Kratos Defense & Security Solutions, Inc. Q2 FY2022 Earnings Call

Good day, and thank you for standing by. Welcome to the Kratos Defense & Security Solutions' Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. And without further ado I would now like to hand the conference over to Marie Mendoza, Vice President and General Counsel. Please go ahead.

Thank you. Good afternoon everyone. Thank you for joining us for the Kratos Defense & Security Solutions second quarter 2022 conference call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer. Before we begin the substance of today's call, I'd like everyone to please take note of the Safe Harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today's call. Today's call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today's press release, we have provided a reconciliation of these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP. With that I will now turn the call over to Eric DeMarco.

Thank you, Marie. Good afternoon. I believe today's report reflects the success of Kratos' strategy to disrupt the national security market space with first-to-market affordable, transformative technology, product systems and solutions. Since our last report to you, we have received each of the three large new space and satellite program contract awards we mentioned on the Q1 call, including the BlueHalo Space Force SCAR program and Intelsat's next-generation satellite network, each of which have now been disclosed by our customers. We have also received the third contract award I mentioned. It has not yet been publicly disclosed by the customer; therefore, we are unable to provide any additional information at this time, but we have received all three. The initial estimated total future potential value of these three new programs for Kratos is several hundreds of millions of dollars over the respective program periods. These new program awards that we have now received, which have a significant OpenSpace software component, are key elements to Kratos' expected fourth quarter ramp and EBITDA margin increase and also our future year expected financial organic growth rate that I'll discuss later. Kratos' first-to-market OpenSpace Platform is the only software-defined satellite ground system today. And this was key to Kratos' receiving each of these three new large program awards. Kratos is the clear market leader in next generation satellite ground systems, which is an extremely large and rapidly growing market area. We believe that these recent program awards and our 1.7 to 1.0 Q2 book-to-bill ratio in our space, satellite and cyber business is representative of Kratos' OpenSpace software and technology disruption potential for Kratos to the multi-billion dollar total addressable satellite market space we are penetrating. We are currently in pursuit of several additional new space and satellite program opportunities with our OpenSpace technology, certain of which we also hope to be successful on by the end of this year. We expect Kratos' Space and Satellite business, which is our company's largest, to be one of our fastest growing and highest margin businesses going forward as customer acceptance of our OpenSpace software-based products increases. We will continue to invest significant internally funded R&D into our OpenSpace software product family and intellectual property in order to further Kratos' position as the leader in what we see as a transformational large and growing market opportunity for our company. Since our last report to you we have had several successful flights with multiple Kratos tactical drones, including Valkyrie for the Skyborg program, and a number of Kratos Valkyries have now been delivered to and accepted by the customer. We now expect to receive additional Valkyrie-related contract awards in the second half of 2022, including a Valkyrie-related contract from a new service branch customer in Q4, which is a key element of our forecasted Q4 Unmanned Systems revenue and profit contribution increase. Since our last report to you, it has been reported that the Air Force will be retiring the entire Global Hawk fleet of drones in order to free up funding for more survivable platforms and systems in a high-end conflict. On the Global Hawk retirement decision the Air Force reportedly said that in part our ability to win future high-end conflicts requires accelerating investment in connected survivable platforms by divesting legacy ISR assets that offer limited capabilities against peer and near-peer threats. It was also recently reported that the USAF is planning the reduction and retirement of the JSTARS fleet as the aircraft is also not considered survivable in a high-end conflict. Since our last report to you, the Deputy Assistant Secretary of the Air Force for Science, Technology, and Engineering informed Congress that the Skyborg Vanguard program, which Kratos' Valkyrie and Mako tactical jet drones have been publicly acknowledged to be part of, will now become a program of record by the end of 2023, and will transition to acquisition. The Valkyrie was specifically designed to be survivable in a high-end fight with the Valkyrie having flown with both the stealthy F-22 and F-35 and the Valkyrie having a very attractive signature characteristic of its own at a cost level that allows the Valkyrie to be deployed in affordable mass. We believe that the world is now seeing that quantities or mass does matter, and the approximately 1,000 drones of all types reportedly lost thus far in Ukraine, including jet drones, emphasize this belief that low cost and the delivery of affordable mass is now considered critical. The UK recently canceled its loyal wingman drone program Mosquito, reportedly due to high cost, a flying system still many years away and the UK MoD has now determined that cost effectiveness is achievable through smaller, less costly, but still highly capable drones. We continue serial production of the initial 12 lot of Valkyrie, certain of which as I mentioned earlier have now been delivered to and accepted by a customer. Based on discussions with the potential new service branch customer certain of the 12 Valkyrie still in production will