Kratos Defense & Security Solutions, Inc. Q3 FY2021 Earnings Call

Good afternoon, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2021 Earnings Conference Call. I would now like to hand the conference over to your host, Marie Mendoza, Senior Vice President and General Counsel. Ma'am, please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions third quarter 2021 conference call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer. Before we begin the substance of today's call, I'd like everyone to please take note of the safe harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today's call. Today's call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today's press release, we have provided a reconciliation of these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP. With that, I will now turn the call over to Eric DeMarco.

Thank you, Marie. Good afternoon. In the third quarter, Kratos' unmanned systems business generated revenues of $61.3 million, which represents organic growth of 14.6% over the third quarter of 2020. Kratos' space satellite and cyber business generated revenue of $72 million, organically increasing 17.5% over the third quarter of 2020. Our unmanned systems and space businesses are our company's largest, they are our fastest-growing, and both are expected to continue to generate very strong year-over-year future revenue growth. This is representative of the successful execution of our internally funded investment, organic growth-focused strategy, which we believe our C5ISR, rocket system, microwave electronics, and engine businesses will each also see growth in the future based on recent program wins like GBSD, Iron Dome, next-generation small engine development contracts and opportunities. We currently have multiple under contract, large new programs, where we are expecting significant future increases, including Sub-Sonic Aerial Target or SSAT with the United States Navy, Skyborg, Thanatos, AirWolf, Offboard Sensing Station, Ground-Based Strategic Deterrent, overhead persistent infrared, tactical intelligence targeting access node, the hypersonic ballistic tracking space sensor, and several classified programs, among others, all of which are under contract. This also provides the confidence in our future year-over-year growth forecast and upward trajectory. As you know, the final revenues from our legacy International training business, which contributed approximately $35 million in 2020 revenue and over $14 million this year before completely winding down in Q2, have been masking Kratos' overall core business growth rate, which we will continue to highlight until financial performance is comparable in Q3 next year. Excluding the legacy training revenues, Kratos' 2021 forecasted overall organic growth rate is still forecast at greater than 8%, even after we saw approximately $31 million of Q3 and Q4 2021 revenues deferred to future periods due to COVID-related travel, supply chain, and customer issues, which we identified as potential execution risks on our Q2 call with you. I will emphasize again here, as I did in Q2, that substantially all Kratos' Q3 and Q4 forecasted revenue was and is already under contract with customers. Accordingly, irrespective of these issues, which will eventually pass, Kratos is in a great position today. We continue to execute, we control what we can control, we are winning new programs, and we are driving the business plan. Specifically to execution, since our last report to you, we have received a $374 million sole-source, single-award target drone related contract with the United States Air Force, of which we expect to realize substantially all, if not the entire $374 million IDIQ amount in Kratos' revenue over the period of performance. The United States Navy's SSAT program office, PMA-208, recently completed three back-to-back test flights with Kratos' newest subsonic aerial target drone, the BQM-177A, in preparation for full operational capability of this Kratos target drone system, which is now expected to come later this year, and we expect the next sole-source full-rate production contract to come in the next few months. Our tactical drone related programs continue to progress, including a recent successful series of customer flights for Kratos' AirWolf drone and Thanatos, which we now, with these successes, expect significant increased future revenues. We have successfully competed and received an AFRL OBSS or offboard sensing station, affordable tactical jet drone program award, which we believe has potential future growth opportunities similar to Kratos' Valkyrie, the Gremlins program, AirWolf, and Thanatos. We believe that Kratos' recent receipt of the OBSS award for a new, low-cost attritable unmanned aircraft program demonstrates Kratos' digital engineering and technology-leading position. The OBSS drone system continues to expand Kratos' industry-leading family of affordable, disposable, reusable, and attritable drone systems, each with their individual capabilities and mission focuses. With the OBSS award, we continue to believe that Kratos is the best-positioned company to realize incredible growth and forecasted to be the largest tactical drone area as Kratos continues to successfully bid for and receive significant awards in this area. Kratos' ghost works, including our Air Gap group, played a key role in our OBSS success, and Kratos ghost works is now currently focused on additional new program system opportunities, certain of which we expect to hear about in the coming months, and hopefully, we will be able to report to you. Just a few weeks ago, as I noted, Kratos' ghost works had a successful Thanatos flight as this program initiative continues to progress. On August 16, the Air Force reiterated its commitment to be ready for a 2023 Skyborg Vanguard program of record, under which Kratos' Valkyrie and Mako jet drones are both recognized participants. The Kratos Valkyries under the contract with the Skyborg program are expected to be delivered shortly, and the Valkyrie aircraft under contract with the LCAT or low-cost attributable aircraft technology program, which remains on track, are also scheduled for delivery. In addition to Skyborg and LCAT, we have been in discussions with additional customers and program offices for Valkyrie, which funding is anticipated in the pending 2022 budget, if everything holds as currently expected. It was reported that the general-in-charge of the Air Combat Command stated that the first low-cost attributable jet drones could be in a stealth red air role as adversaries for fifth generation fighters and that low-cost attributable aircraft systems will be a future growth industry. We believe that Kratos' Valkyrie and its capabilities would be an excellent system for this adverse air mission. We understand that there are currently significant funds planned in the 2022 budget NDAA markup for this air initiative, which we view as another large new potential opportunity for Kratos and Valkyrie. It was also reported that Kratos' Valkyrie was specifically mentioned this week by the government for a certain new mission and opportunity in the Pacific region, which we have been working on. These are just the most recent examples of where Kratos' clear industry-leading position and affordable high-performance made-in-America