Kratos Defense & Security Solutions, Inc. Q3 FY2020 Earnings Call

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

Thank you, and good afternoon. In Q3, we continued to execute on our strategic plan, including being an industry leader focused on the recapitalization of strategic weapon systems by the U.S. and its allies to address the nation-state Russian and Chinese threats. Since our last report to you, we've made important progress, which we believe further positions the company for an expected and sustained up and to the right organic growth trajectory. This includes: we received from the U.S. Navy the SSAT BQM-177 target drone full-rate production contract with an initial estimated total value of approximately $130 million in our Unmanned Systems division, with the initial funding recently received for the first 35 target drones at approximately $30 million. We received from Northrop Grumman in our C5ISR business a GBSD contract Phase 1 award with an expected initial value of approximately $160 million to $200 million to Kratos; receipt of a $950 million ABMS MAC IDIQ contract award by Kratos' Space and Satellite Communications and Unmanned Systems businesses. This ABMS contract award is in addition to the $400 million MAC Skyborg IDIQ contract awarded to Kratos' Unmanned Systems business previously received. Microsoft announced that it is working with Kratos' Satellite business on its Azure Orbital Space Satellite Ground System as a new service offering. It was publicly released that a new Kratos affordable, high-performance turbine engine is on the Speed Racer tactical system; and receipt of an award from an international customer for 20 Kratos target drone systems by our Unmanned Systems business. Kratos' positioning as a commercial culture, venture-backed technology and product company, addressing the national security market, is providing a competitive advantage for our company, as represented by our third quarter 1.8:1 book-to-bill ratio, our $873 million backlog and the $8.3 billion opportunity pipeline we currently have. Related to Kratos' commercial-based, nontraditional and disruptive government contracting and delivery model, the DoD continues to progressively change its procurement approach, including utilizing Other Transaction Authority, or OTA, contract vehicles, which are beneficial to our company. Kratos is recognized as an industry leader in the rapid development and fielding of affordable, low-cost systems, which will be of increasing importance irrespective of administration, with federal budget pressures, conflicting funding priorities, and the need to address nation-state peer threats to the United States. At Kratos, affordability is a technology and our approach to make internally funded investments in advance of contract award, utilization of digital engineering and proven, leading-edge technology as compared to unproven, bleeding-edge technology results in faster Kratos system development and fielding time, reduced schedule risk, lower overall cost, and a first-to-market competitive advantage for our company. For example, Kratos' turbine technologies, in 18 months, went from a clean sheet, next-generation, affordable engine design to engine core run test just a few weeks ago with ground altitude and flight tests now scheduled. In Q3, Kratos' upward momentum and trajectory continued across the majority of our business units, including, as I mentioned before, Kratos' prime partner, Northrop Grumman, being awarded the Ground Based Strategic Deterrent, or GBSD Minuteman ICBM replacement program by the United States Air Force. GBSD is forecast to be an approximate $100 billion multi-decade program to upgrade one leg of the U.S.'s Strategic Nuclear Triad. The initial or development phase of this program, where Kratos is responsible for the design and delivery of sophisticated ground, missile, and other system transport equipment, is currently forecast to be approximately $160 million to $200 million for our company over approximately 7 years. We will be making a significant capital investment in this program next year, and we currently expect the revenue ramp of this GBSD program for Kratos to begin late in '21 or early in '22. We expect GBSD to be one of Kratos' largest and most important future programs and growth drivers for many years into the future, including expected additional and increased funded phases substantially greater than the current development phase once GBSD enters production. We are currently forecasting year-over-year organic revenue growth for Kratos' C5ISR business for fiscal '21 over '20 with growth and profitability accelerating and expanding in '22 as next year's GBSD-related investments wind down and revenue and margins increase. In Kratos' next-generation engine business, we continue to make progress on a number of funded new engine programs, including Kratos' engine being reported to be on the new Speed Racer tactical system, as I previously mentioned. With Speed Racer it has now been reported that Kratos' engines are designed in on 2 new tactical platforms, Speed Racer and Gray Wolf, and I can report to you that there are several additional programs that we are also currently on or planning to be on, which we hope to be able to update you on in the future. We believe the customer demand signal and expected total addressable market for Kratos' class of affordable, high-performance engines is large and increasing, including as related to many of the drone and tactical system programs our Unmanned Systems business is currently on or pursuing, including