Kratos Defense and Security Solutions Inc (KTOS) 2022 Q2 法說會逐字稿

Good day, and thank you for standing by. Welcome to the Kratos Defense & Security Solutions Second Quarter 2022 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded.

And without further ado, I'd like to turn the conference over to Marie Mendoza, Vice President and General Counsel. Please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions Second Quarter 2022 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 will now turn the call over to Eric DeMarco.

Thank you, Marie. Good afternoon. I believe today's report reflects the success of Kratos' strategy to disrupt the national security market space with first-to-market affordable, transformative technology, product, systems and solutions. Since our last report to you, we have received each of the 3 large new space and satellite program contract awards we mentioned on the Q1 call, including the BlueHalo Space Force SCAR Program and Intelsat's next-generation satellite network, each of which have now been disclosed by our customers.

We have also received the third contract award I mentioned. It has not yet been publicly disclosed by the customer. Therefore, we are unable to provide any additional information at this time, but we have received all 3.

The initial estimated total future potential value of these 3 new programs for Kratos is several hundreds of millions of dollars over the respective program periods. These new program awards that we have now received, which have a significant open space software component are key elements to Kratos' expected fourth quarter ramp and EBITDA margin increase and also our future year expected financial organic growth rate that I'll discuss later.

Kratos' first-to-market open space platform is the only software-defined satellite ground system today, and this was key to Kratos' receiving each of these 3 new large program awards. Kratos is the clear market leader in next-generation satellite ground systems, which is an extremely large and rapidly growing market area. We believe that these recent program awards in our 1.7:1 Q2 book-to-bill ratio in our space, satellite and cyber business is representative of Kratos' open space software and technology disruption potential for Kratos to the multibillion dollar total addressable satellite market space we are penetrating.

We are currently in pursuit of several additional new space and satellite program opportunities with our open space technology, certain of which we also hope to be successful on by the end of this year. We expect Kratos' space and satellite business, which was our company's largest, to be one of our fastest-growing and highest-margin businesses going forward as customer acceptance of our open space software-based products increases. We will continue to invest significant internally funded R&D into our open space software product family and intellectual property in order to further Kratos' position as the leader in what we see as a transformational large and growing market opportunity for our company.

Since our last report to you, we have had several successful flights with multiple Kratos tactical drones, including Valkyrie for the Skyborg program. And a number of Kratos Valkyries have now been delivered to and accepted by the customer. We now expect to receive additional Valkyrie-related contract awards in the second half of '22, including a Valkyrie-related contract from a new service branch customer in Q4, which is a key element of our forecasted Q4 Unmanned Systems revenue and profit contribution increase.

Since our last report to you, it has been reported that the Air Force will be retiring the entire Global Hawk fleet of drones in order to free up funding for more survivable platforms and systems in a high-end conflict. On the Global Hawk retirement decision, the Air Force reportedly said that in part, our ability to win future high-end conflicts requires accelerating investment in connected survivable platforms by divesting legacy ISR assets that offer limited capabilities against peer and near-peer threats. It was also recently reported that the USAF is planning the reduction and retirement of the JSTARS fleet as the aircraft is also not considered survivable in a high-end conflict.

Since our last report to you, the Deputy Assistant Secretary of the Air Force for science, technology and engineering informed Congress that the Skyborg Vanguard program with Kratos Valkyrie and Mako tactical jet drones have been publicly acknowledged to be part of, will now become a program of record by the end of 2023 and will transition to acquisition. The Valkyrie was specifically designed to be survivable in a high-end fight, with the Valkyrie having flown with both the stealth the F-22 and F-35 and the Valkyrie having a very attractive signature characteristic of its own at a cost level that allows the Valkyrie to be deployed in affordable mass. We believe that the world is now seeing that quantities or mass does matter, with approximately 1,000 drones of all types reportedly lost thus far in the Ukraine, including jet drones. Emphasizing this belief that low cost and the delivery of affordable mass is now considered critical, the U.K. recently canceled its loyal wingman drone program, Mosquito, reportedly due to high costs, a flying system still many years away and that a U.K. MOD has now determined that cost effectiveness is achievable through smaller, less costly, but still highly capable drones.

We continue serial production of the initial 12 lot of Valkyries. Certain of which, as I mentioned earlier, have now been delivered to and accepted by a customer. Based on discussions with the potential new service branch customer, certain of the 12 Valkyrie still in production, Mission system configuration will be modified to meet a certain requirement. Based on recent interactions with additional potential new customers, we believe the fact that Kratos has active production lines for higher-performance jet-powered drones, including Valkyrie, Mako, Air Wolf and others, all of which are flying today. These are not PowerPoints or simulated videos or concepts that reportedly will be ready 3, 5, 7 years from now at some unknown price is a key differentiator for Kratos. Kratos is ready now with active production lines and in-place supply chain, flying aircraft and known price points. We believe that Kratos is being ready now positioning and affordability, along with recent global geopolitical events, demonstrating that the threat is real and that quantities do matter in a high-end conflict will be a catalyst for us.

Additionally, over the past several weeks, it has become clear based on publicly available information and our meetings with customers that runway independence is an absolute critical requirement for affordable, reusable, disposable and attritable drones. Accordingly, our unmanned business' resources will now primarily be focused on runway independent systems, an area where Kratos is already a clear industry leader having built hundreds of jet drone aircraft, all of which are runway independent. Related to runway independence, Kratos' ghost works is now almost complete with what we believe is a new game-changing capability in this area as specifically related to Kratos' drones. Runway independence, we believe, is also critical to the success of the Air Force's Agile Combat Employment, or ACE, program in the Pacific.

