Kratos Defense and Security Solutions Inc

NASDAQ:KTOS

Earnings Call Transcript 2020-Q2

[Operator]

Good afternoon. My name is Jerome, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Kratos Defense & Security Solutions Second Quarter 2020 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions]. Thank you.

And I would now like to turn the call over to Ms. Marie Mendoza. Please go ahead.

[Marie Mendoza]

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions second quarter 2020 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.

[Eric DeMarco, President and Chief Executive Officer]

Thank you, Marie, and hood afternoon. Kratos continues to follow what we believe to be industry best practices during the continuing COVID-19 crisis, including working at home where practical, social distancing, facility cleaning, temperature checks and only mission essential travel occurring. We also continue to monitor and work closely with our supply chain and vendors, identifying and formulating additional sources and backup plans where we can for critical or potentially vulnerable sources to Kratos’ programs, and we have had no significant supply chain impacts to date.

Though our primary customers, United States’ government and the Department of Defense, work at home, social distancing and travel restriction requirements continue to impact the timing of certain expected contract awards and delay certain planned for system flights at government ranges and the achievement of certain contractual milestones, including customer product acceptance. The Kratos team continues to successfully adjust, adapt, manage and execute in a challenging environment.

As you know, Kratos is a technology company and at Kratos, affordability is a technology. Our proven leading technology system integration approach designed to reduce financial and scheduled risks, accelerate development, testing and fielding and lower costs, continues to be strongly desired by our customers and we believe it is an important competitive differentiator for our company. We also expect that Kratos’ venture capital and commercial base rapid system development, fielding and overall affordability business model, will be even more valuable to our customer base in a future environment, which includes increased federal government deficits and potential reduced discretionary spending.

We believe that Kratos, as the affordable alternative technology company and system provider, is in the right place at the right time with the right products and at the right price point, for today's environment to address U.S. mission critical national security priorities. The recapitalization of strategic weapon systems continues to provide a growing and overall strong market opportunity, environment for virtually all of our business areas, as represented by our 1.2:1 book to bill ratio in Q2 and our approximate $8 billion bid and opportunity pipeline. In the second quarter, Kratos' space and satellite communications business continue to transition to a software defined based business, including a focus on low Earth orbit, mid Earth orbit and geostationary orbit satellite systems and as related to missile defense and hypersonic system applications.

Within Kratos’ space division, we have been making substantial investments to create the world's first dynamic digital space round product family. With the coming of 5G and new software defined spacecraft, the intersection and integration of space and terrestrial networks, particularly for mobility based defense and commercial applications has become very clear. Additionally, new developmental programs, such as hypersonic and ballistic space tracking sensor, or HBTSS, and tactical intelligence targeting access node, or TITAN, will require a new and resilient dynamic ground infrastructure.

Accordingly, a new Kratos product family, the first of which we expect to begin to deliver in Q1 of ‘21 is designed to enable spacecraft and satellite operators to securely connect, operate and manage within terrestrial software defined networks, providing a seamless space to terrestrial ground platform. We believe the same technology can also be used as part of the $1.5 billion plus investment necessary for clearing the C-band spectrum within the U.S. for 5G. And we are in discussions with many of the satellite operators as they begin their transformation to digital infrastructure. We are very excited about Kratos’ 5G and our dynamic software defined strategy.

In the second quarter, we announced the acquisition of ASC, an antenna system and technology leader, positioning Kratos to be an even more comprehensive space and satellite communication systems provider to our DoD, national security and other customers. ASC fits squarely in Kratos’ stated strategic model of being a unique differentiated technology product and system provider and being either number one or number two on our market space. In our space business, we were recently informed that one of our largest and most important contracts, which was coming up for recompete at the end of this year, has now been extended by the customer with Kratos through the end of 2021. This is an outstanding piece of news for our company that Kratos now has only significant recompete coming up at the end of this year 2020, which is in our training business.

Representative space programs Kratos supports include OPIR, SBIRS, WGS, AEHF, MUOS and GPS and we are currently forecasting our space business to have a strong Q3 and Q4 of this year. Our KTT and engine business, next generation and affordable system development initiatives and programs, which are focused on the expected to be extremely large attritable, expendable and reusable jet drone and tactical missile markets remains on track and on budget in Q2. At this time, we have several Kratos next generation affordable engines in our class running, including for the Gray Wolf low cost cruise missile system, which was recently reported.

As I mentioned, Kratos’ affordable high performance engines are focused on new and planned for cruise missiles, powered weapons and drone systems, including as would be associated with the Skyborg and Golden Horde Vanguard programs and also ABMS. Our objective is for Kratos’ engines to be disruptive market and industry growth driver similar to our expectations for Kratos’ high performance jet drones. The class of engines Kratos is focused on is typically the number one bill of material cost item in the related system, and our plan is to deliver more efficient, powerful and capable engines at a significantly reduced cost so that more capable systems can be procured in larger quantities at lower prices.