Skyborg, Gremlins, Golden Horde, ACE, ABMS, IBCS, arsenal plane palletized munitions and the equipment replacement. Unmanned drones, tactical missions and powered munitions all require engines with the engine typically being the #1 cost item in this type of systems billing material. This replacement of legacy technology and the cost-reduction opportunity is driving the demand signal from our customers as extremely large quantities of these low-cost, increased performance, affordable, attritable drones, tactical missiles, and powered munitions are expected to be procured to address the threat. Additionally, I can also report to you that KTT is now under contract on certain hypersonic program engine initiatives, which I hope to be able to provide you details on in the future. We are currently forecasting year-over-year organic revenue growth for KTT and Kratos' engine businesses for 2021 over 2020 with certain increased capital and other investments in '21 as we execute on development programs in conjunction with our government customers and work towards future production. Kratos' Microwave Electronics business also continues to perform well with continued growth forecast as we either begin or expect to see increased production on a number of programs Kratos is currently designed in on. The Microwave Electronics market space is one of the top-funding priority areas for the U.S. and its allies as missile, radar, electronic warfare, communication, and other systems are upgraded and new platforms are fielded to address the increasing threat. Kratos' microwave business continues to have a near-record backlog and opportunity pipeline, and we are forecasting increased FY '21 over FY '20 organic growth for this business. Important programs for Kratos' microwave business include Barak, Iron Dome, Sling of David, Arrow, LRASM, QRASM, the F-15 and F-16, and Gripen. Kratos' Rocket Systems business had a strong Q3, and we are currently executing on a number of programs, including building and performing system integration on vehicles for missile defense-related and other initiatives. Based on the number of programs and systems Kratos' RSS business is currently working on and the increased number of new opportunities we are now pursuing, including in the hypersonic program area, 2021 and 2022 are both currently expected to be heavy mission launch years for Kratos, assuming no additional COVID-19-related or other delays and the current launch manifest holds. We currently expect year-over-year organic growth for our Rocket Systems business for fiscal '21 over '20 with 2021 having increased capital investments as we are developing a new system in conjunction with a certain customer set. Kratos' target drone business also had a solid Q3, including receiving the sole-source full-rate production award from the U.S. Navy on the SSAT program I mentioned before. The 3-year value for SSAT FRP or full-rate production was announced at $130 million with the ultimate SSAT program-related amount to Kratos over this initial 3-year period expected to be tens of millions of dollars greater than the $130 million, driven by payloads, spares, peculiar and other related program materials, solutions, and services. We expect the SSAT program and the BQM-177 target drone to be one of Kratos' largest and most important programs and systems for many years and a key future growth driver for our company. With the SSAT full-rate production award, a significant and sustained multiyear production ramp for the SSAT program is now expected to begin for Kratos in Q3 or Q4 of next year. As I previously mentioned, we recently received a multimillion-dollar contract from an international customer for 20 new target drone systems, which is expected to be an important financial contributor beginning next year, and we now expect this customer to make annual recurring buys of Kratos target drone systems. We have also now reached agreement with a second international customer on an even larger target drone opportunity, and we are awaiting U.S. government approval to finalize this new contract, which is currently expected to be approved around Q2 of next year. If current timing holds, we expect this new opportunity to be an important financial contributor to Kratos beginning in '22. We are currently in negotiation with the United States Air Force on a multi-year, sole-source, full-rate production extension contract, which we expect to complete and receive around mid-next year. We also expect to receive full-rate production on an additional separate sole-source contract in Q3 of next year, which, if current expected contract award timing holds, would become a significant increased financial contributor to Kratos beginning late next year or early in '22. Kratos' industry-leading target drone business is expanding its customer base and growing rapidly as the U.S. and its allies field new weapon, radar, and other systems to address nation-state peer threats. These systems need to be tested and exercised for operational readiness. We are now in pursuit of 2 new, large target and target drone program opportunities from the U.S. government, which, if we are successful, could provide the next step-up in future growth for this business beyond our current growth expectations. For competitive reasons, I will not be sharing too much about these opportunities in the near term. We are expecting organic growth for Kratos' target drone business for fiscal '21 over fiscal '20 with organic growth expected to continue beyond '21 based on current programs, contracts, and expected new