As a result of these recent customer meetings, communications, events, et cetera, we are now planning to increase serial production. We're in the planning process of the Valkyrie beyond the initial 12 lot currently in production. Over the next 12 months, and I currently believe -- excuse me, over the next few months, and I currently believe that by the end of this year, we will be making the decision to begin the next Valkyrie production lot and its size based on the increasing demand signals we are receiving from multiple sources.

As I have mentioned previously, a significant amount of Kratos' tactical drone work and initiatives are now classified CUI or confidential, and we cannot get ahead of our customers from a communication standpoint on certain programs, projects or initiatives we may be working on, including as related to Valkyrie. However, Kratos is the clear industry leader in low-cost, high-performance jet-powered drones, and we remain highly confident in the future potential transformational success of Kratos' tactical drone business for our company.

Kratos' target drone business where Kratos is also the clear industry leader once again is also well positioned, including as a result of the Russian-Ukraine war, Asia Pacific tensions and the related global recapitalization of strategic weapon systems, which systems need to be exercised and tested against target drones. We continue to expect to receive an approximate $100 million sole-source target drone IDIQ contract in Q4, and we are in pursuit of several other new U.S. and international target drone opportunities. Kratos is the primary target drone provider to the United States Air Force, Navy and Army. And U.S. allies want to exercise their respective weapon, radar and other systems against the same target drones that are used by the United States military, which are Kratos drones.

Kratos turbine technologies and our engine business is also performing well. And since our last report to you, the Golden Horde Vanguard program was reported by the Deputy Assistant Air Force Secretary to also now be on schedule to be a program of record in 2023. We believe that the Golden Horde Vanguard program transitioning to a program of record is important to Kratos from a tactical drone, tactical and powered munition and a propulsion system standpoint.

Just last week, Kratos turbine technologies, or KTT, announced a $54 million sole-source, single-award task order to develop a low-cost limited life engine for attritable and expendable systems. Also in KTT, the new Rolls-Royce B-52 engine program we recently received is expected to begin ramping in Q3 of this year as our several space propulsion system programs KTT is currently executing on.

In our C5ISR business, the GBSD or sentinel program with our outstanding prime partner, Northrop Grumman, is also beginning to ramp up in Q3, with an expected increase in Q4. We anticipate that GBSD will also be a key future year organic growth driver for Kratos. Our C5ISR business is also pursuing an additional large potential several hundred million dollar new program opportunity for Kratos where Kratos has now received a development contract.

Kratos' rocket systems business growth opportunities are also robust, including in the ballistic missile defense and hypersonic areas, which is receiving significant funding increases in the 2023 request and the fight up. We continue to progress on Kratos' Zeus propulsion system with our strategic partner, Aerojet and our Erinyes hypersonic vehicle system, including with our stakeholder customer partners, and we are now expecting to receive a large contract related to these systems by the end of this year. We believe that the extremely affordable Kratos' Zeus and Erinyes hypersonic system will be disruptive and transformative, providing significant capabilities to our customers at a low cost.

The SRE transaction closed in Q2 of this year, which further positions Kratos in the high priority and extremely well-funded hypersonics area. Our microwave electronics business has virtually 100% of its Q3 and Q4 revenue forecast now in backlog and has a strong opportunity pipeline similar to virtually every other Kratos business. In our microwave business, we have now been informed by a customer and we have executed a letter of intent with the customer that we have been selected for a potential $250 million Kratos value program related to a C5ISR system. We expect Kratos' microwave business to be under formal contract on this new opportunity by the end of this year, which will further position Kratos' microwave electronics business for sustained future organic growth and margin expansion.

In summary, Kratos' positioned in well-funded mission-critical priority national security areas of the United States and our allies and the demand for Kratos' systems, our products and our solutions has never been stronger, and it's increasing. Virtually every Kratos business unit continues to forecast organic growth for '22 in a very challenging environment, which is representative of the Kratos team's execution.

Assuming no future acquisitions, we are currently forecasting a base case 2023 over 2022 year-over-year growth rate of approximately 10%, with the possibility for an even substantially greater growth above this 10% base case, if certain opportunities in our tactical drone, space, satellite and cyber businesses come to fruition ahead of our base case expectation. The expected growth, of course, could move around a bit depending on the length of any future year continuing resolution authorizations or government funding delays. But irrespective, Kratos' future organic growth trajectory is expected to be very strong.

Operationally, supply chain issues remain a significant challenge, and we now expect them to continue into 2023 with specific representative Kratos issues, including the procurement of FPGAs, aluminum, antennas and certain materials related to composites.

Inflation across every cost point, including as related to materials and wages, is also a challenge, which has gotten worse since our last report to you and which is impacting our Q3 margins on existing firm fixed price contracts and on priced options as we cannot pass the increased costs on to our customers. We expect our margins to increase in Q4 as certain new contracts we have recently received have contemplated inflation and increased costs in them and as the mix of our revenue improves, including in our space and satellite business with open space software as we realize increased leverage also on our fixed cost base and revenue increases.

Hiring, obtaining and retaining personnel, including those with security clearances, is also an operational challenge, and we are having to increase compensation to both retain and obtain qualified personnel, which is also adversely impacting our near-term profit margins.

