage our overall liquidity, including our billed and unbilled accounts receivables and inventories. And as a result, we have already begun negotiating more liquidity-favorable terms where we can contracts.

This focus on liquidity and cash flow will, in certain instances, delay some revenue or profit recognition timing as compared to our previous approach as for example, we will not lean forward as much as we have historically on long lead program items like engines or electronics for our unmanned Systems business, as doing so increases unbilled receivables ahead of receiving associated cash milestone payments.

We believe our new approach will result in increased overall liquidity and cash flow for the company, which is an absolute top priority, while not impacting ultimate revenue and profit generation over a related contract for a period performance.

Also importantly, as Deanna will go through in detail, the divestiture of Kratos' PSS business will be treated as a discontinued operation for financial reporting purposes going forward. And accordingly, the financial results of PSS will be reclassified for comparative purposes for all previous periods.

As a result of this divestiture, once the PSS transaction is closed, and through approximately the end of 2018, we will be reducing cost at Kratos where we can and rightsizing our infrastructure to address the sale of approximately $150 million in revenue of PSS.

For instance, approximately $2.5 million of corporate overhead cost were allocated to our PSS business in 2017, which going forward will now be required to be allocated to the remaining company's segments' financial performance.

Also, similar to the past several years, where we also had an extended federal budget continuing resolution, and as I referred to earlier today, we expect the second half of Kratos 2018 financial performance to be significantly stronger than the first half of the year once we have the 2018 budget in place, primarily as a result of delays and increased production on existing programs like AFSAT and SSAT, a new program starts like our recent U.S. Army UAS contract and related-funding delays.

We are assuming that the CRA will be resolved by the end of March in our initial 2018 financial guidance.

In closing, I want to reemphasize that we expect the underlying strength of our core businesses to provide a long-term multi-year growth trajectory for the company, irrespective of temporary budgetary delays.

Over the past few years, including the last few months, we have won multiple long-term program awards that are or will be entering or experiencing increased production and growth.

Related to this, I encourage you to look at the programs that Kratos Unmanned Systems, satellite communications, Microwave Electronics, training and missile defense-related businesses support, or the programs or contracts we have received recently and the expected significant increased DoD funding related to these areas.

What I just went through is all included in what we refer to as Kratos' base business model.

In addition, we are positioned for significantly greater potential growth above our base business model from Kratos' unmanned tactical drone systems, including LCASD, Mako, Gremlins and several others over the next few years.

I am more confident than ever that Kratos' unmanned tactical drone systems business is going to be very, very successful, and we could start seeing the success accelerate further beyond -- before 2018 is completed.

At Kratos, we have worked bring together and create technologies, products, systems and businesses that the DoD wants and they need. We are focused on bringing the government more for less, and greater effectiveness at an affordable cost, which I am convinced is a winner.

I thank the Kratos shareholder, our employees and all of our stakeholders in supporting us to build this incredible company. Deanna?

Thank you, Eric. Good afternoon.

Kratos' fourth quarter 2017 revenues of $202.2 million exceeded our expectations of $185 million to $195 million for the quarter, due primarily to strong execution and deliveries in our satellite communications and Training Systems businesses and our Unmanned Systems business, with certain deliveries and execution previously expected for the first quarter of '18 occurring in the fourth quarter.

Fourth quarter year-over-year consolidated organic revenue growth of 11% was driven by growth of 65.9% in our Unmanned Systems business, driven by low rate Initial Production of certain of our aerial targets in '17, and growth of 11.8% in our PSS business, driven primarily by a security system deployment program for a mass transportation authority.

Revenues in our largest segment, KGS, declined slightly by 0.4%, due to a reduction of over $15.3 million year-over-year in our legacy government services business, substantially offset by year-over-year increases in all other business units within our KGS segment.

The growth in our KGS segment was approximately 12% year-over-year for the fourth quarter, excluding the reduction in our legacy government services business.

Our Q4 adjusted EBITDA of $17.8 million slightly exceeded this high-end of our expectation of $15.4 million to $17.4 million, due primarily to a favorable mix of higher-margin work and shipments in our satellite communications, unmanned Systems and microwave products businesses, and improved performance in our PSS business.

On a year-over-year basis, our Q4 '17 adjusted EBITDA increased 32.8% or $4.4 million from $13.4 million in the fourth quarter of '16 to $17.8 million in the fourth quarter of '17.