opportunities. The tactical drone market opportunity that Kratos is pursuing continues to grow and gain momentum based on customer demand signals. As you know, Kratos has 4 affordable, high-performance tactical jet drones flying today that we can publicly disclose, which we believe is an important competitive differentiator for Kratos as all of them are manufactured in the United States, which is also important competitively. The 4 drones that we can discuss publicly include the Valkyrie, Gremlins, Mako, and Air Wolf, and we are under contract on a number of additional related and/or derivative tactical drone programs, all of which are in conjunction with a United States government customer or partner. Kratos has recently received a $400 million Skyborg MAC IDIQ contract. Skyborg is the overarching program for developing small, low-cost, high-performance armed drones that can accompany manned fighter jets into combat as affordable force multipliers. The Skyborg program is one of the service's top science and technology priorities under the Vanguard initiative to deliver game-changing capabilities within 3 years to the warfighter. Based on most recent publicly available information, funded Skyborg task orders, including for drone aircraft, are expected to be awarded by the USAF very soon. We also expect to see other non-Skyborg program drone-related contract awards in the coming weeks and months. As we are currently in source selection on Skyborg and these other opportunities, including for Valkyrie, I cannot comment further at this time other than to say our confidence in the ultimate success of Kratos' Valkyrie and Kratos' other tactical drone systems has only increased since our last report to you. Kratos' Gremlins has now completed its second flight, and there are flights scheduled for later on this year, assuming no additional COVID-19-related or other delays. We continue to expect the Gremlins program with our prime partner, Dynetics, to transition to a service next year, and our expectations for future Gremlins high-quantity production have never been stronger than they are today. Kratos' Air Wolf program flight schedule is now anticipated for later on this year and into next year, also assuming no additional COVID-related or other delays. Kratos' Rattlesnake program and their environment system flights are now also scheduled for early next year, assuming no additional COVID-related delays. Kratos' Thanatos development program is on schedule and on track. And if we are ultimately successful here with our partner, we see an opportunity for Kratos potentially similar in size to the opportunity we ultimately see for Valkyrie. The U.S. DoD continues to provide demand signals that there will be thousands of affordable, high-performance jet drones in the disposable, reusable, expendable, and attritable classes. We believe that Kratos is extremely well positioned with both our drone business and our turbine or engine business to address this opportunity. The Air Force has now also defined a price range of between $2 million and $20 million as the target for this emerging class of attritable unmanned aircraft systems, and Kratos' entire family of attritable tactical drones currently fits within or below this price target range. Major drone or tactical system-related programs Kratos' unmanned and turbine businesses are either participating in or currently pursuing that we can talk about publicly include Skyborg, Gremlins, ABMS, Golden Horde, LCAT, LCASD, the arsenal plane palletized munition, Speed Racer, IBCS, Gray Wolf, and the equipment replacement. On the equipment replacement opportunity, Kratos' ghost works, which is compartmentalized and extremely confidential, is considering offering what we believe would be an extremely disruptive and paradigm-changing, low-risk affordable solution. Operationally, in Oklahoma City, the production plan for the 12 Valkyries is continuing with initial delivery now scheduled for around Q2 '21, aligning with the most recent customer demand signals. Similar to the other competitive advantage we believe Kratos has, including 4 affordable jet drones flying today, we also believe that Kratos is up and running production line in Oklahoma, with deliveries off the line beginning next year, which is also an important competitive differentiator for our company. We are expecting significant year-over-year organic growth for Kratos' tactical drone business for FY '21 over FY '20, with the degree of the growth determined by the timing and type of expected contract awards, the ultimate length of the current continuing resolution, and the timing of a federal fiscal and DoD '21 budget. 2021 will also see investments for KUSD as production ramps up on the initial precontract Valkyries being manufactured in Oklahoma. Kratos' Space and Satellite business continued its business momentum and positioning for future organic growth, including Microsoft announcing the launch of Azure Orbital, a ground station as a service for the satellite industry that Kratos is supporting. Azure Orbital will connect satellites directly to Microsoft's cloud computing network. Kratos is collaborating with Microsoft to enable Azure Orbital, using 5 Kratos products from our new open space line to enable the Azure Orbital underlying cloud architecture. Kratos' products facilitate the processing of the signals from the satellite to the antenna and then into the cloud environment, and Kratos' open-space digitizer converts the space analog RF signal into network-ready digital packets. The ground-as-a-service offerings, like Microsoft's