Our forecasted execution plan and revenue growth includes the assumption that we will be able to increase our workforce to meet the production and delivery requirements of the contract awards that we're executing on and that are included in our backlog. However, irrespective of these challenges, we believe that Kratos' strategy of providing affordable technology for national security is spot on. And then we have the right products at the right price at the right time to meet the U.S. and its allies national security priorities.

Our plan remains to focus internally on organic growth and our 10% 2023 over 2022 base case growth rate and to successfully execute on our potentially transformational tactical drone, space and satellite opportunities. Deanna?

Thank you, Eric. Good afternoon. As we have included a detailed summary of the second quarter financial performance and financial guidance in the press release we published earlier today, I will focus on the highlights in my remarks today.

Kratos reported second quarter '22 revenues of $224.2 million, above our estimated range of $205 million to $215 million driven primarily by growth in our space, satellite and cyber and turbine technology businesses and due in part to the contribution from the recently closed SRE acquisition. Excluding impact of the contribution from the CTT, Cosmic AES and SRE acquisitions, which contributed $21.5 million, and excluding the impact of the reduction in our training solutions business of $8.6 million, revenues grew organically 3.2% as compared to the second quarter of '21.

Q2 revenues continued to be impacted by continued and increased COVID-related supply chain and other delays, including obtaining and retaining qualified personnel, resulting in approximately $14.5 million in revenues being deferred into future periods, with approximately $2.9 million of associated operating income, including increased inflationary costs.

Our Q2 '22 consolidated operating loss was $1.9 million compared to operating income of $3.3 million in the second quarter of '21, with Q2 '22, including a litigation settlement charge of $5.5 million. Net loss was $4.7 million for the second quarter of '22 and a GAAP loss of $0.04 per share compared to net income of $1.1 million in the second quarter of '21 and GAAP EPS of $0.01 per share.

Included in second quarter '22, net loss is a $5.5 million litigation settlement charge discussed previously. We generated adjusted EBITDA of $17.7 million for the second quarter, exceeding the higher end of our expected range of $11 million to $14 million due primarily to a favorable mix in our space, satellite and cyber and turbine technologies businesses.

Our Unmanned Systems segment reported revenues of $56.4 million in the second quarter of '22 compared to $60.3 million in the second quarter of '21. KGS reported revenues of $167.8 million in the second quarter of '22 compared to $144.8 million in the second quarter of '21, including contribution of $25.1 million from the recently acquired Cosmic AES, SRE and CTT acquisitions, offset partially by the training solutions business of $8.6 million, which included the loss of an international training services contract, which contributed revenue of $4.5 million in the second quarter of '21.

Despite the continued unfavorable impact resulting from supply chain, COVID and related delays and disruptions, which impacted current quarter revenues unfavorably by approximately $13.9 million. On a pro forma basis, excluding the impact of the training solutions business, KGS revenues grew organically 7.7% in the second quarter of '22. Second quarter '22 operating income and adjusted EBITDA for Unmanned Systems included a heavier mix of more development-based revenues, which are typically lower in margin due to less leverage on fixed overhead manufacturing, SG&A and development infrastructure.

Our Unmanned Systems business experienced an increase of $900,000 in SG&A primarily related to increased headcount and $1.3 million of R&D in the second quarter '22 as compared to the second quarter of '21. KGS operating income and adjusted EBITDA included a more favorable revenues, including software and license-based revenues.

Q2 '22 cash flow from operations with the use of $21.6 million, with the use, including an increase in receivables of approximately $27.1 million primarily related to future milestone and other contractual payments from customers and an increase in our inventory balances of approximately $10.5 million during the quarter, primarily in our Unmanned Systems, C5ISR satellite and microwave electronics businesses in anticipation of the ramps in production in the second half of the year and in part to secure additional safety stock in advanced buys and larger lot sizes to gain pricing benefits where possible and to mitigate the impact of supply chain disruptions.

In addition, operating cash flow also includes the continued planned investments in engineering costs in our rocket system and turbine technologies businesses for new products and investments, including the design and development of an affordable hypersonic vehicle, Erinyes and a complementary propulsion system, Zeus. For the first 6 months of '22, our operating cash flow usage included $15 million of increases in receivables and increases of $25.8 million in inventories across all of our product-based businesses, including unmanned systems, space and satellite, microwave products and C5ISR. In addition, we have made approximately $5.6 million of investments in nonrecurring engineering costs for these new Rocket products during the first 6 months of '22.

Our contract mix for the quarter was 72% of revenues generated from fixed price contracts, 23% from cost plus fixed fee contracts and 5% from time and material contracts. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 70%, including revenues generated from contracts with the DoD, non-DoD, federal government agencies and FMS contracts. In Q2 of '22, we generated 12% of revenues from commercial customers and 18% from foreign customers.

Now moving to financial guidance. Our third quarter '22 financial guidance we provided today includes our current forecasted business mix and our assumptions related to the expected continued impact of employee absenteeism, challenges related to obtaining and retaining qualified personnel, supply chain disruptions, inflation and related expected costs and price increases and other COVID-19-related items that have are currently and expected to continue to impact the industry and Kratos.

Throughout the first half of the year, Kratos experienced a significant increase in the intensity and effects of COVID-19 and the related impact to our employees, absenteeism, consultants, vendors, suppliers, customers, et cetera, which impact included loss of weeks of manufacturing and production functions in our unmanned systems, C5ISR and Microwave Products businesses. We have assumed that these COVID-19 and supply chain-related impact to our business, including increased inflationary costs, which significantly impacted our first half '22 operations will continue to impact the third quarter with an estimated impact of approximately $10 million to $14 million in third quarter revenues and $3 million to $5 million of our adjusted EBITDA.