Our adjusted EBITDA for the fourth quarter is from continuing operation and exclude the noncash goodwill impairment charge of $24.2 million and noncash stock compensation cost of $1 million.

On a GAAP basis, net loss for the fourth quarter was $22.2 million, which includes the impairment of goodwill of $24.2 million mentioned earlier and a loss from extinguishment of debt of $15.2 million related to the refinancing that we completed in the fourth quarter; $2.7 million of expense related to amortization of intangible assets in capitalized contract cost and development cost; noncash stock compensation expense of $1 million and an $11.7 million tax benefit.

The tax benefit was primarily related to the impact of the Tax Reform Act, which resulted from the net reduction of deferred tax liabilities and deferred tax assets due to the reduction of the corporate tax rate from 35% to 21%.

Moving to the balance sheet and liquidity. Our cash balance was $129.6 million at December 31, plus $400,000 in restricted cash.

Our outstanding long-term debt of $293.5 million reflects the refinance we completed in the fourth quarter to replace our existing remaining $369.7 million of 7% senior notes, outstanding at the end of the third quarter, with new 6.5% senior notes with the face value of $300 million with a new maturity date of November 2025.

We utilized approximately $90 million in cash to retire the 7% notes and issued the new 6.5% notes.

We also refinanced our line of credit during the fourth quarter, replacing our existing $110 million line with a new 5-year $90 million line. The borrowing rates in unused lines fees were reduced by approximately 35 to 50 basis points.

There are no maintenance financial covenants and a minimum fixed charge ratio of 1:1, that springs its borrowing availability drops below a certain level.

At December 31, we had zero amounts outstanding on our bank line of credit and $9.5 million of letters of credit outstanding.

Cash flow from continuing operations for the fourth quarter was a use of $10.5 million, which includes approximately $1.6 million of internal noncapital expense-related development cost related to the LCASD program.

Capital expenditures of $7.5 million were primarily related to investments we are making in our satellite communications and Unmanned Systems businesses.

Approximately $5.6 million of the CapEx was related to the Unmanned Systems business, which is primarily relate to the 2 LCASD aircraft and related equipment we are building for our own use. We expect this capital effort to be substantially complete in the first half of '18.

DSOs increased from 115 days at the end of the third quarter compared to 121 days at the end of the fourth quarter. Our DSOs included the impact of milestone payments on long-term delivery projects, where we are unable to contractually invoice for amounts until the completion of certain milestones and/or the final delivery of products or the demonstration of certain flight parameters, specifically in our Unmanned Systems business.

We currently expect certain of these milestones to be achieved in the first half of '18.

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 first and second quarter of 2018.

As we are the prime contractor in sizable projects in our Unmanned Systems and Training Systems businesses, our DSOs will continue to be lumpy as the payment terms will be based upon achievement of milestones rather than progress billings.

Our contract mix for the quarter was 91% on -- for fixed-price contracts 6% on cost plus fixed-fee contracts and 3% on time and material.

Revenues generated from contracts with this U.S. federal government during the quarter were approximately 63%, including revenues generated from contracts with the DoD and non-DoD federal government agencies.

We also generated 7% of our revenues from state and local governments, 17% from commercial customers and 13% from foreign customers, with our aggregate non-DoD revenues comprising 37% of our total revenues.

Backlog at fourth quarter end was $730.4 million, with $531.1 million funded and $199.3 million unfunded.

Our book-to-bill ratio was 0.7:1 for the fourth quarter of '17 and 0.8:1 for the 12 months ended 12, 31, 17.

As Eric has previous imagined, we do not include the full value of contract awards in our bookings or backlog until [tasking] or fundings is received. Also importantly, a number of our systems and products are designed in -- on and support long-term multi-year multi-decade program.

Although these expected Kratos deliveries are not reflected in our backlog, they do provide significant operational and financial visibility to our company.

For instance, we may not necessarily include in our bookings or backlog certain contract award, depending on current government funding on the award.

As an example, we only included approximately $7 million in our bookings for the recent contract award for aerial targets from the U.S. Army of $93 million, which represents the executed delivery orders received to-date. Although, we expect to ultimately received executed delivery orders for full $93 million.