Azure Orbital, represent one way in which ground systems are being disaggregated from the space layer, which is an incredibly important industry trend for Kratos as it is providing a large new market opportunity that previously only the satellite and space system providers had access to. With this trend, Kratos now has access to this market. For example, in addition to Azure Orbital, I will now report to you that Kratos is also under contract or collaborating with other major new entrants to this market, which we are under NDA, and we see this area as a key contributor to our forecasted very strong satellite business' future organic growth rate. Simply stated, Kratos' position with Web 2.0 companies is extremely strong. Additional factors driving technological evolution and the high expectations we have for our ground space business segment include 5G, which I have discussed in detail previously; proliferated LEO; and multi-orbit operations. The space industry is undergoing tremendous innovation and growth, including small cube SATs, software-defined payloads, and proliferated LEOs. It has been recently reported that approximately 40,000 small SATs are forecast to be launched into orbit in the future, all of which will need to be able to communicate and connect to the ground-based infrastructure. That's where Kratos comes in. Kratos' space architecture is based on industry standards and software-defined networking technologies that have been proven in the telecommunications industry, which is entirely consistent with Kratos' low-cost, low-risk, deliver-on-schedule strategy by utilizing proven, leading-edge technology versus unproven, bleeding-edge technology. Additionally, the Kratos satellite network technology being used by Azure Orbital is also based on the same foundation that is needed by certain government programs to enable defense applications, including for connectivity to commercial space systems, which is one of the government's stated priorities and goals. As part of the enterprise management and control effort, Kratos is providing warfighters the ability to roam with satellite communications, whereby warfighters can receive and transport satellite mission data from various satellites and multiple domains, very similar to the way cellphones can roam today, as well as the unified common operating picture across multi-domain systems. With these recent collaboration agreements and contract awards, we believe that Kratos' Space and Satellite business is positioning for an impressive growth trajectory, which we are forecasting to begin in the second half of '21 and accelerating into '22 based on current programs, contracts, and opportunities. We have also received or expect to receive in 2021, a number of new confidential or classified program awards. As a result, we will begin investing in certain shift and other security-related investments next year, with the ultimate order of magnitude of the investment being dependent on the opportunity set and our success rate on these opportunities. Representative programs Kratos' satellite business supports today include the Hypersonic and Ballistic Tracking Space Sensor, HBTSS program; the next-generation Overhead Persistent Infrared, OPIR program; Tactical Intelligence Targeting Access Node, the TITAN program; Advanced Battle Management System, ABMS; Wideband Global Satellite, WGS; Advanced Extreme High Frequency Satellite, AEHF; and Space-based Infrared, SBIRS. Finally, in our space business, the integration of ASC signals is going well with no major issues and no major surprises. I hope you can see from today's report that substantially all of our businesses are performing well and organically growing with an increasing number of opportunities, both in number and size. Challenges Kratos currently faces include the continued commoditization and reduction of our legacy services business due to LPTA contract awards, and our training business with a high-risk international contract recompete now going on, which, if we are not successful, would result in an approximate $35 million negative revenue and related margin impact for Kratos in '21 compared to '20. As related to COVID-19, the Kratos employees have done nothing short of an outstanding job executing in a truly difficult and challenging environment. COVID has clearly adversely impacted Kratos thus far in '20, including in our commercial turbine, our commercial SatCom and rocket launch business areas, and also importantly, in our tactical drone business, where virtually every Kratos program and opportunity has now been delayed or pushed significantly to the right as a result of COVID-related DoD and contractor work-at-home, travel, social distancing, and other restrictions, including, very importantly, the impact on range operations and related missions. However, irrespective of COVID and normal business challenges we all have, as we look forward, Kratos' future has never been brighter than it is today. As a company, we have better visibility or clarity to our future business and financial forecast than ever, including as represented by our Q3 book-to-bill ratio, backlog, and new opportunity pipeline. For 2021, we are currently expecting significant revenue growth over 2020, with the magnitude of this forecasted growth determined in part by the length of the current continuing resolution; the timing of the Federal Fiscal and DoD 2021 budget; the timing and type of expected contract awards, including in the tactical drone area; and COVID-19-related impacts to the business, which we'll deal with as they come.