jet drones with multiple classes flying today. The production of the initial 12 Valkyries remains on track in our Oklahoma facility, with the possibility now, based on the 2022 DoD budget, once finally approved, that we may be making a decision to accelerate and complete certain of these 12 sooner if possible, in conjunction with our customers' input. We have now begun planning for a potential second Valkyrie production spiral lot in addition to the current initial 12, which would also be in close cooperation with our customers' demand signals and expected funded contracts. We recently announced that Kratos' AirWolf Tactical drone system completed a 100% successful flight at the Burns Flat, Oklahoma range facility. This AirWolf mission, which was the inaugural flight at the Burns Flat range location, included multiple new payloads carried by Kratos' AirWolf, including a proprietary Kratos artificial intelligence and autonomy system, which has been developed by Kratos specifically for high-performance jet drone aircraft. Kratos' AirWolf flight demonstrates the value that the Burns Flat range facility asset brings to Kratos, including the ability of Kratos' ghost works to now conduct flights quickly, affordably, and in a secure confidential environment away from competitor sites. Kratos AirWolf also recently performed another successful flight series in addition to the Burns Flat flight, including a critical customer flight, which was 100% successful, and we are optimistic that these recent successful flights will lead to future program opportunities. It was recently reported that Kratos' AirWolf Combat drone launched the loitering munition in flight, an important milestone for the system as we move toward missionization. On Gremlins, it was reported that an additional new test series is now planned for the program with our prime partner Dynetics, with a potential additional contract award in the first half of 2022. This potential additional phase will reportedly feature operations-focused testing and mission demonstrations that could include a single operator controlling multiple Gremlin vehicles and payloads and intelligence, reconnaissance, and surveillance missions facilitated by certain types of electronic and cyber payloads. This phase would serve as a pilot program to develop and mature military mission capabilities and assist the DARPA Gremlins program to successfully traverse the infamous DOD Valley of Death and transition successfully to a military service program of record, which Kratos fully expects will occur similar to Valkyrie and AirWolf. It was reported that multiple service branches have been involved in conversations about the future of the Gremlins program after transition, including the Air Force, the Marine Corps, and now the U.S. Navy, and that DARPA intends to bridge the DOD Valley of Death with at least two drone programs, both of which are currently supported by Kratos, one of them including Gremlins. Kratos' Mako tactical jet drone is also achieving success under various programs and initiatives, but as I have mentioned before, most of this is now classified. The Thanatos development program remains on track, including the recent successful flight as do each of our other tactical drone programs and initiatives. We expect significant future year-over-year organic growth for Kratos' unmanned aerial jet drone business, both tactical and target, as the demand for these types of drones and systems continues to increase. Directly related to Kratos' affordable drone initiatives, the Air Force's Research Lab recently announced that Kratos is part of their team under the design for manufacture of attributable aircraft primary structure or DMAS program, which is an AFRL aerospace system director team of researchers and engineers. They have successfully tested a new low-cost attritable aircraft fuselage and wings design. As you know, attritable refers to a new class of unmanned aircraft that are purpose-designed and routinely reusable, built affordably to allow a combatant commander to tolerate putting them at risk. Improving attributable aircraft technology is crucial to providing the operational warfighter with the tool that is affordable and easily manufactured under tight time constraints. The AFRL stated that the autonomous collaborative platforms will play an increasingly important role in various Air Force missions and that the main tenets of ACP are autonomy, affordability, speed of design and build, and mission effectiveness, each of which are Kratos' strength areas. The DMAS program is directly addressing these characteristics, which are critical to the ability to develop affordable, attritable drone systems in large numbers and present the military challenge to peer adversaries. The announcement of Kratos' participation in DMAS is incredibly important to our unmanned tactical drone system long-term strategy and success, and once again, is representative of Kratos' industry-leading position in the next-generation UAV area. Simply stated, as I believe is reflected in today's report, unmanned jet drones will be joining the combat Air Forces flying alongside manned aircraft, carrying additional munitions, performing surveillance and jamming, and making attacks, including to protect their manned wingmen. Low-cost attributable unmanned drone systems will affordably increase the size and capability of air fleets without adding additional pilots, and unlike manned systems, these drones are designed for short operational lives, reducing or eliminating the cost of depot-level maintenance or service life extensions. So needless to say, we're extremely excited and optimistic for Kratos' unmanned systems business and our related next-generation engines that go in these systems. Kratos' space and satellite and cyber business has now successfully delivered the first set of products to support the U.S. Army Tactical Intelligence Targeting Access Node space to ground system prototype, which is being developed by Kratos' partner, Northrop Grumman. The purpose of the space-to-ground TITAN system will be to provide near real-time data to commanders at all levels for timely targeting solutions. In Q3, our space and satellite business continued to successfully perform and deliver on OPIR and missile warning satellite programs. Kratos' space, satellite and cyber business also supports various classified programs. Our third quarter adjusted EBITDA was stronger than forecast, primarily due to a more favorable mix in our space satellite and cyber business, including certain government agency programs. We expect this favorable mix to continue in the fourth quarter and beyond, based on our backlog, opportunities, and execution plans. We also continue to forecast future year-over-year organic growth with increasing margins for Kratos' space, satellite, and cyber business. From a value creation standpoint for our shareholders, Kratos' space and satellite business is approximately $280 million in revenue, growing organically about 17.5%, with mid-teen EBITDA margins that are expected to increase. There is significant interest in the space and satellite industry, driven in part by expected market growth, including estimates of as many as 100,000 operational satellites in orbit by 2030, up from 3,500 today and a future $1 trillion space