Going forward, as we adopt a new revenue standard on January 1, 2018, ASU 2014-09, our backlog will be calculated as a dollar value of the remaining performance obligation from executed contracts as defined under the new accounting standard.

Backlog will not include orders for -- which neither party has performed and which grant each party the unilateral right to terminate a wholly unperformed contract without compensating the other party.

As such, backlog generally will not include options for additional performance obligations, which have not been executed unless they're considered and material right of the base agreement or contract.

For IDIQ contracts, only tasks that have been approved should be included for backlog purposes. Based on the current expected impact of the transaction price that will occur upon adoption of this ASU on January 1, we currently expect that our backlog balance for us going forward as well as many companies in our industry will be negatively impacted, based upon the guidelines in the new accounting standards.

Today, we also announced the pending divestitures of our PSS business.

As Eric mentioned previously, for all financial statements going forward, we will be recasting the operating performance as the PSS business as a discontinued operation with all prior periods recast for comparative periods -- purposes.

Accordingly, today, we are providing initial guidance for the first quarter and full year 2018, reflecting PSS as a discontinued operation.

Kratos' PSS business was forecast to achieve full year 2018 revenues and adjusted EBITDA before corporate overhead of approximately $140 million to $150 million and $9 million to $12 million, respectively.

PSS generated full year 2017 revenues and adjusted EBITDA, excluding the allocated corporate overhead cost at $149 million and $6.9 million, respectively. As a result of the pending sale, Kratos' Q1 2018 and full year financial guidance provided today excludes PSS as does all other financial information covered.

As Eric had mentioned, once the businesses discontinued, any corporate or public company costs that were previously allocated to that discontinued business are required to be allocated to the remainder of the continuing operation on a retroactive, historical and go-forward basis.

Specifically for 2017, approximately $2.5 million of corporate public company costs that were allocated previously to PSS will now be required to be allocated to our remaining businesses on a retroactive basis, when historical financial payments are presented.

Our first quarter 2018 financial guidance for revenues of $140 million to $150 million as compared to $132 million for the first quarter of '17, and first quarter 2018 adjusted EBITDA guidance have $9 million to $11 million as compared to $10.2 million for the first quarter of '17.

Kratos is forecasting first quarter 2018 adjusted EPS of breakeven to $0.01, reflecting net income from continuing operations, excluding noncash amortization and stock compensation expense and utilizing estimated cash taxes.

Our full year 2018 financial guidance for revenues is $640 million to $650 million, as compared to $603.2 million for the full year '17, and full year '18 adjusted EBITDA guidance of $55 million to $59 million as compared to $47.5 million for the full year of '17.

Kratos is forecasting full year '18 adjusted EPS of $0.16 to $0.18 per share.

We expected our -- we expect our total capital expenditures to be in the range of $23 million to $26 million for '18, with approximately $14 million to $17 million related to our unmanned system business. The balance of the capital expenditures is expected on a satellite communications and training and microwave products businesses to fund growth initiatives in both of these businesses.

We expect our operating cash flows will be impacted by the remaining estimate investments of $7 million to $10 million we plan to make to develop the LCASD platform to maintain the 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 when we were awarded the contract.

Accumulative to date through Q4 end, we have funded approximately $12 million of noncapital LCASD investment.

In summary, our estimated cash investments for the Unmanned Systems business for 2018 including the LCASD capital and other development cost is $21 million to $27 million. We expected that these cash investments for our unmanned tactical initiatives will be substantial -- substantially complete in the first half of '18.

We expect our estimated cash taxes to be approximately $3 million to $4 million for 2018.

We expect the impact of tax reform to be fairly insignificant to our estimated cash taxes due to our net operating loss position.

Our NOLs as of 12, 31, 2017, were approximately $390 million. Despite the high end level of continued investments in '18 of approximately $30 million to $35 million between capital expenditures in the remaining noncapital investments for LCASD. We expect to generate cash flow from operation of $35 million to $45 million and free cash flow of approximately $12 million to $19 million for 2018, as we expect the number of the billing milestones, which have impacted DSOs to be collected during the year.

Eric?

Great, Deanna. In closing, I want to state that the -- our Public Safety & Security businesses management and their employees, did just an outstanding job, supporting Kratos in the midst of the 2011 Budget Control Act, related sequestration and the significantly declining and reduced DoD budgets. I know the entire management team extremely well and I thank them all for everything they've done for this company.