We are having some success with certain customers on building in cost and inflation escalators on new bids and new upcoming price options, and we expect to begin seeing certain benefit of these efforts in the fourth quarter of this year. However, since our contract mix is predominantly fixed price with certain of the contracts under a longer period of performance terms, it will take some time to transition the contract to those with increased pricing. As a result of each of these pricing and inflation factors that we are contractually obligated to absorb and the continued delay of our ability to produce and deliver certain products with the most significant impact to our third quarter forecast, which we had originally expected to significantly improve, we are adjusting our fiscal '22 adjusted EBITDA to $80 million to $85 million with the most significant impact to the forecasted third quarter margins with improvements expected in the fourth quarter based upon the projected ramp in new large programs, which includes more recent cost leverage, leverage realized on the SG&A and overhead infrastructure and a more favorable revenue mix, including more software-based revenues, driven largely by the 3 new open space programs that Eric mentioned earlier. We are forecasting increased revenues in the third and fourth quarters of this year, with the trajectory increasing in the fourth quarter.

We are also adjusting our revenue guidance up to $890 million to $930 million to reflect the expected contribution from the SRE acquisition, along with forecasted organic growth driven by our bookings and backlog, offset partially by continued revenue delays caused by supply chain disruptions. The growth expected in the fourth quarter of '22 is largely driven by the forecasted execution and delivery schedules of 5 new programs, 4 of which have already been awarded, the 3 satellite program awards, GBSD and an expected Valkyrie award from a new customer.

In order to maintain our fiscal '22 estimated use from free cash flow estimate of $30 million to $40 million, we have adjusted our FY '22 capital expenditure plan to mitigate where possible, the additional uses of working capital that we have extended this year to bolster our inventory levels and advanced inventory purchases. Eric?

Excellent. Thank you, Deanna. We'll turn it back over to the moderator for any questions.

(Operator Instructions) Our first question comes from the line of Michael Ciarmoli of Truist Securities.

Eric, just on the guidance, I guess, 2 questions. For the current year, you've got this bigger fourth quarter. How are you contemplating or thinking about a continuing resolution? And then even just in the -- it seems pretty early to be talking about '23 given the range of unknowns and supply chain. And are you thinking it takes some time for supply chain to normal out? And just, I guess you're calling that 10% of base case, but just maybe more thoughts on why throwing out that number now?

Right. On the first one, Michael, we -- our fourth quarter is substantially all in 2022 or prior year money. So we're -- there's very little that's on the '23 in there. Very little. Okay. On -- putting out a number relative to next year, as Deanna kind of sort of went through, big, big drivers we have are Sentinel, which is under contract, and we've got the work plan laid out through at least '23. The big space awards that we've won our target drone production schedules primarily with the Air Force and the Navy. They're pretty much laid down out for the next 18 months. So we're -- we believe we have pretty good visibility, and we understand the pricing and cost elements in those. And as I went through, certain of those are new. And so there have been inflationary factors built into them. So we feel pretty comfortable.

The primary risk we have right now is hiring the people operationally, Mike. That is absolutely the primary risk. It's not winning new business. We're winning a lot of business, and we're going to win a lot more in the next few months that we know. But hiring these people, particularly with security clearances, and not just engineers, manufacturing people that have security clearances and some of these programs we've won, that's where we've got to stay focused to achieve the top line.

Our next question comes from Mike Crawford from B. Riley Securities.

Eric, with Skyborg looking near a lot to become a program of record in the next budget, what does that specifically mean for Valkyrie? And what -- ancillary to that is, what about these other myriad platforms that you've been developing over the years, ranging from (inaudible).

Right. Right now, Mike, the primary focus of the customer set is on 3 platforms. And I believe it's because they're mature and they've all been flying for a number of years. It's Valkyrie, Mako and Air Wolf. That is where we are having the most significant activity with customers and in particular, the past couple of months. I believe, as I said in the prepared remarks, it's in part, maybe a big part being driven by what's going on in the Russian-Ukraine war. I saw this just this morning that the Russians alone now has lost over 800 drones, including lots and lots of jet drones. And as are established -- as the DoD, as I went through, is retiring the Global Hawk for survivability reasons, retiring JSTARS. You've seen the discussion around the Reaper, which is excellent asymmetric warfare as we just saw recently, but survivability is not so much. My opinion is the customer focus on Valkyrie right now, Mako and Air Wolf is because they're flying, they've proven, they've exercised things, they've deployed things, and that's where the focus is now. That's where the money is.

Okay. And of course, those are attritable, expendable, disposable platform. So it's good you have the whole mix there. And I guess maybe Air Wolf being runway independent, is that what gives it a leg up over, say, Gremlins?

Yes. And my opinion, the Air Wolf is much more survivable, even though it's extendable than the Gremlins was designed to be. The Air Wolf is an incredible high-performance aircraft. It is a -- it has very interesting characteristics on it as far as identifying -- it's even there versus the Gremlins was not designed for that mission. And that's why I believe survivability to get to the mission area, to exercise its mission, it has a leg up on the Gremlins.

And then what about this down select on the On-Board Sensing Station or your Demogorgon project?

Yes. So that's -- we're in phase 1 as is the other party. And the down select or the move to phase 2 is scheduled for Q4. I think it's October or November. And so we're headed down, and we're focused on that.