economy. Kratos is the industry leader in satellite ground systems, including our new first-to-market open space virtualization products. The vast majority of the satellites in orbit, and that are going into orbit, are going to require ground infrastructure to successfully perform their mission, including command and control, telemetry tracking and control or TT&C, modems, recorders, antennas, digitizers, and more, all of which are Kratos' product and solution areas. Kratos is also the only company in the world with the Kratos-owned and operated global space domain awareness network, the value of which is substantially increasing and in demand by our commercial customers as more satellites go up that can interfere or crash into each other; our customers want to know where they are, what they're doing, and they want situational awareness. Kratos can provide that through our global network. Kratos' space and satellite business is both an industry and the Kratos crown jewel, with valuations of assets and businesses in the space and satellite industry receiving valuations as high as 15x revenue. We are focused on continuing to invest and create significant value for our shareholders with this asset. Since our last report, Kratos' Rocket Support Systems business provided multiple advanced ballistic missile targets for the First Test Aegis Weapon System 33, supported by the United States Navy and Missile Defense Agency, and we have multiple additional future missions currently planned, which are part of our forecasted organic growth trajectory. We expect future year-over-year organic growth in Kratos' rocket support systems business, including in the ballistic missile target, sounding rocket, special mission, and hypersonic systems areas. Our C5ISR business received approximately $13.2 million in program awards, including for a large U.S. National Security program, which we hope to provide details on in the future. Our C5 business is currently under contract for or in pursuit of multiple large missile, radar, space, satellite, and other system-related programs, many of which focus on the recapitalization of strategic weapon systems to address the peer threat. We continue to expect future year-over-year organic revenue growth for Kratos' C5ISR business, including significant expansion and growth in the GBSD program beginning in the second half of next year and increasing into 2023, where Kratos is a subcontractor for Northrop Grumman. Kratos' turbine Technologies business received a contract award for the development of a next-generation small engine for a certain national security program. KTT is currently under contract and in development for several next-generation turbo jet, turbofan, and other engines for national security priority areas, including unmanned aerial drone systems, cruise missiles, powered munitions, and other platforms and systems. KTT expects to receive a large additional engine-related contract in the next few months, continuing this business's momentum, which also includes our work on Gray Wolf, Speed Racer, and several other missile and powered munition programs. We are also forecasting 2022 over 2021 year-over-year organic growth for KTT in both our government program areas and in our commercial program areas, where we expect recovery from the recent COVID-related industry impacts. We expect future year-over-year organic growth in our microwave electronics business, driven partly by Israeli demand, India and other international radar, missile communication and satellite system demands, as well as a recapitalization of hundreds of Iron Dome interceptors, of which Kratos is a supplier. Fiscal federal 2022 began on October 1, 2021, with no fiscal 2022 budget in place, and the U.S. government is now operating under a continuing resolution through at least December 3, 2021. The continuing resolution continues the preexisting appropriations at the same levels as the previous year, with no new program starts, no transition from development programs to production programs, and no increases in existing production programs, all of which relate directly to Kratos, especially in light of the new and increasing programs Kratos has recently received and is currently executing under. The possibility of CRs is the primary reason why we typically wait until our fourth quarter to provide the next year's financial guidance. In this case, the guidance for FY2022 will be directly impacted by the length of the CR on Kratos' next fiscal year forecast and performance. Accordingly, we will provide our FY2022 forecast in February when we report our Q4 and our full year 2021 results. As I mentioned in our Q2 report and earlier today, similar to many other companies in the industry, supply chain issues and delays related to COVID continue to be a challenge, particularly related to increasing lead times for critical parts from vendors, and vendors canceling or significantly changing previously committed delivery schedules at the last minute. We have seen approximately $31 million of under contract revenue deferred from our third and fourth quarters of 2021 to future periods as a result of COVID, supply chain, and customer-related issues. These issues include our microwave electronics, space and satellite, and C5ISR businesses being unable to timely receive certain parts, which were previously committed, and COVID-related international quarantine and travel restrictions in our commercial satellite business. As soon as we can practically enter the countries to complete the work where we receive product from certain suppliers, we'll be able to execute and record the related revenue. Included in the $31 million is approximately $14 million shifted from 2021 to future periods in our C5 business on a large Kratos program where our customer had to re-baseline their execution plan and schedule in cooperation with the government request. On September 9, 2021, the President issued an executive order mandating that by December 8, 2021, all federal contractor employees must be fully vaccinated against COVID-19 and less excluded by certain limited exemptions. The company is moving to comply with the President's executive order. However, as a result of the executive order, Kratos and our subcontractors, suppliers, and partners are experiencing certain disruptions, including but not limited to employee distraction, unrest, some retirements, resignations, and other situations that we had not previously anticipated or planned for. All of which we are now monitoring and managing to the best of our ability, with potential impacts included in today's forecast. Irrespective of these challenges, as I discussed today, Kratos continues to successfully execute the business plan. Our unmanned systems, space, and satellite communication businesses have industry-leading growth. We continue to win large and important new program opportunities, and we're forecasting continued strong year-over-year organic growth with increasing profit margins. In closing, Kratos' business model is organic growth-based, one where we are making targeted internal investments in pursuing and winning large new program opportunities. Accordingly, we do not expect to pursue or consummate any acquisitions, except for potentially small tuck-ins that are clearly aligned with our current business and strategy.