We also see our engines further increasing Kratos’ drone and tactical weapon system’s affordability and low cost competitive advantage, while bringing greater value to the customer set. We are currently forecasting to achieve certain important ground and flight test milestones in our engine businesses in the second half of this year and next year, and we believe that we are on track for our plan to achieve future production for our engines.

As we discussed in our first quarter call, KTT’s commercial business areas are being adversely impacted by the global COVID-19 pandemic. And as a result, KTT’s financial performance for the second quarter came in below our expectations. Unfortunately, this impact is now expected to continue throughout the remainder of 2020 with the current estimated impact being incorporated in our updated financial forecast. Kratos’ C5ISR business continues to perform well, including a large second quarter missile defense related contract award. Our C5ISR business supports missile defense, space and satellite, strategic triad, the unmanned drone area, high power directed energy, combat and other systems.

As previously reported, earlier this year, Northrop Grumman announced that Kratos' C5ISR is part of the Northrop ground based strategic deterrent team, and we are looking forward to supporting Northrop, an incredible partner of Kratos’, on this critically important national security program. On the $50 million contract award that Kratos received early in Q1 of this year, which was subsequently protested by a competitor, the customer is currently going through a procurement reevaluation and we are waiting the determination. We are currently forecasting strong revenue and EBITDA performance in the second half of 2020 for our C5ISR business unit with a significant amount of the expected production and deliveries, driven by 2.4:1 second quarter book to bill ratio for this business.

Kratos’ Israeli based microwave electronics business continued to perform strongly in the second quarter of 2020, as we increased production on certain programs and we are currently forecasting significant revenue and profit growth in the second half of this year as compared to the first half as these programs ramp. The electromagnetic spectrum and microwave electronics area are two of the highest priority and well-funded areas in both the United States and internationally. And the U.S. and its allies pivot and focus the potential peer near peer conflict and Kratos' microwave business is uniquely positioned to address and grow in this mission critical area.

Representative systems Kratos' microwave business supports include F-15, F-16, Gripen, Iron Dome, Barak, Spyder, Arrow and Sling of David. Kratos' rocket support services business had a very solid second quarter, and we are expecting continued solid performance for the second half of the year for this business. RSS is currently working on a number of ballistic missile target and other program launch systems with Kratos' 2021 mission launch portfolio looking very substantial, based on current production and the launch manifests.

Similar to Kratos' satellite, C5ISR and microwave electronics business areas, RSS is uniquely positioned in the well-funded missile defense and hypersonic program opportunity areas. Kratos' training solutions business had lower than expected revenues and EBITDA in Q2, and we are focusing on a large international program recompete at the end of this year that I mentioned previously.

Our unmanned target drone system’s business continued strong execution in the second quarter with the U.S. Navy, Air Force and Army being our primary customers. We continue to track towards full rate production on the Navy SSAT and another program, increased future quantities with the U.S. Army and the U.S. Air Force and we're tracking for our annual revenue target drone objective of $0.25 billion in revenue.

International target drone demand also remain strong, driven by systems testing and evaluation requirements related to the recapitalization of weapon systems. And we are currently expecting two large drone system orders in the second half of the year. Since our last report to you, we have continued to make significant progress in Kratos' tactical drone system business with a total addressable market opportunity for this class of drone and for the engines they utilize continuing to expand.

At the end of July, it was reported that Kratos was one of four recipients of an $400 million ceiling MAC, Skyborg, IDIQ contract. Skyborg, one of three U.S. AF Vanguard programs outlined in the Air Force Science and Technology 2030 initiative, is an affordable unmanned system that will partner with fighter jets and utilize artificial intelligence to conduct strikes and intelligence collection missions that are too dangerous for manned aircraft, significantly increasing capability and being a forced multiplier of the United States Air Force.

The Vanguard initiative’s objective is to accelerate the time it takes to go from research to operational use, and the U.S. AF has stated that it want Skyborg to be a program of record and drones to be fielded and operationally capable by 2023. Under the Air Force’s Skyborg program, as reflected in the recent Air Force video, there are envisioned to be multiple types or classes of drones, including expendables like Kratos’ AirWolf, reusables, like our Gremlins or our Mako, attritables, like our Valkyrie and exquisites, like certain Kratos’ other program drones.

With these various drone classes and mission specifically designed for permissive, contested and highly contested environments. We believe that in addition to Kratos’ partnership with the Air Force on the XQ-58A and other related initiatives, we are uniquely positioned for future Skyborg the opportunity, including the Valkyrie program, which is a partnership between the Air Force Research Laboratory and Kratos to develop semi autonomous drones that can work in concert with unmanned fighters. The Valkyrie is affordable. It is flying today. It is not a model, a PowerPoint or an exquisite high cost aircraft. As part of Kratos’ partnership with the USAF on the XQ-58A, we have two Kratos owned Valkyries in inventory that can be utilized or delivered to the Air Force immediately, and we have a hot production line with the first of an additional 12 Valkyries currently scheduled to come off the line in March of next year with an additional one or two a month thereafter.