As I did mention, Mike, in the prepared remarks, though, Mike, the nearer-term opportunity for meaningful revenue and profit margin increases for our company right now is in Valkyrie, Mako and Air Wolf. And we've all been patient. We've waited a long time, but we're doing everything we can to pull some of these in now that the geopolitical position has changed. That's where our focus is primarily.

Just the last question on Unmanned Systems. So with the growth and the targets and then these opportunities, is your Oklahoma facility like highly underutilized now or that's one place you need to staff up or exactly how you're going to go about this operationally?

Yes. So that is absolutely an area where we are staffing up, and we are staffing up. We need to staff up. We're looking at executing the next option to expand the facility once again. We're going to probably make that decision by the end of this year, similar to we're going to make the decision -- I don't think it's going to be any later than the end of this year that we're going to begin the next lot. I'll call it lot #2 of the Valkyries. That all ties together. But -- and that's where we're going to get leverage on the margins going forward, of course, as we continue to fill up that facility. And Mike, it's primarily Valkyries and Air Wolfs right now and one other program that we just haven't talked about.

Okay. And then final question, switching gears, just relating to open space. So there -- you have the software virtual commercial platform, but there are others that have their own proprietary platforms that may be interoperable. Do you see those as alternatives for the customers you're going after? Or are those just customers that are kind of -- that you're locked out from maybe assisting?

Yes. If you could see me, I'm smiling because that's the exact dynamic we're going after. But what you just mentioned is the legacy traditional model that's vendor locked that the operators like the U.S. Air Force and Intelsat, they can't stand it because they're vendor locked into dedicated ground equipment for those satellites where open space is open and it's open architecture and it's software. And the -- as I think I talked about on the last call, these new operators, these new constellations that have software-defined satellites that are mega capable, this is greenfield for us, and that is our primary target opportunity market. We are not looking to displace anybody on an existing 20-year constellation. We're going after the new stuff, and there's a lot of them national security-wise and commercially.

Next up, we have Ken Herbert from RBC Capital Markets.

Eric, I just wanted to first start off, with the wins on the open space, the 3 large programs and the contracts you called out, what is it -- considering the size of the opportunity there, what -- can you quantify what you expect to be sort of the revenue impact in the back half of this year as they ramp, or I guess, more importantly, maybe in 2023 in particular? And how do they factor into the expected double-digit growth next year?

Ken, this is Deanna. So obviously, we're not giving any guidance on '23 at this point. But the ramp in the second half, we would expect a portion of that in the third quarter and then a more significant ramp in the fourth quarter. And remember, a lot of these are license-based. So it'll be a much more favorable mix from a margin perspective.

Yes. And Ken, your question kind of dovetails into Mr. Ciarmoli's question on why we're giving some -- our initial thoughts on growth rate between '22 and '23. We've -- with these contract wins, and those are bolted in, they give us a pretty -- obviously, they give us pretty good visibility into our space and satellite business, our company's largest in '23, which is a layer of comfort of what we're looking at next year.

Okay. Okay. No, that's helpful. And I guess considering the risks around not only this year, but next year, when you look at hiring, what -- operationally, Eric, what are you doing differently maybe now to try and accelerate that to the extent to which you can? I know you're in obviously different parts of the country, but what levers do you have to pull besides just salary perhaps as you look at addressing that issue? Because it's an issue, obviously, across the industry. And so it seems to be phenomenally competitive for talent right now. So how can you maybe accelerate that or differentiate yourself there?

Yes. And so it's different in certain of our different business areas. So let me tell you what I mean. In our unmanned area, we're finding it much easier to bring people in because they like the work, and it's exciting. And they get to work on a new airplane every couple or every 3 years. They're not like stuck on the B-2 bomber for 30 years, okay? So there's that group, and we're having better success in that area. We're also having better success in the hypersonic area because that's exciting. That's exciting work. It's interesting stuff. There aren't very many people doing it, et cetera.

In our C5ISR business, that's different, also having better success in the hypersonic area because that's exciting. That's exciting work. It's interesting stuff. There aren't very many people doing it, et cetera.

In our C5ISR business, that's different. That is very challenging. You have these very skilled machinists that work on all types of exotic and unique materials to build weapon systems and platforms. And there's incredible demand for that in the industry right now as the entire industry is ramping up and doing the pivot away from the war on (inaudible) to protecting against the peer threats. That's very difficult, and that is money. And it's trying to take people from other companies, if we can, through relationships, we have referral programs that we're trying to -- that we've rolled out, we're doing that, we've got mentorship programs that we've rolled out. And Deanna, what's the name of the program with the colleges (inaudible).

It's both high school and colleges, internship.

Internships where we're training, internship programs, but that -- but Ken, that is a challenging area, very challenging.

Appreciate that. And just maybe remind us what percent of your overall contract mix is revenue recognized on a percent complete basis or maybe what could be the risk of incremental delays on those contracts based on your ability to get people in the door?

Yes. I don't have the percent complete as far as what the total percentage is. But our fixed price contracts are 72%, and I would say a substantial majority of those are on cost-over-cost percent complete. There is a portion that's on units delivered, and that's primarily from an international contract perspective. So I would say the vast majority of that 72% is percent complete.

Next up, we have Josh Sullivan from The Benchmark Company.

Just the lack of mill capacity for Kratos products, and I think you mentioned carbon fiber and aluminum antennas issues as well. What's the visibility on these issues? Are lead times improving? Are they still going out at this point? And then are you having any issues with smaller suppliers facing any financial liability issues?