have their mission system configuration modified to meet a certain requirement. Based on recent interactions with additional potential new customers, we believe the fact that Kratos has active production lines for high performance jet powered drones, including Valkyrie, Mako, Air Wolf and others — all of which are flying today — these are not PowerPoints or simulated videos or concepts that reportedly will be ready three, five, seven years from now at some unknown price, is a key differentiator for Kratos. Kratos is ready now with active production lines and in place supply chain, flying aircraft and known price points. We believe that Kratos' readiness now, positioning and affordability along with recent global geopolitical events — demonstrating that the threat is real and that quantities do matter in a high-end conflict — will be a catalyst for us. Additionally, over the past several weeks, it has become clear based on publicly available information and our meetings with customers that runway independence is an absolutely critical requirement for affordable, reusable, disposable and attritable drones. Accordingly, our unmanned business resources will now primarily be focused on runway independent systems, an area where Kratos is already the clear industry leader, having built hundreds of jet drone aircraft, all of which are runway independent. Related to runway independence, Kratos' Ghost Works is now almost complete with what we believe is a game changing capability in this area as specifically related to Kratos' drones. Runway independence, we believe, is also critical to the success of the Air Force's Agile Combat Employment or ACE program in the Pacific. As a result of these recent customer meetings, communications, and events, we are now planning to increase serial production. We're in the planning process of the Valkyrie beyond the initial 12 lot currently in production. Over the next few months I currently believe that by the end of this year we will be making the decision to begin the next Valkyrie production lot and its size based on the increasing demand signals we are receiving from multiple sources. As I've mentioned previously, a significant amount of Kratos' tactical drone work and initiatives are now classified CUI or confidential, and we cannot get ahead of our customers from a communications standpoint on certain programs, projects, or initiatives we may be working on, including as related to Valkyrie. However, Kratos is the clear industry leader in low cost, high performance jet powered drones, and we remain highly confident in the future potential transformational success of Kratos' tactical drone business for our company. Kratos' target drone business, where Kratos is also the clear industry leader, once again is also well-positioned, including as a result of the Russia-Ukraine war, Asia-Pacific tensions, and the related global recapitalization of strategic weapon systems, which systems need to be exercised and tested against target drones. We continue to expect to receive an approximate $100 million sole source target drone IDIQ contract in Q4, and we are in pursuit of several other new U.S. and international target drone opportunities. Kratos is the primary target drone provider to the United States Air Force, Navy and Army, and U.S. allies want to exercise their respective weapon, radar and other systems against the same target drones that are used by the United States military, which are Kratos drones. Kratos Turbine Technologies, our engine business, is also performing well. Since our last report to you, the Golden Horde Vanguard program was reported by the Deputy Assistant Air Force Secretary to also be scheduled to be a program of record in 2023. We believe that the Golden Horde Vanguard program transitioning to a program of record is important to Kratos from a tactical drone, tactical empowered munition, and propulsion system standpoint. Just last week, Kratos Turbine Technologies, or KTT, announced the $54 million sole source single award task order to develop a low cost limited life engine for attritable and expendable systems. Also in KTT, the new Rolls-Royce B-52 engine program we recently received is expected to begin ramping in Q3 of this year, as are several space propulsion system programs KTT is currently executing on. In our C5ISR business, the GBSD or Sentinel program with our outstanding prime partner Northrop Grumman is also beginning to ramp up in Q3 with an expected increase in Q4. We anticipate that GBSD will also be a key future year organic growth driver for Kratos. Our C5ISR business is also pursuing an additional large potential several hundred million dollar new program opportunity for Kratos where Kratos has now received a development contract. Kratos' rocket systems business growth opportunities are also robust, including in the ballistic missile defense and hypersonic areas, which is receiving significant funding increases in the 2023 request and the FYDP. We continue to progress on Kratos' Zeus propulsion system with our strategic partner Aerojet and our Erinyes hypersonic vehicle system, including with our stakeholder customer partners, and we are now expecting to receive a new large contract related to these systems by the end of this year. We believe that the extremely affordable Kratos Zeus and Erinyes hypersonic system will be disruptive and transformative, providing significant capabilities to our customers at a low cost. The SRE transaction closed in Q2 of this year, which further positions Kratos in the high priority and extremely well funded hypersonics area. Our microwave electronics business has virtually 100% of its Q3 and Q4 revenue forecast now in backlog and has a strong opportunity pipeline similar to virtually every other Kratos business. In our microwave business, we have now been informed by a customer and we have executed a letter of intent with the customer that we have been selected for a potential $250 million Kratos value program related to a C5ISR system. We expect Kratos' microwave business to be under formal contract on this new opportunity by the end of this year, which will further position Kratos' microwave electronics