Thank you, Eric. Good afternoon. Kratos' third quarter 2021 revenues of $200.6 million were at the midpoint of our estimated range of $195 million to $205 million. Unfortunately, delays in deliveries from our vendor and supply chain base and travel restrictions have resulted in the delay in our ability to execute and deliver on certain projects, primarily in our commercial ground satellite and antenna and C5ISR businesses, which resulted in expected third quarter revenues of $8.3 million deferred to future periods. As we mentioned on our last call when we provided the guidance range for the third quarter and full year, the revenue and EBITDA forecast assumed an increase in execution and delivery timing and our supply chain's ability to deliver on time and budget and our ability to hire necessary resources. Unfortunately, similar to what we see across the industry, our ability to execute and timely deliver has been impacted by supply chain challenges and COVID restrictions, including international travel restrictions. Our Q3 2021 consolidated operating income was $10.5 million, down from the third quarter of 2020, operating income of $12.7 million, which includes third quarter 2021 increases in stock compensation expense of $1.4 million, increased R&D of $300,000, primarily in our unmanned systems business and increased SG&A costs of $5.1 million, including increased headcount in our unmanned systems business. Total headcount in our unmanned systems business has increased from 755 million in Q3 of last year to $885 million. Net loss was $2.4 million for the quarter and GAAP EPS loss of $0.02 per share compared to GAAP EPS of $0.02 in the third quarter of 2020. Included in the net loss for the third quarter was a tax provision of $5.7 million on income before taxes of $4.6 million or an approximate 124% tax provision rate, primarily due to nondeductible, noncash stock compensation expense and taxes related to international-based income. As a reminder, we have over $280 million of U.S. federal net operating losses, which shield domestic federal income tax payments. We generated adjusted EBITDA of $23.8 million for the third quarter, above the range of our expectation of $16 million to $20 million, primarily reflecting a more favorable mix of revenues in Kratos' space, satellite, cyber and turbine technologies businesses. In the third quarter, our unmanned systems segment reported revenues of $61.3 million, up 14.6% from the third quarter of 2020 due primarily to ramps in production and target programs, including the 167 and work performed on the Valkyrie program. Unmanned systems generated operating income of $2.6 million, down from $3.7 million in the third quarter of 2020, primarily reflecting an increased mix of development programs and increased R&D investments of approximately $500,000 and increased SG&A costs of $1.6 million. Unmanned systems generated adjusted EBITDA of $4.7 million, down from $5.6 million in the third quarter of 2020. KGS reported revenues of $139.3 million in the third quarter, down from $148.5 million in the third quarter of 2020, reflecting a reduction of legacy government services revenues of $6.2 million, down from $17.4 million in the third quarter of 2020 to $11.2 million in the third quarter of 2021, and a $5.5 million year-over-year decrease resulting from the previously disclosed reduction of certain international contracts in our Training Solutions business. On a pro forma basis, excluding these reductions, revenue grew organically 5.8% in the third quarter of 2021 as compared to the third quarter of 2020, reflecting a year-over-year reduction of $1.8 million from the ASC acquisition, offset by organic growth across our space, satellite, and cyber defense, rocket, and microwave products businesses. KGS' third-quarter revenues were negatively impacted by the delays in supply chain deliveries, resulting in approximately $8.3 million of revenue expected in the third quarter deferred to future periods. KGS reported operating income of $14.6 million, up from $14.1 million in the third quarter of 2020. KGS' adjusted EBITDA for the third quarter of 2021 was $19.1 million, slightly up from $19 million in the third quarter of 2020. Our consolidated adjusted EBITDA for the third quarter is from consolidated continuing operations, including net income or loss attributable to non-controlling interest and excludes noncash stock-based compensation costs of $6.4 million and acquisition and restructuring-related costs of $300,000. Net income attributable to non-controlling interest of $500,000 and a foreign transaction loss of $200,000. Moving on to the balance sheet and liquidity, our cash balance was $369 million at September 26, with