Kratos is currently producing approximately 150 jet drone systems in this class a year in the United States, including our tactical Mako, Gremlin, AirWolf and Valkyrie systems, each of which are flying today. As a result of Kratos’ long production experience with this class of drone, Kratos’ supply chain, our vendor base, subcontractors and partners, are all on board and in place, producing and delivering product in quantities today. As a result, we know the build time and actual cost to manufacture and produce our drones. There was no guessing and no expected large cost overruns or surprises to our customers from what we quote them.

As I mentioned, Kratos’ drones are made in the United States of America in concert with our U.S. government partners and U.S. based suppliers. Through our partnership with U.S. Air Force, all Kratos drones, including the Valkyrie, are designed from inception to be runway independent, both at launch and at recovery. As a result, the Valkyrie can be predeployed and recovered virtually anywhere and has certain unrefueled range, performance, payloads, survivability and other characteristics, all of which were determined in concert with our partner, the Air Force Research Lab.

The Kratos Valkyrie was also specifically designed to fit inside standard shipping containers, further reflecting the expeditionary nature of the Kratos systems. Kratos’ tactical drone systems, those flying today and in development, including in our very close hold ghost works, are all a result of a multiyear strategy plan and methodical execution, beginning with the DoD unmanned systems strategic roadmap and the evolving Air Force vision, including as described by the Assistant Secretary of the Air Force, Dr. Roper and the Air Force Chief of Staff, General Brown.

For Skyborg, the most current expected timeline and related milestones as recently reported by the Air Force include a kickoff meeting with all four Skyborg winners invited, followed by the down select for drone system experimentation. The Air Force deciding in the next 60 to 90 days which of the four Skyborg prototyping competitors will have their drones participate in operational experiments at multiple test centers around the country to produce the services first autonomous vehicle for manned unmanned teaming. The number of contracts the service will award for these exercises, as well as the number of drones procured overall and from each individual vendor, will depend upon USAF, funding availability and drone unit pricing.

The Air Force has identified roughly 15 different mission sets that the program seeks to prove in an effort to achieve operational capability for the Skyborg drone. Information and data from the drones provided flights and experiments will assist in determining the ultimate timeline for the planned program of record and rate production. We believe that the Air Force Vanguard Skyborg program is planned to move ahead very rapidly, including the Skyborg program.

We believe that the total addressable market opportunity for Kratos' class of drone systems and for our engine business is continuing to increase with program opportunities that we can discuss, including Golden Horde, ABMF, LCASD, LCAT and ACE, all of which we believe that Kratos' Valkyrie and other drones are uniquely qualified to rapidly and affordably address as I previously discussed.

Related to the market opportunity, as I mentioned before, I encourage you to view the Skyborg Air Force Vanguard program video, which provides the USAF vision and notes the various types of Skyborg drones that are part of the Air Force's planned future force structure and ConOps. Additionally, it was just reported that the Air Force recently disclosed their vision for expendable, attritable and other drones as related to the ABMF program, including price and cost points, which we are all very excited about.

In addition to the Kratos Valkyrie, as to certain other Kratos tactical drones we can discuss, our Mako jet drone continues to execute with certain customers and platforms, including as was recently publicly reported, the Gremlins program with our partner, Dynetics, has made important progress since our last report to you even with the program experiencing certain COVID-19 DoD range related other delays. Additional flights are now scheduled for Q3, Q4 of this year and we fully believe and expect Gremlins to become a major future Kratos program similar to our expectation for Valkyrie.

Kratos' Thanatos program is on track and we continue to have high future expectations for Thanatos similar to our expectations for Valkyrie and Gremlins. On our Rattlesnake program with our partner AeroVironment, this has also made substantial progress since our last report to you and is currently expected to fly later this year based on current range scheduling, which has also been delayed due to COVID. And program AirWolf has also continued to move forward, including certain payload and system integration efforts. However, similar to Kratos’ Rattlesnake, ABMS, Gremlin and other programs, our planned AirWolf flights have been delayed due to the impact of certain DoD range and travel COVID-19 related restrictions with a series of AirWolf flights now scheduled for later on this year and in Q1 of 21, and we also continue to have high expectations for this program.

We’re extremely excited and proud of what Kratos has accomplished, and we remain focused on our long-term strategic objective of being a leading drone system provider to the DoD in this expected to be extremely large new market space. We understand that the government processes and related timelines for contract awards, system deployments, test flights et cetera, can be methodical and fluid and are not always consistent with desired public company expectation timelines. I can assure you that at Kratos, we are focused on what we can control and the ultimate success of the long term strategic plan and vision we have communicated to you.