To the PSS employees, over the past several months, I've gotten to know the key leadership at Securitas and I can assure you that there is no better home for you other than this company. Their leadership team and their management team is outstanding. They have the absolute right strategy for their business and your business combined and the opportunities you're all going to have personally and professionally are very candidly far greater than we could have given you because their focus is solely on your business. So I thank all of you as well. With that, I'll turn it over to questions.

(Operator Instructions) Our first question comes from Mike Crawford from B. Riley FBR.

How would you characterize your capacity utilization in the Unmanned Systems operation today in California? And what room do you have to increase that before you're up and running in Oklahoma?

That is actually an excellent question. The business is ramping very, very rapidly. My most recent estimates is we're going to generate well over 100 -- maybe 130 drones this year, just in the current base plan, and we expect some additional significant orders coming in. We believe, that we are very well resourced and have the capacity to handle whatever practically comes through the end of this year. Our facility in Oklahoma, progress there is moving rapidly now. It will be prepared to start manufacturing in the second half of this year. However, we have also announced -- have started having discussions with another mid-cap defense company that we know very, very well. We have an excellent relationship with them. And it is possible that we may bring them into the partnership to help us with this production as well. So we are -- we're mapping it out, Mike, because things are accelerating rapidly and here are some big things we're not able to talk about that may come to fruition in the first half of this year and we've got to be ready.

Okay. And then just 2 more quick ones, I'll just ask them both now. So you said your unmet contract for the 5GAT, so I'm wondering if that is to be used as the target drone or as a tactical combat drone? And then the other one is, you talked about recent information leading you to believe that Gremlins could be a game changer. And I'm wondering, what information would lead you to believe that there will be a game changer versus prior expectations?

On the 5GAT, obviously, 5GAT stands for fifth-generation aerial target. That's all I can say about that. And on the Gremlins, Mike, I'm sorry, I cannot comment on that. There has been a number of pieces that have come out in the past 3 weeks, relative to that program that might give you some additional information. But I can't talk about that right now as it's still competitive.

Our next question comes from Ken Hubert (sic) [Herbert] from Canaccord.

I just wonder, Deanna, really I mean the guidance calls for a very significant improvement in cash from operations and free cash flow for the full year. I know you went through some of this. But how would you characterize maybe the risk to that $40 million in cash from operations at the midpoint for 2018? And maybe just a little more detail on specifically what you assume working capital and some of the other key pieces to provide?

Sure. So some of the rest are there's some flight milestones that need to occur on some of the unmanned programs, which just doing to -- due in part to range time to get onto certain ranges that can delay that milestones. So that's one of the risks. Some of the other ones we don't really see as risky because they're just really hitting certain some performance metrics that are in our control, which obviously, the flights on range time, those are not totally in our control. From a working capital requirement perspective, we do expect some use in working capital as we continue to grow the business, but that -- some of that is offset in the cash flow guidance that we've given with some of the milestones that we do expect to collect. Some of these milestones are milestones we had expected in the second half of '17, and they have moved into '18. So some of them we do expect to see some in the first half of '18.

And Ken, let me touch on that also. It ties in my prepared remarks on the change in methodology we've now implemented relative to liquidity to increase the liquidity and it's going to significantly drive it. Let's say, for example, we have a 15-month production run. And let's say, based on the billed plan, I'll just talk about one subsystem. The turbofans, they can come in month 8, and you still deliver on your delivery schedule in months 10 through 15. Historically, to be safe to build credibility with the customers, to make sure our past performance qualifications were bulletproof, we would place the orders because we would know -- we would have an indication we're going to get the order and we would receive those engines, in my example, in month 1. We might not get the milestone for that until month 7 or 8. So we would carry that either in unbilled -- in inventory or if it was percent complete, it would be unbilled and in revenue. So we've been able to change that now with the improved capital structure. And our past performance quals, we're mapping everything in, in my example to come in, in month 8. That's when the milestone hits. So we get the engines in and my example, we pay for them, there's no liquidity carry. Yes, it has moved some of the revenue recognition out into months 9 through 15 in my example. It all still comes in the 15-month period of performance, but it significantly improves liquidity. And we're doing that across the company now, we've just begun.