Thank you, Eric. Good afternoon. Kratos' third-quarter 2020 revenues of $202 million were as we forecasted and in our range of $195 million to $205 million. Adjusted EBITDA for the third quarter was $24.6 million, above our expectation of $17 million to $20 million, due primarily to a favorable mix of revenues, including certain programs and products and more mature life cycles. In the third quarter, our Unmanned Systems segment reported revenues of $53.5 million, up 17.1% from the third quarter of '19, due primarily to target drone programs, including the SSAT 177 program with the U.S. Navy. Unmanned Systems generated adjusted EBITDA of $5.6 million, up from $4.9 million in the third quarter of '19, primarily reflecting the increased revenues. KGS reported revenues of $148.5 million, up from $138.4 million in the third quarter of '19, reflecting $10.2 million from the recent ASC acquisition and organic growth in our Defense Rocket, Microwave Products, and C5ISR businesses. This increase was offset partially by a net reduction of approximately $6.3 million in our trading solutions business, which was related to the previously disclosed reduction in scope of certain international contracts. KGS's third-quarter 2020 revenues also included a net reduction of $2.8 million in the company's KTT business, resulting primarily from COVID-19 impacts in our commercial aero business area, partially offset by increases in our federal turbine business. KGS's third-quarter 2020 adjusted EBITDA increased to $19 million from $15.5 million in the third quarter of '19, reflecting a favorable mix of revenues, including certain programs and products and more mature life cycles. Kratos' adjusted EPS of $0.14 per share was above our forecast of $0.08 to $0.10 per share for the quarter. GAAP EPS was $0.02 per share. Our Q3 consolidated operating income was $12.7 million, up from the third quarter of '19 operating income of $11.5 million, reflecting the increased revenue volume and a favorable mix of revenues. Also included in the Q3 '20 operating income was an increase in noncash stock compensation expense of $2.2 million, increased R&D expenses of $3.1 million, primarily in our Space and Satellite business, and increased depreciation expense of $500,000. Our adjusted EBITDA for the third quarter is from consolidated continuing operations, including net income or loss attributable to noncontrolling interest, and excludes noncash, stock-based compensation costs of $5 million, acquisition and restructuring-related costs of $400,000, and foreign transaction gains and losses of $700,000. On a GAAP basis, net income for the third quarter was $2.4 million, which includes a tax provision of $5 million and a loss from discontinued operations of $200,000. Moving on to the balance sheet and liquidity. Our cash balance was $374.7 million at September 27. We had $0 amounts outstanding on our bank line of credit and $6.1 million of letters of credit outstanding. Debt outstanding was $300.3 million at quarter end, and net cash at quarter end was $74.4 million. Cash flow generated from operations for the third quarter was $8.3 million, less capital expenditures of $8.9 million, resulting in free cash flow used from operations of $600,000. During the quarter, we collected $400,000 related to the retained working capital of the legacy PSS business that we sold in 2018, bringing the total receipts we have collected to $6.8 million since we sold the business. Our contract mix for the quarter was 76% generated from fixed-price contracts, 20% from cost-plus-type contracts, and 4% on time and material contracts. Revenues generated from contracts with the U.S. government were 72%, including revenues generated from contracts with the DoD, non-DoD federal government agencies, and FMS contracts, which were approximately 3%. We generated 8% from commercial customers and 20% from foreign customers. Our backlog at quarter end was $873.1 million, up sequentially from the second quarter end backlog of $683.4 million, with bookings of $356.7 million and a book-to-bill ratio of 1.8:1 for the third quarter of 2020. Funded backlog at quarter end was $579.3 million with $293.8 million unfunded, with our bookings and pipeline giving us visibility into our expected future revenue flow over the next 18 to 24 months. Under the new accounting standard 606, depending on the contractual terms and customer sets, revenue will be either recognized over time or on a percent-complete basis or at a point in time as units are delivered to the customers. In general, based on the new accounting standards, contractual terms with international customers will typically be recognized at a point in time as units are delivered, which can span over an 18- to 24-month period. And now for our financial guidance. We are affirming our full-year 2020 guidance of revenues of $740 million to $780 million and adjusted EBITDA of $72 million to $78 million. We are also affirming our full-year 2020 free cash flow guidance of a generation of $7 million to a use of $18 million, including capital expenditures of approximately $36 million to $40 million, which reflects certain previously expected outlays for unmanned drone systems now being reflected as inventory or as uses in operating cash flow. The 2020 capital expenditure forecast currently includes expected outlays of $11 million to $15 million associated with the production of 12 Valkyrie aircraft prior to receipt of expected customer awards. Therefore, these aircraft are currently reflected as company-owned tactical drones until receipt of the related customer awards. We will adjust 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 can be estimated. 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 in our financial forecast adjusted once such contracts or orders are received and the related financial contribution can be estimated, which would be dependent on criteria including the type of contract, vehicle, scope, timing, and period of performance. Our full-year 2020 guidance range also includes our current forecasted business mix in the fourth quarter, our assumptions of the expected impact of COVID-19 and the estimated impact of the current continuing resolution, the CRA, on our industry business operations and forecast financial results. Under a CRA, which began on October 1, since our last report to you, new or increased contract and production awards are delayed and cannot occur until the relevant federal fiscal year budget is approved, i.e., the 2021 federal fiscal year budget. Consistent with previous years, we currently intend on providing Kratos' initial fiscal 2021 financial guidance when we report our full-year 2020 results, which will enable us to incorporate current information and impacts from expected tactical drone awards, the election, the CRA, and the estimated impact of COVID-19, including to our tactical drone business programs and initiatives that Eric mentioned before, and the most recent information on the very large international training recompete.