Yes. On the aluminum and castings, that has not improved at all for us. And you can imagine both aerospace and defense, the demand that's going on there. So that is not good.

On the composite side, and certain resins in that area, Josh, it's become challenging. We are reaching out not only to the supply base to other companies that do composite structures that we have great relationships with, and we're having some luck with some of those that have a significant amount of inventory available. We just hit it with somebody -- a company you know very well last week where we got some. So that's choppy. I don't expect that one to get worse, but it's choppy. Josh, what was the third part of the question?

Just -- I mean are you having any issues with smaller suppliers facing any financing issues?

Knock on wood, we have not had any to date, but that is an area where our team routinely is doing the due diligence and the checks, the financial reviews of them routinely. And the corporate team here, we go through that with the divisional teams monthly. So we're trying to stay on top of it. We have not run into any issues to date.

And then on the $50 million low-cost jet engine development contract, what are some of the time line issues there or time lines and any milestones you're looking for?

Right. So the time line -- we've already received the initial funding of several millions of dollars. So we're off and running. The -- in my opinion, this effort here by the AFRL is directly related to programs like Golden Horde and swarming munitions that need very small, low life, which means low-cost turbo jet engines for missiles and powered munitions and things like that. So we're off and running with that. I expect that to ramp up between now and the end of the year. And then that's going to be a significant contributor next year.

And I'm not going to be surprised, Josh, if we don't see more of those coming our way as a result of all of the new missile systems, weapon systems, powered munitions, drones that are on the drawing border that are coming online. Let me be specific on that, and I'm just talking generally here. You've seen Lockheed Martin, they've talked about Speed Racer. As you know, we're on that one. They've rolled out just a couple of weeks ago a whole new family of small aircraft that they're planning on bringing out in the next few years. They announced that a couple of weeks ago. That is perfect ground for Kratos turbine technologies and our engine business.

Northrop Grumman, they announced a couple of weeks ago or a month ago that they've got -- they're working on a jet-powered loitering munition that can get there very quickly. That's another area that's right up the sweet spot of that contract and other efforts we have going. So I see a lot of inertia in this area that ties into the thesis we've been talking about for a while and today.

Quantities have a quality all their own and affordable mass. And that's where I think the requirements are heading.

Next up, we've got Austin Moeller from Canaccord Genuity.

So my first question here -- it looks like the Valkyrie is in the process of ramping here right now. So I assume you guys must feel pretty good about this. You've got multiple service branches that are looking at or committing to purchase the aircraft now. And the closest competitors, Boeing's Bat is way behind in development relative to the Valkyrie and General Atomics' Gambit is even further behind them and then the other proposed UCAVs that are sort of in development, a lot of them are flying wings, which is useless in air-to-air combat. So if we think about that next production lot, can you sort of talk about directionally how many we should expect quantity-wise compared to the existing lot?

Yes. Not yet. But over the next several weeks and couple of months, we have a number of meetings scheduled with these potential customers and certain existing customers to talk exactly about this. Often, if things go as I currently see them, I'm hopeful -- and I put the time line out there by the end of the year. I'm hopeful by the end of September, October, we're going to have the data points, and we're going to have received certain things that are going to give us the confidence to pull the trigger, order the engines in the long leads and get going on the next lot.

And to give you a data point on this, Austin, to kind of frame it for you -- and these are by memory, so they may be off, Austin, but they're close. On the engines, we get price breaks on lots. And so like if we order 6, we get a price break. If we go to 12, we got a price break. If we go to 18 or 24, we get an even bigger price break, which drives it lower. So it's going to probably be somewhere -- and I don't use those numbers, but it's going to be partially driven by the price break we get on the engines, which also gives us a quicker slot to get them. And so those are the dynamics that we're thinking through with the customers and the prospective customers.

Okay. That's helpful. And then if we think about all the inflation that's going on, should we still expect the Valkyries -- and I know it's a lot dependent, but should we expect them sort of around a $5 million price point or closer to $10 million? I know it's still a step function below whatever the next competing drone is going to be priced at.

Yes. I'm glad you asked that question. So as you know, the Air Force's definition of attritable is $20 million on down. That's a fully missionized aircraft. The Marine Corps, as you've probably seen and has been talking a lot about attritables, et cetera, their all-in missionized price point is substantially less than that. Okay. I'm going to throw out $10 million, fully missionized.

We -- because of our target drone business and the quantities that we produce, and as you know, our tactical drones -- we use substantially the same composites, avionics, electronics, flight control, et cetera, et cetera, et cetera, we're still getting leverage there, and a lot of that is made in America. So the price increases there haven't been terrible yet. We're seeing them, but they haven't been terrible yet. So I am very comfortable that we are going to be for the aircraft and the full mission systems. And I can't get into much more than what I just said on that.

We're going to be well within those price points. And mission systems can be $3 million, $6 million, $8 million. So we are beautifully positioned because of how low cost, I'll use the word, the truck -- our truck, our flying truck is. And as you alluded to, in my opinion, any of the other players, even if they ever do get anything flying, they can't practically get anywhere near us on price -- on cost. They can't do it. They're not designed to do it.

Okay. That's very helpful. And then just one last, if I could. I think you mentioned in your remarks or earlier comments, Eric, that the Air Wolf has a radar cross-section that is considered to be interesting to the customer?

I said that they're hard to identify, is what I said. That's the term I used, and I'll stick with it. They're hard to see, very maneuverable, very hard to hit. That's what I'll use.