And Eric, can you just -- it sounds great. Can you just maybe quantify or bracket sort of where you think just to taking those kind of steps and more focused on efficiency, what that can contribute say in '18 on maybe in '19 on a full year basis?

Well, this is customer-by-customer. We're negotiating it. We've been successful on some thus far, which tied into your initial question. Your improve liquidity forecast for '18. I'm not prepared to do that yet. Maybe later this year, once we get some more of these negotiated, we'll be in a better position. But I'd hate to throw a number out there with you and we're unsuccessful with certain customers.

Got it. And then, just finally -- Mike I appreciate that. Just finally, it sounds like with the better, sort of, budget visibility, I know we're obviously still operating under a CR (sic) [CRA] and I think we all agree that the end of March is a realistic assumption of when we get things finalized for '18. What's the pressure in your view? And will there be things that might slip into fiscal '19? Or your calendar '19, just because the ability of your customers to maybe put all this capital to work in a sort of a truncated 6-month fiscal year, is that a risk that you potentially see that could impact timing on some things? Or are you already starting to see maybe things loosening up just with obviously the better visibility and sort of broader agreement on the budget numbers?

So -- we had a very similar situation last year in 2017. And last year in 2017, assuming we get the '18 budget at the end of March, it's very similar to where we got it last year. And we did not receive a number of our contracts starts or increased productions until June, July, August and we didn't get one of them until December of '17, because of the CRA. We have taken those same assumptions and map that into our 2018 forecast where assuming we get a 2018 budget at the end of March, we are not making the assumption we're going to get all the stuff in April and May. We are spreading it based on our historical experience, which we just had last year.

Okay, so even though you're obviously guiding to a very strong second half and particularly very strong fourth quarter, that already reflects the potential timing risks of some of these contracts.

Yes, yes, it does. Yes, our assumption in our guidance is if we get it, there's a budget in place by the end of -- March 23, I think, the end of March.

Our next question comes from Mark Jordan from NOBLE Capital.

Eric, a question relative to the SSAT contract there are option exercise you announced yesterday, the $24 million or the DoD announced. Was that a plus up to LRIP 1? And when do you expect LRIP 2 to be released?

Mark, I have to be very careful on what I say here. The recapitalization of strategic weapon systems has not only begin but it's accelerating, because of perceived nation states threats. And those weapon systems need to be exercised. So for example, over the past couple of decades, appropriately, we've been addressing the terrorist threat and most recently ISIS. And so, I'll use an example, our fighter aircraft have been flying missions not against nation-state peers in the air, but against terrorists on the ground. So part of readiness now is the increased use of targets to prepare them in my example for taking on nation-state weapon systems. So things are pulling to the left and quantities are increasing. I don't want to specifically answer your question and get ahead of the customer. But I'll say it again at this level, things are moving to the left and things are accelerating. And that's one program that, putting aside these tactical ones, that is going to be the largest opportunity -- the largest program in the company very soon. Very soon.

Is it correct that you've completed manufacturing of Lot 13 of AFSAT and that 14 is expected to be awarded in the second quarter? So you'll have a gap here in the first half of the year, pushing that -- those revenues may lead to the second half?

Yes. So we're almost substantially complete with Lot 13. We are expected -- keeping in mind our liquidity plan, we are expected to get going on Lot 14, I'm going to say July, end of June, July. However, we are working on, I cannot name customers, certain international opportunities that are in the line as well. So we should not -- we should not have a significant break.

Okay. The LCASD is going to be -- its first flight will be in Q3. Do you have an idea when the decision point might be for the Air Force to look at procurement of potentially production units?

Yes, we do.

Will you share it?

I'm sorry. No sir. I'm sorry. I'm sorry.

Last question for me. Just a clarification, PSS is all-in service revenue? Is that correct?

As far as a service revenue that we report, there is some other service revenue within KGS that is supported in the services line. Because there are some services that are wrapped around product and there are actually classified as services.

But 100%, PSS.

But Eric is right. 100% of PSS is serviced.

Okay. So I can subtract that out of that service -- prior service.

That's correct. That's correct.

Our next question comes from Seth Seifman with JPMorgan.

This is actually Ben Arnstein on for Seth. Just wanted to ask a couple of quick ones on the divestiture of PSS. I mean why now, why is now the time to sell this business? I think it had been investors' mind for a while as a non-core aspect?