Eric, you mentioned several investments planned for fiscal '21. While I understand you won't provide guidance until late February for '21, could you share any quantitative details regarding the investments in these various programs that you might have better visibility on at this time?

As you mentioned, I won't elaborate on the specifics for '21. Mike, I can share that we've seen a significant increase in opportunities, especially in the space sector, including classified projects. We're currently under an NDA with Northrop, which we will respect. Under GBSD, this will likely become one of the largest programs in the company for the foreseeable future as we move through the initial phase and into production. We do need to make investments for what we are going to construct, as we will be building massive systems. Our focus is certainly connected to contracts like GBSD, but I won't disclose any financial figures right now. I expect to have much more clarity regarding wins and other details when we reconvene in a few months.

Okay. Given the transition in the space and satellite business, when you acquired Integral Systems in 2011, I think it was much more of a hardware business. And so now I think maybe revenues are probably maybe not growing, but EBITDA margin would be. Is that the case? And is there like a revenue and EBITDA margin-type profile that you can share that this business is at today within government systems and where that could be in a few years from now?

Yes. Mike, to your point, and we talked about this over the past year or so, there's been a transition going on from geo-synchronous orbit satellites and large monolithic ground stations that were dedicated to them that we were involved in, that were very hardware intensive. That transition has been going away from that to, as you absolutely spot on said, to software-defined ground equipment. We are crossing that point right now where the downdraft on the revenue is about over, large systems, and now it's increasing. As we go forward, both revenue in our space business and margins are forecast to increase, including in the current quarter, going into next year. Starting in the second half of next year, as we start working on and delivering some of the things I talked about today, we see it ramping significantly, both revenue and margin late next year into '22. We're looking at minimum growth, with minimum growth rates in the space business, and I'm going to exclude some very large binary opportunities that, if they hit, would dramatically increase this minimum top-line growth rates of 10%, minimum, with significantly increased margin rates expanding because it's software.

Okay. And then for my last question, we are all looking forward to updates on the tactical combat drone front, and we are very pleased to see the start of full-rate production on SSAT. What is the status of full-rate production on other confidential target programs? Is that a goal you are still pursuing, or are you unable to discuss it?

No. I may not have been clear. I mentioned in my prepared remarks, everything is on track. We'll get that next year. We'll get into full-rate production on some other ones, including the one you're talking about as well.

Eric, I wanted to follow up on the target drone question. Is it reasonable to assume that now that you have achieved full rate production on the SSAT and have visibility on the other programs, that this business should reach a run rate of around $250 million? Is that the correct perspective? If so, what time frame should we expect for that?

Absolutely. We are tracking right to it. The only flex point, Ken, is the continued timing on the budget and continued resolution because we're in LRIP, low-rate initial production 2 on certain programs right now. We've been awarded LRIP 3 in my example, which has substantially increased quantities and money. We can't get LRIP 3 until we get a '21 budget, okay? We can't move into full-rate production on certain things until we get a '21 budget. And so we are absolutely moving right toward the $0.25 billion that we talked about. The international award was part of that. We got it. The second international award, which we've won but now is in U.S. government department review. And next, I see it no later than '22. It's just...

So if we get obviously a '21 budget at some point in December, barring any other sort of major change, the run rate for '22 sounds very reasonable.

Yes, we'll need to obtain the '22 budget because there are two programs that are either new or one of them is in production and will see increased production related to '22, which starts on October 1 of '21. We'll have to determine how that situation develops, and we'll move forward from there.

Okay, great. I have a follow-up regarding the tactical side. I understand there may not be much to say about the Valkyrie, but you seem very confident about securing an initial production contract. The Air Force has increased the number of companies involved in the initial opportunity, particularly with the Skyborg program. How do you see the competitive landscape evolving? Additionally, from a technology perspective, there appears to be a risk that the hardware could be delayed if AI and other aspects of the program cannot progress at the same rate as the hardware development. Is this a valid concern, and do you think it could be an issue going forward?

Regarding your second question, you're correct about the importance of AI. It plays a crucial role in Skyborg and related programs, and its development could impact timing. Leidos is handling the AI as the system design agent for Skyborg, and we have a strong partnership with them. Your observation is valid, but I’m not worried about it since it is what it is. On the topic of competition, we are focusing on our strategy. We currently have multiple jet drones in operation and active production lines, so we have a clear understanding of our costs. We avoid speculation and potential changes that could inconvenience customers. Our programs, all backed by U.S. government sponsors and constructed domestically, present a significant advantage. The Valkyrie has been in the air for over 1.5 years, while the Mako has been flying since 2015. We're engaged in payload integration and testing, which gives us a competitive edge. Most importantly, we offer an attractive price point. We acknowledge that our customers will make objective decisions, which we respect. However, we feel well-positioned to participate in what we anticipate will be a significant new market for expendables, reusables, and attritables. I don't expect us to enter the exotic category, and as mentioned, our Ghost Works is pursuing some intriguing developments related to replacement technologies.