As I mentioned before we believe that we have the future tactical drone system market will be in the billions of dollars and various types of drones system, some opportunities in the Kratos class. We believe that we have the right partner, the United States Air Force, the right high performance drone systems at the right time and at the right affordable cost point, to obtain a large market share and deliver value for our customers and our shareholders. Deanna?

[Deanna Lund]

Thank you, Eric. Good afternoon. Kratos’ second quarter of 2020 revenues of $170.4 million slightly exceeded our estimate of $160 million to $170 million. KGS reported revenues of $128.4 million, down from $145.4 million in the second quarter of 2019. As expected, our second quarter 2020 KGS revenues were impacted by a reduction of approximately $12.1 million in the company's training solutions business, which reduction was principally related to the previously disclosed reduction in scope of certain international contracts.

KGS’s second quarter 2020 revenues also reflect the continued reduction of approximately $3.6 million in the company's legacy government services business and reductions of approximately $6 million in the company’s international satellite communications deployment business and $3.3 million in the company’s KTT commercial aerospace business area, which have both been impacted by COVID-19. Organic revenue growth in the second quarter of 2020 was experienced in our microwave products, ballistic missile defense and C5 ISR businesses.

Our adjusted EBITDA of $15.3 million was in our expected range of $12 million to $16 million. Kratos’ adjusted EPS of $0.08 per share also was within our forecast of $0.05 to $0.09 per share for the quarter. GAAP EPS was a loss of $0.01 per share. At the second quarter, our unmanned system segment generated adjusted EBITDA of $3 million, down from $3.5 million in the second quarter of ‘19, primarily reflecting the higher mix of development programs, including Thanatos and low rate initial production programs, which are typically lower margin programs than full rate production programs and also reflecting increased infrastructure costs. This increased mix of development programs is expected to continue into 2020 until certain new production awards or increases in existing production programs are received.

KGS generated adjusted EBITDA of $12.3 million, down from $15.7 million in Q2 of ‘19 and operating income of $7.7 million, down from $10.7 million in Q2 of ‘19. a more favorable mix of operating margins and adjusted EBITDA margin in the company’s space and satellite, C5ISR and microwave products businesses in Q2 '20, were offset primarily by expected less favorable margins and the company's training solutions business as a result of the completion of a large international fixed price contract at the end of 2019, and due to a less favorable mix in the company's turbine business.

Our Q2 consolidated operating income was $2.9 million, down from the second quarter of '19 operating income of $9 million, reflecting a higher mix of development programs, increased infrastructure costs, an increase in non-cash stock compensation expense of $2 million,

increased R&D expenses of $1.5 million, primarily in our space and satellite business and increased depreciation expense of $200,000.

Our adjusted EBITDA for the second quarter is from consolidated continuing operations, including net income or loss attributable to non-controlling interest and excludes non-cash stock based compensation costs of $4.8 million, acquisition and restructure related costs of $1.1 million and foreign transaction loss of $100,000. On a GAAP basis, net loss for the second quarter was $700,000, which includes a tax benefit of $1.8 million and loss from discontinued operations of $200,000.

Moving on to the balance sheet and liquidity. Our cash balance was $397.2 million at June 28th, which includes $240.5 million of net proceeds raised in the company's June equity offering. At quarter end, we had zero amounts outstanding on our bank line of credit and $5.7 million of letters of credit outstanding. Debt outstanding was $295.9 million at quarter end and net cash at quarter end was $101.3 million.

Cash flow generated from operations for the second quarter was $6.8 million less CapEx of $7.7 million for free cash flow used from operations of $900,000. During the quarter, we collected $600,000 related to the retained working capital of the legacy PSS business that we sold in 2018, bringing the total receipts we have collected to $6.2 million since we sold the business. Our contract mix for the quarter was 74% of revenues generated from fixed price contracts, 20% from cost plus fixed price contract -- fixed fee, excuse me, and 6% generated from time of material contracts. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 76%, including revenues generated from contracts with the DoD, non-DoD federal government agencies and FMS contracts, which were approximately 5%. We generated 8% from commercial customers and 16% from foreign customers.

Our third quarter and full year 2020 guidance includes the expected contribution from the recently closed ASC Signal acquisition. We're providing third quarter 2020 guidance of revenues of $195 million to $205 million and adjusted EBITDA of $17 million to $20 million. We are increasing our full year 2020 guidance for revenues from $720 million to $760 million, to $740 million to $780 million, primarily reflecting the expected contribution of the ASC Signal acquisition for the second half of 2020. We are maintaining our adjusted EBITDA full year guidance of $72 million to $78 million, which reflects the expected contribution from the ASC Signal acquisition, offset primarily by margin compression in our commercial aero turbine business, which has been impacted by COVID-19.