If you could see me, I'm smiling because from our perspective, the vast majority of Kratos' investors or potential investors have been encouraging us, particularly in the last 12 months and it's been ramping up in the last 6 months as the other businesses are gaining traction, as why too, we don't divest this and become a pure-play systems and product company. And so, we looked at as we announced that this was a non-core business I think at the end of '16. And we've had a lot going on as you would imagine, this process, I use that word delicately with this, took an extended period of time. And we are where we are, and I am absolutely convinced with what we see coming in our Satellite business, our Training business, our Microwave Electronics business and our Unmanned business, focus. We have got to focus on those because we won some big stuff. We're going to win some big stuff and we need to focus where the big growth opportunities are.

And I guess, not to read into the press release too much. But you mentioned the rocket support being non-core and taking the charge there. Should we think about a similar path for that piece of the business?

I -- we are routinely looking at the portfolio to see what makes best sense for the shareholders. And that's all I should say about that.

Okay. And then maybe one last one on cash flow. How should we think about the timing of cash for 2018? Should we expect to know, first half to be an outflow based on LCASD investments and the other drone programs? And then, thinking about the run rate, is it wrong to think that beyond 2019 after these investments are made, cash flow will be significantly higher?

No, I think you're thinking is in line with our expectations.

The investments are going to wind down.

Because the predominant investment is in LCASD and that flight is scheduled for Q3. So that investment will be complete by say the end of Q2. The timing of the milestones that will drive what the cash flow is -- I think your comments on the cash flow generation or the second half being stronger, that's in line with our expectation.

And all other things being equal, with the LCASD investment being done this year, everything has been equal, you would expect '18 by definition would go up significant -- '19 will go up significantly.

Especially, if you take into consideration the CapEx that we were historically running at prior to 2017 when we launched this initiative. So our CapEx in those years was anywhere from $11 million to $15 million. The last 2 years have been in the $25 million-plus range. So we don't foresee that heightened level of CapEx going forward past around 2018.

Our next question comes from Noah Poponak of Goldman Sachs.

What percentage of the 2018 revenue outlook range that you've given us here is already in your funded backlog? And how does that compare to how you've started the last few years on average?

So our total backlog is roughly -- typically, in our total backlog what we see (inaudible) converting into revenue in the next 12 months is typically about 50% of that. So -- and that's about in line with what we -- how we've started each year in the past.

That's on funded or on total?

On -- looking at it it's on -- it's actually more than that from a funded prospective. So it's probably closer to over 70%.

Okay. And so, I should think -- so it's 70% on the -- on funded, 50% on total?

Correct.

Okay. And so, I should think of -- call that 55%, 60% of the year is already in backlog?

Correct.

And is that a pretty normal starting point?

Yes. And as I had mentioned in my prepared remarks, backlog may not be indicative of what's going to turn into revenue. So for instance, this $93 million award that we received from the U.S. Army at the end of the year, which only $7 million that's included in backlog currently. But we fully expect to deliver on that this year and the next 3 years. So that may not be necessarily in backlog, but we have very good visibility on that revenue in 2018 and '19 and '20 and 3 years of performance.

So how much of the remainder of the outlook that's not in funded backlog would you say fits into that category of seeing where it's a little bit of -- little bit definitional and you do have visibility versus something that you have to go capture?

So a significant piece, because we know the OPTEMPO. So far, we know the Navy's OPTEMPO for their targets in SSAT. We know the Air Force's OPTEMPO for AFSAT and the 167. And right now, we have nothing in there at all for Lot 14, 15 and 16. We're going to get all 3 of them once. On the Ballistic Missile target, launch schedule. Obviously, we have that schedule. We know exactly what's coming on that. With the U.S. Army, on another drone, I can't get into the name on it, we know their OPTEMPO. None of this is in backlog. But it is, it is very, very significant. And this maps into our guidance. We give our guidance based on what I just went through.

Okay, that really helps to clarify that. If the -- if unmanned is doubling '18 versus '16 on the nose, so call it $150 million, it would imply KGS is growing -- in your guidance, is growing about 3%. Is that accurate? And could you talk about some of the moving pieces there? It would seem like it would have potential to be faster than that, given some of the businesses you're in there? Maybe the government services piece is a drag. Again, if you could walk us through that in a little bit more detail?

That is -- you are absolutely correct. The government services piece is a drag.