Maybe a question just to focus a little bit on the top line guidance kind of range for the year. You reaffirmed that, but it implies kind of a bigger swing factor in the fourth quarter on the top line. Maybe what are some of the puts and takes that would put you at the bottom end or the top end of that range?

Okay. So the biggest factor we've been looking at relative to this is the following, okay? Obviously, we're in the CRA that goes to December. That's number one, all right? We have an election coming. We don't know what's going to happen with that. That has brought in that if things don't go according to some people's plan, maybe there's going to be a government shutdown. We don't know that, all right? Now let me give you a very important one, okay? Timing of customer sign-off on our products, okay? The COVID restrictions have been significantly impacting travel, including customers coming out to sign off on products so we can execute delivery or revenue; and also, our ability for our people to travel to customer sites, in particular international, where they're not letting Americans in without a quarantine period. If we deliver a large space system, which we have several that we're supposed to be delivering, we have to go there and get it signed off, and that has been an issue. So we've tried to map all this out relative to our range in Q4. I know it's rather large, but there are some big moving pieces, and we wanted to make sure we encapsulated them all in what we provided.

Okay. That's helpful. And just on the quarter specifically under KGS operating margins, 9.5. I think that's kind of one of the highest margins we've seen in many, many, many quarters. It sounds like you view this to be sustainable and maybe even transitioning into the double digits. How does ASC signal kind of impact margins going forward?

You're right. The margins were very strong, and Deanna mentioned the maturity of some of the programs we are involved in. We are engaged in certain weapon system programs, and the deliveries or execution in the quarter were very favorable for us. Now regarding your sustainability question, I believe that number will be achievable and sustainable for us once we start on GBSD. We will be making some investments because we've been awarded the contract, and we’ve won. I might be mistaken, but the team is doing excellent work. However, we have programs that we've secured, and once we get started, we will return to that level, and we believe we will exceed it in the future.

Right. And then just lastly, you talked about the international training headwind potentially for '21. I think it was $35 million you mentioned. When will you know on that in terms of the timeline?

Currently, we are under a contract that is expected to be extended through January, assuming an option is exercised soon. I want to highlight that this situation carries higher risk compared to our other engagements because it lacks intellectual property, technology, or any significant product differentiation. While there are some advantages on our side, for competitive reasons I won't discuss them. However, due to the absence of those differentiators, which we typically have in the majority of our business, this is a risky situation, and I wanted to ensure that everyone is aware of this.

Nice results. Eric, to follow up on Peter's question regarding the fourth quarter, what about the EBITDA range? Even at the lowest end of your revenue guidance for the fourth quarter, it appears that EBITDA will be down. Is there anything changing in terms of mix or factors that might be affecting EBITDA in the fourth quarter?

In our C5ISR business, we had significant activity on major programs, as Deanna mentioned, which were strong in Q3. However, we do not expect this level of performance in Q4. While it will still be profitable, we do not anticipate a repeat of those results. Typically, in Q3 and Q4, our space and cyber business receives several orders from customers due to the federal fiscal year-end, which influences money obligation and spending. Should we receive a number of those orders in November and December, they tend to be very profitable because of the specialized nature of our software. This could greatly impact our EBITDA, but we usually won't know the outcome until December.

Okay. That's helpful. What about the order flow? Obviously, very strong; the backlog, up significantly. Was there any contribution to the backlog from ASC?

That was about $30 million to $35 million, Mike.

Okay. Perfect. And then just one last question, Eric. I understand you won't provide guidance for 2021, but you mentioned that several individual markets and product lines are positioned for organic growth. Even if there are challenges with training losses or protests, do you still feel confident that the other product lines can achieve organic growth next year? Also, considering expectations, you mentioned the NRE on GBSD and other investments. Should we anticipate that margin expansion and free cash flow might be somewhat limited due to these factors?

On the second part, I would, and it's because of the nature on some of these big programs that we've won and the profitability of them early on because of the related investments that we've been making. To the first part of your question, let's say that the training goes against us. Yes, we absolutely believe we will still grow '21 over '20, and it will be important. It's not going to be like $5 million. It's going to be a lot. So we've got some good stuff coming. If we get the CRA done and we get the '21 budget and we get movement on that stuff, the second half of next year, when that kicks in, it will be strong.

I wanted to just follow up on the backlog, Eric. You had a pretty nice sequential step-up. How do we think about that conversion? Any changes to duration? I don't know if you noted it, but was the September award for GBSD in the backlog?

Yes.