We are affirming our full year 2020 free cash flow guidance of generation of $7 million to a use of $18 million, including capital expenditures of approximately $38 million to $42 million. Our third quarter and full year 2020 guidance includes our current assumptions of the expected impact of COVID-19 on our industry, business and operations. We will provide an update to these assumptions and the expected impact to our financial projections, if any, in our third quarter earnings conference. Our adjusted EBITDA guidance reflects an overall forecasted improved revenue mix and profitability in our DoD and national security business areas, including in our space, satellite unmanned systems and microwave electronics operations.

Kratos’ fiscal year 2020 guidance excludes any potential contribution from expected Valkyrie or other tactical drone production or system contracts, with expected orders to be taken into consideration and our financial forecast adjusted once such for contracts or orders are received and the related financial contribution can be estimated. The 2020 capital expenditure forecast currently includes expected outlays of $15 million to $17 million associated with the production of 12 Valkyrie aircraft prior to receipt of expected customer awards and therefore, reflected as company owned tactical drones until receipt of the related customer award. At which time, the costs incurred maybe transferred to project costs. Kratos will adjusted these initial forecasted capital expenditure outlays and the ultimate balance sheet classification of these investments, once expected customer orders and the nature of the contract terms and related financial contribution can be estimated. Eric?

[Eric DeMarco, President and Chief Executive Officer]

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

[Operator]

[Operator Instructions] Your first question comes from the line of Josh Sullivan from Benchmark. Your line is now open.

[Josh Sullivan, Benchmark]

On Skyborg, congratulations on the win. How should we think about IDIQ past quarter, you got the end of this fiscal year coming up. Is there an impetus to make an award? And then can you just remind us what's in the budget for ‘20 and ‘21 at this point?

[Eric DeMarco, President and Chief Executive Officer]

So Josh, as the Air Force has tried to give guidance publicly, we're in source selection right now. So we really can't say much more than what we've said in our prepared remarks, which a week or two ago the Air Force indicated that they would like to make the first task order award within 60 to 90 days and that was a couple of weeks ago. The Air Force made that comment. On the funding specifically for Skyboag, the Air Force recently made a comment that they have adequate funding to execute what they've been articulating for both this year and all of next year. They've said that, they said adequate.

As you know, Congress has made a couple of -- they've made one congressional add that's law that added $100 million to, I think they had like $120 million on their RD&TE accounts last year for things like this. And right now there's a negotiation going on between the senate and the house on the ‘21 budget. I think the senate had looked for an add of like $128 million. So what appears there's adequate funding for them. I'm going to say, you know, a couple of hundred million each year based on looking at the different accounts, to execute what they want to get done tracking towards program of record, as they’ve said in the following year.

[Josh Sullivan, Benchmark]

And then just under the new Trump administration interpretation of drone export

rules. Can you talk about your exposure to that and any international interest in the drone portfolio at this point?

[Eric DeMarco, President and Chief Executive Officer]

Yes. So, first of all, I want to be very clear. We are focused primarily on the United States Department of Defense and the Pentagon. That's where we are focusing the vast, vast majority of our resources. We have received State Department approval to discuss market, both the Valkyrie and the Mako in a number of countries and I think five eyes and maybe beyond that. It is getting a little competitive in a couple other countries internationally. And so I don't want to get into too many details, because we've got some plans that we're going to be, that we're executing. But we’re primarily focused on the U.S. and let's say that there are a couple of them internationally that we were executing some plans that are very confidential right now.

[Josh Sullivan, Benchmark]

And then jus switching over to the space opportunity. You talked about software defined solutions. How do you see this developing? What's the mote Kratos have around that? We saw the terrestrial communication systems like [jitters] walk down this road. What are your thoughts about the market size? How much of it can you capture if you could talk a little bit about that?

[Eric DeMarco, President and Chief Executive Officer]

This was one that has kind of overshadowed about what we're doing in the drone area. But the number of LEOs and MEOs that have gone up and that are going up and the number of spot -- we’re going more to spot beam, satellites and high throughput satellites, this is driving an entire next generation of ground equipment and all this obviously ties into and relates to what's going on with 5G and converting analog signals up in space and to IP protocol systems and 5G on the ground.

And this is what is driving our software, I call it, our software defined radio space platform strategy, where instead of us making the ground equipment and the modems that talk to large monolithic geostationary orbit satellites that are 22,000 miles up and everything is siloed and specific for it, the equipment that we're delivering now and the new stuff that we're going to be delivering next year, as I mentioned, is going to be able to talk to multiple different types of satellites, on multiple different types of bands, it’s going to be able to hop between military satellites and commercial satellites and go into the 5G infrastructure.

And we have, in addition to our space individuals, we have a number of telecommunication individuals from the telecommunication industry on staff in leadership positions that are driving the strategy. And as I mentioned, we're actually working with the operators on it. So, this is the plan that we have, what we're looking in the next year or two, Josh, for our satellite business to start growing 10% to 20% a year organically again that's what we see here.

[Operator]

Your next question comes from the line of Ken Herbert from Canaccord. Your line is now open.