Is it declining in 2018?

It is declining. It is -- we deemphasized it and the bid pipeline is down. As I mentioned in the prepared remarks, we lost -- no, we lost a couple in Q4. One was like a $50 million, we got purple across the board, and we lost on price by couple of hundred thousand. So that low price technically acceptable, as you know, is ruthless in the Services space, it's terrible. So let me give you another data point on that business for 2017. That RSS business, the book-to-bill ratio was 0. So think about what our book -- I know, look, so you can reverse engineer what our book-to-bill ratio is, excluding that. And as Deanna said, on a number of big programs we don't even put it into backlog. So the book -- the programmatic our contract of our book-to-bill with the company is extremely strong. But that is -- that's not a tailwind, it's a face wind. It's a face wind.

Understood. I'll ask one more. Just on margins, so you guys had this 10% EBITDA -- adjusted EBITDA all-in target for kind of the longer-term, medium-term long-term framework. I guess, that included PSS. So for Unmanned and KGS combined, I guess that implied 11% or 12% guidance for this year as kind of 9%. Is 11% or 12% is the right way to think about that beyond 2018? Or maybe just update us there.

So the #1 item to look at first is the $2.5 million number that Deanna mentioned, that was allocated -- yes, that was allocated. So we're going to cost-rationalize. There were things like licenses and things like that we have agreements on that we have negotiated. You just can't kill them, day 1. We think we can negotiate ourselves out or they'll wind down by the end of the year. So our plan is to reduce that -- by the end of the year. Obviously, the other businesses are going to grow to make up for it. And we're still looking for a normalized EBITDA margin for the company. When we get a rate on these things is low teens.

Our next question comes from Michael Ciarmoli from SunTrust.

This is actually Les in for Michael. Just to go back on the divestitures of PSS. I guess the cash receivable of that coming in 2Q, is that way to look at it?

What we had mentioned was the -- in our press release announcing that transaction that, with regulatory approval and customary closing conditions, that we expect it in 90 days.

Okay. I guess, and then, once that clears, what will the capital structure for the company look like? And perhaps an interest expense outlook?

So this is going to depend on what we -- on the proceeds. So under our current bonds, we have a year with the proceeds. And if they're not redeployed into inventory or receivables or growth in the business, there is the ability...

Or other investments.

Or other investments, thank you. There is the ability, pro rata to bring some bonds back in that a -- at par, okay? We -- as Deanna and I went through in the prepared remarks, we have a lot of opportunities right now that we've won. That production is going to get going as soon as we -- God willing, as soon as we get the budget in the second half of the year, is going to get going. I think we're looking real good on several other very large opportunities. I think we're going to win. And so, our plan at least initially is to hold the cash initially. All things being equal. And let's see, how we do on some of these, because if we do it -- and I'm the CEO I drink the Kool-Aid. If we run the table of them, we're going to want a good part, if not all of that liquidity to execute on these programs.

Got it. Okay. I guess the last one. How would you say that Gichner fits strategically into the portfolio at this point?

Yes. So, that's our modular systems division as you know. And right now, we are in the middle of some very large production runs. One of them being Patriot. So whenever you see Patriot, Les, just recently, you saw Patriot in Sweden, that's Kratos. Raytheon is an extraordinary strategic partner of Kratos'. Because they're a wonderful company to work with. We are in a number of their missile and associated radar programs. We work very closely with Lockheed Martin, very closely with Northrop. And the majority of what we -- what we're focused on there is Ballistic Missile Defense systems. We are also on a number of unmanned systems where we built ground, controlled stations for unmanned systems. We are also involved in Littoral Combat Ship. We are one of the providers of the mission modules for the Littoral Combat Ship. We're designed into electromagnetic rail gun. We're designed into high-powered directed energy systems. This business fits into our focus on strategic systems and it's in a number of areas we see the budget increasing significantly with the '18, '19 bipartisan spending bill that was signed, assuming it gets approved.

And our next question comes from Brian Ruttenbur from Drexel Hamilton.

Couple of housekeeping. Adjusted EPS for '18 should be down from 2017, is that how you kind of looking at it going forward? Where you maybe have a negative in the first quarter and then turn positive in the second half?