Yes, it was. We're proceeding with guidance from the prime. Imagine it as a bell curve. Development takes about a year to 18 months, and the curve starts to rise. After that, we begin delivering results, and the curve rises significantly in the middle over a period of six or seven years, starting in year two or three. Then the curve begins to decline. By that time, we hope that Phase 2, which is production, will be successful for the entire team.

Okay. And then I'm sorry if I missed this as well. I think earlier this month, you received the BQM-177 full-rate production Lot 1 contract. Can you just go over the timelines of main production programs and where you are in the life cycle and maybe potential volume step-ups?

Absolutely. Regarding the Navy SSAT, we are currently in Low Rate Initial Production (LRIP), and we will complete this phase in the next few quarters. We anticipate moving into full-rate production in year one sometime late next year, following a three-year contract that includes a base year plus two additional years. This is one of the reasons we expect 2022 and 2023 to be very strong due to that full-rate production. We also have another confidential contract currently in LRIP that is expected to transition into full-rate production next year. If the timeline holds, we should see a significant increase from that contract late next year, no later than 2022. For the Air Force, we are also a sole source provider and are in production year 16, with negotiations underway for the next five years, which we expect to be awarded in the middle of next year. We do not anticipate any interruptions in production and expect a slight increase in 2022 and beyond. The contract we recently announced with an international customer is set to begin next year, with initial deliveries likely in the second half of next year into 2022. That customer has indicated plans for similar annual purchases, which is promising. Additionally, we are fulfilling orders for the U.S. Army, which is currently purchasing multiple target drones from us. Recently, the Army successfully shot down several of our target drones during tests at White Sands, and there are new anti-cruise missile systems being deployed on both the East and West Coasts, where our target drones have also been used in exercises. Overall, the target drone business is performing very well and is on the rise.

Most of my questions have been asked already. But not only during the third quarter, but also in the year-to-date, you mentioned a little bit, you've seen a pretty, percentage-wise, big increase in R&D spending. I was wondering if you could give us a little more color to that. And how long do you think that is going to last?

That's a great question. So that is our space business, and these are our software-defined products. This is why we've been announced with Microsoft. This is why I said we're under NDA, but we're with some other big guys. This is what's driving our 5G. This is why I affirm our belief that our space business is going to grow. It has begun, and this is going to be long term, and it's not pie in the sky, I don't believe. I believe this is going to need to continue because our space business is now truly turning into a technology play, with higher margins and good organic growth. We're going to need to spend R&D to ensure we stay ahead of everything else, where I believe we are today with these software-defined products.

Okay. Great. And then just I know I've asked this in the past. I just kind of like to keep abreast here. A couple of quarters ago, you mentioned how you were looking to hire over 200 people. I think I asked a question last quarter, and you said it was going well. Just wanted to get an idea of given the state of the labor markets out there, how confident are you guys? Or how is that progressing and getting the number of employees you need to increase production going forward?

Recently, several large companies in the aerospace sector have announced layoffs of thousands, including in their defense divisions. This situation has created a valuable opportunity for us by providing access to skilled individuals, particularly in our drone and system development areas. While it's a challenge for those affected, we are able to support them, and this trend has positively impacted our operations. We currently have several hundred positions to fill, especially in the drone, space, and C5ISR sectors, exceeding 100 positions that we need to hire for. We are planning to make investments and will be opening a new facility dedicated to developing these systems.

I guess in terms of the several growth opportunities that you outlined for next year, if you were looking at the magnitude of those, what would be maybe the top 2 or 3 that you would highlight in terms of what would contribute the most in '21?

Our unmanned systems, including Valkyrie, target drones, and other tactical drones, are our top priority. Following that, our space business is performing very well. Lastly, our Rocket System business will depend on timing. While I can't provide exact numbers, we have over 25 launches scheduled in the next 30 months, indicating strong growth in that area. Additionally, could you remind me of the contract we secured last year for those 30 rocket motors?

All right. Okay. As a quick follow-up, you've mentioned reaching the $200 million to $250 million level for the target drone business. When considering the F-35 and the increasing number of international customers, should we see this as a market that has reached full production, or does the international marketplace and the growing installed base indicate that the market still has potential for growth?

It's going to continue to grow because as international customers purchase systems like the F-35, Aegis, PAC-3, Standard Missile 3, or Standard Missile 6, they seek to test these weapon systems against the most advanced target drones available, which are ours. The BQM-177 is now entering full-rate production, and countries typically wait for the U.S. to begin full-rate production before they start deploying it to their fleets and then begin their purchases, which is expected to start happening now.

Eric, can I just put you on the spot? When do you think you get the Skyborg order? Where do you think we are with that?

We are in source selection. I am sorry.

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

Very good. Thank you for all joining us this afternoon, and we look forward to communicating to you again as soon as we can. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.