[Ken Herbert, Canaccord]

I first wanted to just ask you, you called out, Eric, a couple of potentially large target export drone contracts you could sign in the second half of this year, maybe in the fourth quarter. Can you just provide a little bit more detail on those and clarify whether or not those are currently reflected in the guidance for the expectations, because those represent perhaps some upside?

[Eric DeMarco, President and Chief Executive Officer]

So they are both international. One of them is an existing customer but this would be a significant increase in the quantities that they're talking, it’s approximately two dozen drones with one of them just under. And the other one is a new customer, brand new and it's tying directly into what I mentioned, Ken, is these customers are procuring new weapon systems, new radars and they want to exercise and improve them out against threat representative drones. And we make the highest performance drones in the world that's just unknown both in the target area and in the system area.

Relative to the guidance, as you said, I'm hoping and I think we're going to get these, both of these in Q4. They really won't be additive until for us until next year, because unlike say for like the U.S. army where we'll build drones in advance and put them in inventory or put them in capital so we can quick turn them. Since these are international, we don't lean forward, if you know what I mean, until we’ve got them. And so once we get them, we'll get rolling on them. And so these really will kick in next year for us.

[Ken Herbert, Canaccord]

And as I think about your engine business, both TD and KTT, you've obviously been able now to publicly talk about Gray Wolf and what you're doing there. Could you maybe just comment on what some of the next catalyst could be in this business or contracts we should potentially watch out for?

[Eric DeMarco, President and Chief Executive Officer]

I think the catalyst, as you know, we have not talked about Gray Wolf. It has been publicly reported a couple of times, including a couple of weeks ago and that's part of the government contracting and working with national security customers. The next catalyst that I believe that we can control and I am hopeful we will be able to communicate on the next earnings call and then I think the one when we report Q4 in early next year, if our timeline hold on some things, there could be some significant catalysts are some of the ground tests in air vehicle tests that we're doing that we're planning to do.

And if these go according to plan, hopefully, I'll be able to give some direction on -- I may not be able to say the program, but I'll be able to say we're on a certain program and this was the trajection as we start delivering units and we head into LRIP and maybe full rate production later on. I'm hoping to be able to frame that up. But you picked up on it, we're making great progress and we're getting there. And there was one in particular the KTT is working on that we have not talked about, but this could be the first one where we could have meaningful unit revenues next year.

[Ken Herbert, Canaccord]

And just one final clarification, you called out a couple of times the COVID related disruption on the commercial business within KTT. Can you maybe size what that was in the quarter, either in an EBITDA or revenue standpoint or was it relatively immaterial?

[Deanna Lund]

So, Ken, on the commercial turbine business that's about $3 million to $5 million impact from a revenue perspective in the quarter.

[Operator]

Your next question comes from the line of Mike Crawford from B. Riley. Your line is now open.

[Mike Crawford, B. Riley]

So can you talk about the ABMS? So are you qualified on all seven lines of that effort? And then you said there was some information about the cost ranges for these different categories of vehicles, be they attritable, expendable, whatnot?

[Eric DeMarco, President and Chief Executive Officer]

So on the first one, I am not going to -- I apologize, because it is competitive. However, on your second question, there was an article that came out last night. I believe it was an aerospace Aviation Week or something like that, where they talked about, they reported on an ABMS briefing, where they talked about four ABMS, which is the Internet of -- which has been categorized, or called, or referred to as the Internet of military connectivity. Then I believe they're looking at disposables, attritables and exquisites. The disposables were zero to 3 million, I believe. The attritables were 3 million -- it was zero to five, five to 20 and 20 and above. And those were the price points. And they gave some examples of the types of drones. And one of the actual briefings from the Air Force there were two renditions that looked awful close to a couple of ours. So the point of that, Mike, is it's not just Skyborg, it is not just Golden Horde and the LCASD program, but it's also ABMS, it's what DARPA is doing with ACE and there are several more. The opportunities for this class of drone is it's growing and it's accelerating.

[Mike Crawford, B. Riley]

And then final question, I know you probably can't talk per se about what your Skyborg competitors are proposing for vehicles. But do you think that you have a good sense of which aircraft each of the other three competitors would be positioning to get onto some of these programs?

[Eric DeMarco, President and Chief Executive Officer]

Absolutely.

[Mike Crawford, B. Riley]

Okay, you're confident…

[Eric DeMarco, President and Chief Executive Officer]

Yes, we are highly confident. As always, we're confident in place. And Mike, as I went through in the prepared remarks on why we're confident, we're building them today. The supply chain is in place. Four of them are flying today. Our partner is the Air Force Research Lab, on and on and on. And we we’re highly confident that we are the solution that they are looking for in this first round.

[Operator]

Next questions are from the line of Peter Arment from Baird. Your line is now open.

[Eric Ruden, Baird]

Actually, I’m Eric Ruden on the line for Peter. I guess first off just a housekeeping question. In terms of timeline on the Skybog, I know last quarter we were talking about a fifth test flight concurrent contract award in August, September timeline. Is that now replaced by the 60 to 90 day timeline you mentioned or the down select, or am I confusing those?