Next up is Noah Poponak from Goldman Sachs.

Eric, I guess the key question is, why is 2023 the year that will prove to have had the visibility, the accurate visibility on growing double digits organically relative to each of the past few years where I think you came inside of the original guidance range that was an official guidance range each of those years, but they were all described 1 or 2 years in advance as step function years or game changer years or double-digit organic revenue growth years. How can we feel comfortable that this is different?

I'm glad you asked that because I can clarify and (inaudible) to what I said. Our 10% base case growth that we're looking year-over-year '23 to '22 does not include any significant production of tactical drones. I said -- so to clarify, it doesn't include it. And if things occur, that's where I said we could substantially beat it. But our base case does not include it. The base case is driven by (inaudible) space business, target drones, GBSD, which has come online now. And we got that LOI on that microwave program, that quarter billion microwave program, we're going to be under contract by the end of the year, and it includes that. Those are some of the biggies.

Okay. That's helpful. Within the guidance for this year, if I take the full year and then I take the third quarter top line, it implies a sequential revenue growth rate, 4Q over 3Q, that's significantly higher than you had any time in the recent past. Can you speak to what drives that?

Yes. Noah, this is Deanna. So those 5 programs that we've highlighted, the 3 space satellite contracts, GBSD and the new customer that we're expecting to book on Valkyrie. Those 5 contracts comprise about over a $20 million sequential revenue increase from Q3 to Q4. So that's the lion's share of the growth that we're projecting for the fourth quarter over the third quarter.

Okay. That's helpful. And Eric, on Valkyrie, why is a new customer kind of seemingly sliding in front of some of the older customers? And you've highlighted in the past the budget dollars for the category of aircraft that have been in the few hundred million dollar range for a few years? Where is that money? Like was that not really ever -- just not ever obligated on to contract? And how I square that -- where those numbers were for a little while with the lack of orders and the revenue that you've had on the program?

I will tell you how I square it. When the Secretary of the Air Force -- the new Secretary of the Air Force came in, Mr. Kendall, he announced late last year that he was rolling out 2 new classified drone programs. And the Secretary used the term that all of the other drone programs are -- virtually, all of the other drone programs to date would be feeders into these 2 new programs. In my opinion, a significant amount of the funding on the other programs were feeders into those 2 new programs. I believe they sucked the air out of the room. I'm not saying that in any way negatively. But as we saw at Farnborough 3 weeks ago, the Secretary has now canceled one of those 2 new drone programs, which was the loyal wingman for the B-21 bomber. And I'm paraphrasing now, saying that it would take too long, it would be too far out, and they would be too expensive. So that might change again now. I don't know. So a lot clearly, Noah, as you're pointing out here, but a lot has happened, is happening in the last 6, 8 months, and really, in the last 4 weeks.

Why? I mean if they -- given their commentary about the desire to have this product, your ability to have it ready to go, is it just not needed imminently, so they'd rather figure out exactly what they want to buy before they start buying larger quantities?

So my opinion with that last part of your statement is what has been going on for the last year or two. They truly wanted to assess and figure out exactly what they wanted, which makes total sense. I totally get it. Things that have changed...

Do they now know exactly what they want (inaudible)?

I don't know. I just -- I will refer the group here to public statements. I mean there was an incredible interview with a Navy Admiral last week where he specifically talked about the Valkyrie and what that is going to be used for. He talked about it. The 4-star General of Pacific Air Force recently did an interview, and he said the -- I'm paraphrasing, the only way we can deter China is up by hundreds or thousands of low-cost affordable jet drones. This is just recently.

So I don't know if they've decided, but I know what their narrative is, and I know what has been specifically going on with our company. And we're doing everything we can to respond to them.

Next question comes from Sheila Kahyaoglu from Jefferies LLC.

Just on Noah's line of questioning. If we could think about it, Eric. You mentioned that customer potentially coming in, in Q4. How do we think about Valkyrie options into 2022? Is it contributing $100 million? Does it go to $150 million in '23? What are the range of options for Valkyrie?

Yes. So I'm going to be -- as I talked about in the last call and the one before that, I'm going to be very, very conservative. I'm going to assume we continue to execute on RDT&E and S&T money and S&T funds. I'm going to assume that we continue to do demonstration flights of different capabilities, carrying different payloads and different mission packages. And I'm going to assume that we continue to sell or lease a handful or 2 a year. That's one scenario.

The upside scenario and the data points that support this could happen or the cancellations of all these other programs, the Mosquito has been canceled. And take a look at one of our -- some of our competitors have said recently. So the upside scenario is -- what's going on in the Ukraine. I've talked about the losses of the drones, what we're seeing going on over in the Taiwan straight as we speak, that a decision is made to field affordable math with the capability that we have today that we know is flying. And so we -- next year or the year after, we get some significant production runs. That's how I see it, but I'm focused on the conservative one.

Okay. That sounds good. And then on your 10% baseline for next year potentially, what are the top 3 growth drivers of that? One, I would guess is GBSD? Maybe can you talk about what your top 3 are?

Yes. GBSD (inaudible).

Yes. GBSD, the continued ramp of the space programs.

And there are a couple of 3 of them.

Yes. There's 3 of those. And some of the production in our target drone business as well.

Okay. And then last question from me. I think you mentioned supporting Rolls-Royce and their B-52 re-engining. What's your role on the contract? And how do we think of timing of revenue there?