I guess, when you made the comment that it's down from 2017, our adjusted EPS for the year was like $0.12. And what we just guided to was $0.16 to $0.18. And then in the first quarter of 2017 was that - adjusted, I think that was a loss of $0.01. So it's actually, we're guiding to be up on the quarter and up on the year.

Okay. Sorry I missed that part. I didn't miss though the next question that I have. Is can you name the top 3 big programs for us to watch? Is it #1 Gremlins? Can you just give us a top 3 that we should be monitoring?

Okay. So #1, and we're still waiting for formal award, God willing, it's competitive is Gremlin. As I mentioned in the remarks, if we -- with our partner Dynetics, are fortunate enough to be successful here, based on most recent data points, this is a game changer for the company, it is. The SSAT program. The SSAT is, with the Navy, is replacing certain target drones, the 34 and the 74. They're almost out of them and there is a significant demand for those. You asked me about the 3 to watch so I'm telling you 3 I can tell you about. The third one is LCASD. The LCASD program, as I mentioned, is on schedule, on budget. I cannot talk about much of this anymore as I mentioned to everybody at Q2 of last year. But this is a biggie as well.

Our next question comes from Greg Konrad the Jefferies.

Just a couple of quick ones. Most of mine have been asked. But in the prepared remarks, you mentioned smallsats and it didn't seem like there was much you could say. But I was just thinking just from the opportunity, is that near term, longer term and maybe just a little bit more color on the size of that opportunity?

Yes. So it is happening right now as far as getting designed into the constellations and getting designed into the operators. Now is the time to get designed in on the ground side where we are. And this is an entire new suite or generation of ground, command, control and communication equipment for these LEOs versus the GEOs. As I'm sure you know, these small nano and cube sats, they're going to be far, far less capable, far, far less costly than the GEOs. But there's going to be thousands of them. And so, it's a whole new generation of ground equipment, smaller, arguably less dynamic. But there's going to be a lot more of it. And so, right now is the time to get -- we're getting designed in and trying to pick the winners. And because of our pedigree with EPOCH, our industry-leading command-and-control software, our system, we -- this is a real opportunity for guys like us that we know the operators. They're our customers, and we've got the past performance quals and the credibility.

And just staying on space, I mean commercial space, I think, where you've had really high market share. I mean the industry itself has kind of been down. It seems like it's starting to thaw. And maybe we're getting into kind of recovery mode there. Maybe any type of trends that you're seeing on the commercial side?

The primary trend is on the high throughput side and the spot beams. And issue that we're seeing that we're addressing with our globally owned spectrum monitoring business is monitoring interference related to those spot beams or jamming related to those support beams, whether it be unintended or intended. Identifying where it's coming from being able to geo-locate or use other means to identify where it's coming from so it can be mitigated or neutralized depending on what the customer wants. That is -- that's a trend we're seeing in that area. And it's only going to grow. This, in our opinion, the potential for jamming or beams getting crossed or interfering with each other as more and more satellites go up, is only going to increase and being able to, because of KPIs, being able to quickly identify and remedy that is big business and big money. And we are the industry leader in that. And I believe, we are the only company that has a globally owned and operated network that is -- we're monitoring hundreds of beams in doing what I've said. It's growing rapidly. I think we've said in the prepared remarks, it grew 35% year-over-year and that ties into directly what you're asking.

And our final question comes from -- follow-up from Noah Poponak with Goldman Sachs.

Deanna, I just -- I wanted to ask you about the NOL. One, does U.S. tax reform change its value? And then two, because the divestiture change its value? Is it used as a tax shelter?

Sure. So tax reform changes the value of that is recorded on the balance sheet because it's just at a different rate. So that's some of the movement on the tax benefit that was recorded this period. It was a change in rate from 35% to 21%. But as far as the -- so going forward, tax reform carryback is no longer allowed. But carryforward is unlimited. So we are -- under the current law or prior to the tax reform, it was carryback 2, carry forward 20. So that's not impacted of the NOLs that we have, of nearly $390 million. But the go forward piece is what would be impacted by -- it's actually unlimited going forward. So -- and there's no change, no impact related to the divestiture on our NOLs.

With no further questions in queue, I'd like to turn the call back over to Mr. DeMarco for closing remarks.

Thank you all for joining us today, and our next scheduled chat will be when we report the first quarter unless something comes up between now and then. Thank you very much.

Ladies and gentlemen, that does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.