[Eric DeMarco, President and Chief Executive Officer]

Yes, you're just a little confused. The fifth flight was not related to Skyborg, it was related to the LCASD program. And so that is not correlated to Skyborg, they are mutually exclusive.

[Eric Ruden, Baird]

So is that timeline still on track for the August, September then?

[Eric DeMarco, President and Chief Executive Officer]

On which timeline, which one?

[Eric Ruden, Baird]

The fifth test flight?

[Eric DeMarco, President and Chief Executive Officer]

No, I don't know what's been publicly announced on this, but let's just say events have changed so that fifth test flight, we don't need to refer to it as that anymore. We've achieved everything we needed to achieve under that program and the flights we completed.

[Eric Ruden, Baird]

And then switching gears a bit, on the ASC Signal acquisition, I saw you added $20 million of the revenue for this year. But any color you can provide on the annual run rate and just margin profile going forward?

[Deanna Lund]

For the $20 million of revenue that we expect to contribute for the second half, it’s roughly about $1 million to $2 million of adjusted EBITDA for the second half associated with that $20 million.

[Operator]

Your next question comes from the line of Sheila Kahyaoglu from Jefferies. Your line is open.

[Sheila Kahyaoglu, Jefferies]

Eric or Deanna, because it's a numbers question. I just wanted to talk about the puts and takes for the first half versus the second half. I think you mentioned about 5 points of COVID impact to the top line in the first half. So that will help you from the down 3% organic you have. But how do we get to growth in the second half? You had mentioned some C5ISR contracts. Maybe can you talk about the growth contributions in the second half in terms of revenue for 2020?

[Deanna Lund]

So on the unmanned side, we are expecting awards from a production perspective on some of our programs so to go into full rate production. On our Navy program, that’s one of the expectations for the growth from the first half to the second half, as well as some of the contract awards that we've seen in our C5ISR business and in our microwave products business, and the anticipated production and deliveries in the second half, as well as on our space and satellite business.

[Sheila Kahyaoglu, Jefferies]

And does that also help profitability then in terms of the business contributions…

[Deanna Lund]

Yes, so it's a more favorable mix as well as leverage on the infrastructure costs.

[Sheila Kahyaoglu, Jefferies]

And then Eric, one for you. I guess I can't help but notice you mentioned 5G comments and there was some speculation about Kratos and potential partnership with another large prime. How do you think about your business just given the runway and opportunity that you have?

[Eric DeMarco, President and Chief Executive Officer]

Our space business, as you know, I've referred to…

[Sheila Kahyaoglu, Jefferies]

To total company, sorry, total company, I apologize…

[Eric DeMarco, President and Chief Executive Officer]

For Kratos, we have never been better positioned across the entire company than we are today. All of the work the team has put in on the development programs, on getting designed in positions in our microwave business, our 5G and digital strategy in our space business that we've been working on, we just don't talk about it a lot. I think I mentioned we're talking to the operators. It's all coming together. And our target drone business continues to just cruise track right along. Obviously, the tactical business, as I mentioned the total addressable market, it’s not only getting bigger but it appears to be accelerating. We feel great right now, probably better than we've ever felt for the company.

[Operator]

Your next question comes from Seth Seifman from JPMorgan. Your line is now open.

[Ben Arnstein, JPMorgan]

This is Ben on for Seth. I wanted to quickly ask about, give us some more color on the training, recompete that you mentioned that I guess is up for the end of this year. Just kind of, how should we think about the potential headwind from that in case you can extend that?

[Deanna Lund]

So Ben, the contribution this year for that contract is at roughly about $35 million and that will be up for recompete at the end of this year.

[Ben Arnstein, JPMorgan]

And I noticed that the CapEx guidance has come down since the beginning of the year. I was just kind of wondering what was driving that production in your expected spend?

[Deanna Lund]

It's actually classification related. So if you noted, some of the commentary we put on CapEx that the classification on the balance sheet could potentially adjust to other balance sheet items, depending on the nature of the contract. So, for instance initially we had included in our CapEx guidance about $4 million to $5 million of capital targets for our Firejet or our 178 target. Now that those contracts have been awarded, those have actually been reflected in inventory. So it's not necessarily a change in total investment but it's just a change in classification on the balance sheet.

[Operator]

[Operator Instructions] Your next question comes from the line of Michael Ciarmoli from Truist Securities. Your line is now open.

[Unidentified Analyst]

This is Amanda on for Michael. I just had a quick question on some of the flight testing that you have later in the year or early next year. Is any of that dependent on whether there is a vaccine or solution for COVID? Just wondering if there's any risk in the ongoing environment for it to get pushed out further.