zero amounts outstanding on our bank line of credit and $6.6 million of letters of credit outstanding. Debt outstanding was $296.5 million at quarter-end, and net cash at quarter-end was $73.4 million. Cash flow generated from operations for the third quarter was $12.6 million, less CapEx of $12.9 million or a use of free cash flow from operations of $300,000. Contract mix was 75% fixed price, 20% cost-plus, and 5% time and materials. Revenues generated from contracts with the U.S. Federal government during the quarter accounted for 72%, including revenues generated from contracts with the DoD, non-DoD federal government agencies, and FMS contracts, which were approximately 0.4%. We generated 9% from commercial customers and 19% from foreign customers. Backlog at quarter-end was $839.1 million, down sequentially from $865.6 million in the second quarter of 2021 with bookings of $174.2 million and a book-to-bill ratio of 0.9-to-1 for the third quarter of 2021. Our book-to-bill ratio for our unmanned systems business was 1.1-to-1 for the third quarter of 2021, with bookings of $70.4 million. Of the $374 million IDIQ award from the Air Force of sole-source target drones that Eric mentioned earlier, only the amount initially obligated of $30.4 million is included in our backlog and booking amounts for the quarter. As expected, we have continued to see contract awards in the fourth quarter. Since our third-quarter-end, we have booked over $50 million in additional awards in October in our unmanned systems business. Funded backlog at quarter-end was $618 million with $221.1 million unfunded. For the last 12 months ended September 26, 2021, our book-to-bill ratio was 1:1, with total bookings of $770.9 million. Our book-to-bill ratio for the last 12 months ended September 26, 2021, was 1.0-to-1 for unmanned systems, 1.1-to-1 for our space, satellite, and cyber business, and 0.9-to-1 for our KGS segment. Now moving on to financial guidance. We are adjusting our 2021 revenue guidance range from $810 million to $850 million to $805 million to $815 million, primarily to reflect continued and increased supply chain and customer delays, COVID-related quarantine issues and restrictions, including where we are unable to enter certain countries to execute or deliver systems for customers. The adjustment primarily reflects over $31 million of under contract revenues that have been deferred from our third and fourth quarters of 2021 revenues to future periods, including in our satellite, microwave electronics, and C5ISR businesses. We expect supply chain, customer, and COVID-related disruptions and delays to continue industry-wide as related to Kratos for the foreseeable future, which we are taking into consideration in our future forecast. The adjustment also reflects a Kratos customer re-baseline execution plan and schedule on a greater than $150 million C5ISR under contract Kratos program, which shifted approximately $14 million in revenues into future periods, including 2023. At the midpoint of this revenue range of $810 million, excluding the ASC acquisition and international training contract, Kratos revenues are forecasted to grow organically over 8% year-over-year from 2020 to 2021. We are adjusting our full-year 2021 EBITDA guidance range of $81 million to $87 million to $80 million to $84 million to reflect the impact of the revenue shifted from our third and fourth quarters to future periods. We are improving our 2021 free cash flow used from operations guidance from a use of $30 million to $40 million to a use of $20 million to $30 million to reflect expected reductions in our day sales outstanding and increased collections, and lower than initially forecast capital and other investments as certain initiatives are ahead of schedule, under budget, or reduced for other reasons. The full-year 2021 estimated operating cash flow includes approximately $5 million to $6 million of planned investments in our rocket support systems and engine business for new products, including in the hypersonic area and efforts to increase Kratos' market share, as well as approximately $5 million of the required payback of the 2020 deferred employee-related payroll taxes. The 2021 capital expenditure forecast currently includes expected outlays of approximately $25 million associated with the current production of Valkyrie aircraft prior to receipt of expected customer awards. Therefore, these aircraft are currently reflected as company-owned assets awaiting related customer orders. Kratos will adjust the forecasted capital expenditure outlays and the ultimate balance sheet classifications of these investments once customer orders and the nature of the contract terms can be determined.