Yes. I don't believe that they've -- Rolls-Royce has disclosed what we're doing. But let -- so let me talk in general about what we do in that area. We are one of the industry leaders, if not the industry leader in building the ground rigs for jet engines for test and evaluation purposes, all types of testing, all types of evaluation. That is one of our expertise areas. We are an expertise area in the exotic materials that are used in all types of engines. That is another area where we are one of the industry leaders. And so those would be the types of areas that a company like Rolls-Royce would come to us on.

And then on the second part of your question, as you know, we just received that initial contract. It is growing. It's expanding. I can't get into numbers, but it's a big program for us. It tends -- it's a big program. And it's expected to begin ramping in Q4 and then it will ramp in Q1, I think. And then it's going to flatten out a little bit because some of the big work we're doing, including materials is Q4, Q1.

The next question comes from Peter Arment from Baird.

On the space business, Deanna mentioned that a lot of it is licensing. And so that's obviously less of the top line story, better on the margin. What do we think about is the margin opportunity when we're looking at space compared to what you report today?

Yes. So our -- it will be different probably for government versus commercial because there are certain limitations on the government side that there aren't on commercial. But our mid- and long-term view is mid-teens, profit margins for our space business. And the reason I'm saying that is because we've gone -- if we're going to a more of a software model, so there's significant R&D and continued development on next versions. I talked about that in my prepared remarks.

In addition to that, let me just throw this piece in there. As you know, we build, manufacture and deliver very sophisticated antennas, okay? Those antennas can have a lower margin than the software side. And the antennas business is very lumpy depending on the stage of the ground deployment for the base station we're building. And so those can be mid-single digits, not even high single digits, mid-single digits because it's a hardware type thing, and it's really not all that unique. And so one quarter, the space business could be very, very high, but another quarter could be lower because we delivered significant antennas in that one. So think of blended mid-teens.

Okay. That's helpful. And then just regarding your space business. Just, it's your largest business, how long do you expect it to be your largest business? Ultimately, what I'm asking is, when do you think Unmanned can kind of overtake it?

In my conservative view, Unmanned will not overtake space for the next several years because our space business, Peter, it's ripping. And we may have a tiger by the tail here. We are first to market with the total software-based virtualized ground system. We're 2 or 3 years ahead of everybody else. We -- the first 3 big programs we went for, we won. As I said in my remarks, we're lined up to win some more. And I think we're going to -- and I've gone through on previous calls on why this is such a big differentiator. So in the base case, the space business will continue to be the lead horse. In the upside case, the drone business in a couple of 3 years could pass it.

That's helpful. And just related to your drones, just -- any updates on (inaudible), just we don't hear as much about that recently? So maybe if you could just give us your thoughts there.

Yes. So let me -- Peter, I have to answer it this way. The most, if not all, of the previous drone programs have become feeder programs into other programs that are all classified.

And next up, is Pete Skibitski from Alembic Global.

So guys, pretty solid revenue in the quarter. I want to make sure I understood, Deanna, your comments about the reduction in the operating income guidance. Obviously, you had the $5.5 million charge in the quarter. Is the whole rest of the balance all due to inflation? Or were there any other, I don't know, negative EAC adjustments at all that impacted that guidance?

All due to inflation.

And primarily in Q3 because we're substantially firm fixed price contracts. And we can't pass it on in the existing contracts or the existing price options. So we just (inaudible).

And in terms of the recovery -- recovering that inflation through the contracts. Obviously, you have a positive mix in the fourth quarter, but is it reasonable to assume that first half of '23, you'd still be kind of in process of repricing your contracts? So hopefully, by the back half of '23 is when you kind of make up all the inflation that we're seeing this year.

Yes. Yes, sir. It's a process of the existing contracts or options, which are typically 1 or 2 years priced transition off. And the new negotiated ones or the new wins come in.

Right. Okay. Okay. And then on the charge, the $5.5 million charge on the training program, does that impact kind of the go-forward revenue from that customer? Were there -- I think it sounds like maybe international targets? Any color you provide there?

Yes. So we have not had any other work with that customer since the original contract of 2011. So it should not impact any future revenue streams.

Obviously, you haven't generated revenue there for a while on that one.

That's correct.

I see. Okay. Okay. Okay. Last one for me, Eric, on open space, you're winning new contracts, but I feel like I've been hearing about development for a long time. So I just want to make sure I understood this. Is kind of the core development of open space completed? Or is there -- do you kind of have to do some bespoke R&D every time you get a new customer? Is that how it works? Can you help me kind of understand the business model there?

Yes. So think of it like an operating system, okay? So like on your Apple iPhone, the iOS system. So the operating system for space ground infrastructure is substantially complete, if not complete for the existing customers. R&D now -- think of the apps on the operating system. And so the apps in the space area -- think of like modems. They're all hardware right now. All the different types of communication modems that are not just related to satellites that are on drones or aircraft or ships, we're turning them into software. And you can just think about what -- instead of having a rack of all types of different modems or communication systems on a drone, now you have just code, okay?

So the R&D is for -- in my example here is for the apps. And think of it on the operating system. Each customer is probably a little different. So there's some R&D -- I'm making this number up, 10% or 15% to modify that operating system for that specific customer. But it's substantially done as you can see when the program wins.

Okay. At this time, I'd like to turn it back to Eric DeMarco for closing comments.

Great. Thank you all for joining us this afternoon. And truly, for the interest and the questions, we'll circle up with you at the end of Q3.

Okay. Thank you for your participation in today's conference. This concludes the program, and you may disconnect.