[Eric DeMarco, President and Chief Executive Officer]

On the first part, I truly do not know if it's dependent on that, it's customer driven. And we are working very closely with the customer, the DoD and honoring and respecting their protocols and restrictions, including travel and social distancing and getting in command centers and things like that. The information I provided today is the most recent information on what is currently scheduled for our flights. And we have a number of other programs that we don't talk about for obvious reasons that are scheduled for flights as well. So that's the most recent information. I'm hoping things to move to the left. But as you indicated correctly, we've had a few moves to the right from when we last spoke to, because the virus situation just got worse. And so I know it's not crystal clear but that's the best we can do. We're literally giving you the best information we have today.

[Unidentified Analyst]

If I could ask one more quick question. In your guidance is there any flexibility built in for the possibility of the CR this year?

[Eric DeMarco, President and Chief Executive Officer]

It just really depends, that's why one of the reasons we give a range, we give a range but it depends on how long it goes and it depends on if it's just a standard CR, a few years ago the government shutdown. Right now we feel pretty good and based on what we're getting from our contacts in Washington, including our lobbying firm. Right now based on what's being discussed as possible, we feel good about our forecast. It's very solid. Our government business, our military business is knocking it out of the park right now. It's literally just knocking it out of the park. And the only reason in my opinion that we're not doing better than we had forecast is we have some small commercial pockets primarily in our engine business that where things have been delayed till next year.

[Operator]

Your next question comes from the line of Pete Skibitski from Alembic Global. Your line is now open.

[Pete Skibitski, Alembic Global]

Eric, can you talk about the sequential growth in backlog? It looks up almost 6% sequentially, and I think somewhere I read that that does not include ASC. So I'm just wondering if you can maybe give us some of the chunky pieces that led to that growth.

[Eric DeMarco, President and Chief Executive Officer]

And Deanna help me, one of the bigger chunky pieces is in our C5ISR business.

[Deanna Lund]

You're exactly right, yes. And that was really into our book to bill.

[Eric DeMarco, President and Chief Executive Officer]

The missiles system, radar system, defense and we do some classified systems in there, this is all hardware, is really, really going good. And I'll tell you, if things come together the way they look like in the next few months, either our second half and potentially Q3 bookings in that business are going to be incredible, bookings are going to be incredible. And also as Deanna mentioned, if timing holds on certain production programs we already have where we're expecting to go from LRIP to full rate production and receive those contracts, those full rate production contracts in the second half, our second half booking for the company could be very, very strong, which is one of the reasons we're so optimistic about ‘20, ‘21 and beyond.

[Pete Skibitski, Alembic Global]

And kind of related to that is the C5. I think Northrop has said they expect to book their first kind of chunky GBSD award, I think by the end of this month. So should we expect on that basis that maybe you guys see your first chunky order from them by the end of the quarter?

[Eric DeMarco, President and Chief Executive Officer]

As I said, Northrop is incredible partner, and I'm sorry, we will not get ahead of them. So I just got to let this go.

[Pete Skibitski, Alembic Global]

Last one for me, just I'm a little confused on the training programs, the $35 million a year program that's coming up for recompete at the end of this year. Is that separate from the Saudi Navy program that I think is running down over the next two years? I wasn't sure if that's being recomputed as well or not.

[Deanna Lund]

No, that is the same contract fee.

[Pete Skibitski, Alembic Global]

It's the same one. Okay. Perfect. Okay, thanks very much guys.

[Operator]

Your next question comes from the line of Joe Gomes from Noble Capital. Your line is now open.

[Joe Gomes, Noble Capital]

Most of my questions have been answered, but just two quick ones. Eric, last quarter you talked about you had, I think it was said 200 job openings, you’re trying fill quickly. Given what's been going on with the COVID and some of the programs, government programs that have been out there. How has that progressed for you guys?

[Eric DeMarco, President and Chief Executive Officer]

So far, so good. And I chalk it up to and I'm getting this from our division presidents that the work that we're doing is extremely interesting. The space work that we're doing, it's we’re like the commercial technology company literally in Colorado Springs where we’re doing our space work and our 5G work. And it's exciting work for these, I call them kids, for these kids. And the C5ISR work that we're doing in Pennsylvania, I mean, working on these weapon systems and seeing, it's incredible, very interesting work. And obviously, the drone stuff is really, really interesting. So, so far so good. But your question is very correct, because our hiring plan for the next six months and into Q1 of next year is very strong. So, that's an area the entire team is focused on. We got to get the right people in with the right clearances to execute the programs.

[Joe Gomes, Noble Capital]

And just a technical one, with the offering completed. What's a good number for diluted shares now?

[Deanna Lund]

$125 million.

[Operator]

There are no further questions at this time. You may continue.

[Eric DeMarco, President and Chief Executive Officer]

Very good. Thank you for joining us this afternoon. And we look forward to speaking with you with the next planned call, which should be early November. Thank you very much.

[Operator]

This concludes today's conference call. You may now disconnect. Thank you.