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

Your first question comes from the line of Sheila Kahyaoglu from Jefferies.

Maybe if we could think about a lot of these awards you won like OBSS and Valkyrie moving forward. Lots of good things. But can you summarize it for us in terms of how we should be thinking about the growth outlook for next year? It seems like we have a pretty robust double-digit growth outlook. What programs are the biggest incremental drivers? And does anything go away as we think about 2022?

Right. Nothing goes away that comes to mind at all. There will be increases, and the biggest one is probably going to be in the tactical area, and this is going to be Valkyrie related, Thanatos related, and we'll have to see if that additional phase for Gremlins gets awarded that I mentioned. We're going to get third year full-rate production in the next few months on SSAT. This is going to be one of the top two target drone programs in the company. So that's going to be a significant addition for next year. I'm not going to detail the percentages of growth because a lot will tie to the continuing resolution and the duration of it since we have many programs transitioning from development to production. We expect significant organic growth in our unmanned systems business year-over-year, 2023 over 2022. Absolutely, we see it.

And then maybe on margins, if I could ask one more. Profitability was really good this quarter, above our expectations. How do we think about that mix heading into Q4? What drove some of that big improvement?

The primary driver of the big improvement was in the space area. There are a few military programs or national security programs we're on, and one in particular changed phases, generating significant profit margins in Q3. We expect our profit margins to remain strong and potentially continue increasing depending on the mix. And that's not just for Q4, Sheila, but probably for next year. The business mix is improving. Development programs typically have lower margins than production programs or later programs. If they are doing well, you just got OBSS, which will carry a lower margin. However, in 2018, 2019, and 2020, we won several programs in development that are now transitioning to production in the space, microwave, and unmanned areas. The weighting is moving towards more mature programs, which will naturally increase our margins, especially as our manufacturing facilities, including those in Oklahoma building the tactical drones, are filling up with more products. For example, we're building many Air Wolves right now, spreading fixed overhead over a greater number of units, which is also enhancing profitability. So we have several factors working in our favor for increased margin expansion.

Your next question comes from the line of Ken Herbert from RBC.

Eric, I wondered if you could just level set us on Valkyrie production. I believe you're still producing 12 this year. How many are under contract? And when do you expect all of them perhaps to be under contract? How should we think about production levels on that particular platform into 2022?

We were recently with the customer regarding the under-contract vehicles. We are still explicitly being told we cannot discuss quantities yet for national security reasons. For the Skyborg program, which the Air Force reiterated will be a program of record for 2023, we foresee significant additional Valkyrie orders once the 2022 budget is approved and becomes law. We will evaluate and potentially accelerate and pull left some of the 12 we are currently building to get them to customers faster based on customer demand signals, and we likely will make decisions on ordering long leads for a subsequent batch as we progress into 2022.

And if I could, maybe without getting into specifics, how is pricing trending for these aircraft? Obviously, you're the low-cost leader, but as you incorporate AI and other aspects into these aircraft, are you seeing a path to better pricing? Or how should we think about that?

I wouldn't anticipate better pricing above the previously mentioned ranges. This competitive pricing is one of our primary advantages. We're confident in this approach with Valkyrie, across the board. We deliver a Valkyrie for $3 million, $4 million, or $5 million each, allowing the customer to add $1 million to $3 million worth of sensors or payloads, keeping overall costs under $10 million.

Your next question comes from the line of Mike Crawford from B. Riley Securities.

Regarding the OBSS, are there any different long-term implications for margin profile if OBSS airframes hit production, given I think the government is going to own some of the data rights for this airframe?

There are no margin implications relative to that aspect based on our program outlook. However, there will be significant positive margin implications for us as more tactical aircraft ramp up production, which spreads fixed costs over more units, driving costs down for the government while likely increasing our margins. As you also know, significantly greater than 50% of the bill of materials for tactical drones overlaps with target drones. As we ramp up our tactical drone portfolio, we gain additional leverage on that supply chain, which should also lift margins.

Can you talk more about this runway-independent Air Force cargo mission in the Pacific that you alluded to earlier, including how many times a reusable Valkyrie could actually be reused?

A Valkyrie can be reused multiple times. It is designed to exceed initial specifications. The capability needed by the Air Force is similar to Valkyrie, Gremlins, and AirWolf; we have the aircraft ready to meet those needs. The budgets are constrained, but we are strategically positioned to deliver value against these initiatives.

Your next question comes from the line of Austin Moeller from Canaccord.

My first question is for Deanna. Is the $369 million in cash sufficient to support the production ramp and all of these new major program wins, be it Valkyrie, OBSS, AirWolf, etc., or do you think you're going to have to look at a potential capital raise?

At this point in time, we believe that it is sufficient. Of course, if there are multiple production runs and depending on size, we may have to revisit that. But for now, it is sufficient.

And then, Eric, as you talk about that second batch of Valkyries, you're planning the second set of 12. Is the plan to do what you did before and pay for the initial production of those out of pocket? Or do you plan to have that paid for via a production contract? Is that timing in 2022? Or do you have to wait for Skyborg to be a program of record for that?

Our plan is absolutely not to produce the spiral lot exclusively using Kratos resources unless it's deemed absolutely necessary. However, we are clarifying our visibility with several customers, and if the 2022 NDAA marked up goes through as projected, we might decide to start ordering long leads. It looks promising for us, so we are prepared to coordinate closely with customers before making decisions.

And then just one quick follow-up. The Army's announcement about testing the AirWolf—have they put a dollar amount on that contract or not?

No, they have not put a dollar amount on it yet. But it's a very low-cost system. However, for future production, we have been successful making investments in aircraft to have them as capital or inventory. This strategic approach has been a significant boon for AirWolf and Mako, allowing us to become more competitive while ensuring readiness.

Your next question comes from the line of Seth Seifman from JP Morgan.

I was wondering, Eric, if you could give us an update on open space and kind of to what degree any of the delays affecting supply chain are impacting open space rollout and your plan to ramp up there from last quarter? How is that progressing?

Open space is progressing. Right now, we have numerous military and national security programs we have won, especially in the classified area, which has contributed to organic growth in the space business. We are reallocating some resources from the commercial open space area towards the DoD side. Additionally, ongoing partnerships with organizations like the Standards Board have been productive as we contribute to the open architecture standards board for virtualized ground systems, which Kratos chairs. We are rolling out and demonstrating products with several customers, anticipating these efforts will be mid- to long-term growth drivers.

As we think about the CR, I know in the past it has sometimes required you guys to start acquiring long lead items and build ahead. I know you talked about that with the spiral on the Valkyries, but is that something we should prepare for heading into 2022?

Yes, that's correct. It includes the target drone side. Because we are sole-sourced with both the Navy and the Air Force, we understand the trajectory, and we may make the decision to lean forward and order additional engines two years in advance if the situation deems it necessary.

Your next question comes from the line of Peter Skibitski from Alembic Global.

Eric, I was wondering if you could give us more color on the Air Force multiyear target award that you received back in August? I think as Deanna mentioned, you got the initial award under the IDIQ, so it sounds like you could start work immediately. Can you clarify if you can recognize revenue until delivery is completed, which I would think is in 2022? Also, will there be additional payload-related contracts to go along with that?

Yes, we can start immediately, as Deanna mentioned, since we received the initial funding of around $30 million. We're finishing previous production runs, which will prevent production breaks and ensure financial performance remains steady. This initial funding is significant, and we expect to see numerous target drones utilized in upcoming systems. Regarding your other question, yes, we expect additional contracts related to payloads and ancillary equipment for all of our target drone programs, so the core program vehicle we are focusing on is the single-award IDIQ.

So you're anticipating additional sizable contracts from international opportunities in the future?

Absolutely. There are more contracts expected; one international contract is nearing the final review process, and we hope to announce this in the next couple or three months. This includes relevant ground equipment for range operations. Additionally, there is a confidential program currently increasing in quantities, which is expected to transition from LRIP to full production by late next year or early 2023. There are several substantial opportunities on the horizon, including the upcoming Next Generation Aerial Target program.

And for the record, the international target award will not allow any percent completion revenue recognition until delivery begins, which will consequently not commence until 2023. Our quarterly bookings in October were strong, at over $50 million, including the OBSS contract. OBSS value was just under $18 million.

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

So I want to clarify a little something here in KGS. You mentioned how the revenues came down, but how the satellite and cyber was strong. If I'm looking at that and some of your other product lines, was it all related to push-out? Or are some of the product lines coming in weaker than expected?

Nothing came in weaker than expected. Virtually all revenue in our Q3 and Q4 was and is under contract. There are countries, particularly in the Pacific Rim, that we cannot access due to COVID quarantines preventing us from sign-offs on satellite systems. Delays have arisen in certain delivery dates where suppliers have committed but then extended delivery. We have taken these factors into account in our forecast.

And then I guess the Air Force recently talked about eliminating at least three of their fighter families. Is there a positive or negative impact on Kratos?

The Air Force recently talked about high-performance jet drones being integral to future force structure. They also mentioned the advantages of low-cost, high-performance systems, which is the direction we are leaning towards. This aligns well with our focus on tactical drones.

The next question comes from the line of Michael Ciarmoli from Truist Securities.

Eric, I know we mentioned supply chain a couple of times. Thinking about some of these early development programs, maybe even Valkyrie, are you feeling any significant pressure on raw material pricing? Are there any contracts where you're executing on older IDIQ awards where you're now seeing some inflationary pressures?

Yes, we are experiencing some of those pressures, especially in composite and wire harness areas. We have long-term agreements on pricing for engines and other materials. However, in some cases, we are seeing price increases in the target and tactical drone area that we've included in our pricing strategy. Most of these are firm fixed-price contracts with firm fixed-price options, and we'll have to manage that effectively.

You called out space and cyber and how strong it was. If it's currently $280 million at mid-teen margins, that sort of implies maybe $40 million of EBITDA. Based on that, the rest of KGS only running around 6%, 7% EBITDA margins. Is that accurate perception?

Your understanding is mostly correct; however, it has to do with our significant corporate G&A expenses associated with the space and satellite business, which is our largest revenue generator and thus has a greater share of corporate expenses.

Your next question comes from the line of Peter Arment from Bayer.

Eric, your target drone business is growing substantially, either north of $200 million now. How do you see the tactical business playing out? What needs to happen for it to surpass the target business?

I absolutely believe our tactical drone business will soon surpass our target drone business. The customers are interested in reusable, disposable drones for various missions, including cruise missiles. Now we are in the DoD Valley of Death with several of our tactical drones, and we are working hard with the DoD to encourage accelerated progress in this area. We have several classes of jet drones ready and awaiting orders, and we've aligned our strategy to ensure we can meet future demands, reinforcing our strong competitive position.

This concludes our question-and-answer session. I would now like to turn the conference back to Mr. Eric DeMarco for the closing remarks.

Thank you very much for joining us this afternoon. We appreciate the opportunity to update you, and we truly look forward to our next update when we report Q4 as we head into 2022. Thank you.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.