business for sustained future organic growth and margin expansion. In summary, Kratos is positioned and well funded in mission critical priority national security areas of the United States and our allies and the demand for Kratos' systems, our products and our solutions has never been stronger and it's increasing. Virtually every Kratos business unit continues to forecast organic growth for 2022 in a very challenging environment, which is representative of the Kratos teams' execution. Assuming no future acquisitions we are currently forecasting a base case 2023 over 2022 year-over-year growth rate of approximately 10% with the possibility for an even substantially greater growth above this 10% base case if certain opportunities in our tactical drone, space, satellite and cyber businesses come to fruition ahead of our base case expectation. The expected growth, of course, could move around a bit depending on the length of any future year continuing resolution authorizations or government funding delays, but irrespective Kratos' future organic growth trajectory is expected to be very strong. Operationally, supply chain issues remain a significant challenge and we now expect them to continue into 2023 with specific representative Kratos issues including the procurement of FPGAs, aluminum antennas, and certain materials related to composites. Inflation across every cost point, including as related to materials and wages is also a challenge, which has gotten worse since our last report to you and which is impacting our Q3 margins on existing firm fixed price contracts and on price options as we cannot pass the increased costs onto our customers. We expect our margins to increase in Q4 as certain new contracts we have recently received have contemplated inflation and increased costs in them and as the mix of our revenue improves, including in our space and satellite business with OpenSpace software, as we realize increased leverage also on our fixed cost base and revenue increases. Hiring, obtaining and retaining personnel, including those with security clearances, is also an operational challenge and we are having to increase compensation to both retain and obtain qualified personnel, which is also adversely impacting our near-term profit margins. Our forecasted execution plan and revenue growth includes the assumption that we will be able to increase our workforce to meet the production and delivery requirements of the contract awards that we're executing on and that are included in our backlog. However, irrespective of these challenges, we believe that Kratos' strategy of providing affordable technology for national security is spot on and that we have the right products at the right price at the right time to meet the U.S. and its allies' national security priorities. Our plan remains to focus internally on organic growth and our 10% 2023 over 2022 base case growth rate and to successfully execute on our potentially transformational tactical drone, space and satellite opportunities. Deanna?

Thank you, Eric. Good afternoon. As we have included a detailed summary of the second quarter financial performance and financial guidance in the press release we published earlier today, I will focus on the highlights in my remarks today. Kratos reported second quarter 2022 revenues of $224.2 million, above our estimated range of $205 million to $215 million, driven primarily by growth in our Space, Satellite & Cyber and Turbine Technologies businesses and due in part to the contribution from the recently closed SRE acquisition. Excluding the impact of the SRE acquisition, which contributed $21.5 million, and excluding the impact of the reduction in our training solutions business of $8.6 million, revenues grew organically 3.2% as compared to the second quarter of 2021. Q2 2022 revenues continued to be impacted by continued and increased COVID-related, supply chain and other delays, including obtaining and retaining qualified personnel, resulting in approximately $14.5 million in revenues being deferred into future periods with approximately $2.9 million of associated operating income, including increased inflationary cost. Our Q2 2022 consolidated operating loss was $1.9 million compared to operating income of $3.3 million in the second quarter of 2021, with Q2 2022 including a litigation settlement charge of $5.5 million. Net loss was $4.7 million for the second quarter of 2022 and a GAAP loss of $0.04 per share compared to net income of $1.1 million in the second quarter of 2021 and GAAP EPS of $0.01 per share. Included in second quarter 2022 net loss is the $5.5 million litigation settlement charge discussed previously. We generated adjusted EBITDA of $17.7 million for the second quarter, exceeding the higher end of our expected range of $11 million to $14 million, due primarily to a favorable mix in our Space, Satellite & Cyber and Turbine Technologies businesses. Our Unmanned Systems segment reported revenues of $56.4 million in the second quarter of 2022 compared to $60.3 million in the second quarter of 2021. KGS reported revenues of $167.8 million in the second quarter of 2022 compared to $144.8 million in the second quarter of 2021, including contribution of $25.1 million from the recently acquired Cosmic AES, SRE and CTT acquisitions, offset partially by the training solutions business of $8.6 million, which included the loss of an international training services contract, which contributed revenue of $4.5 million in the second quarter of 2021. Despite the continued unfavorable impact resulting from supply chain, COVID and related delays and disruptions, which impacted current quarter revenues unfavorably by approximately $13.9 million on a pro forma basis excluding the impact of the training solutions business, KGS revenues grew organically 7.7% in the second quarter of 2022. Second quarter 2022 operating income and adjusted EBITDA for Unmanned Systems included a heavier mix of more development-based revenues, which are typically lower in margin due to less leverage on fixed overhead manufacturing, SG&A and development infrastructure. Our Unmanned Systems business experienced an increase of $900,000 in SG&A primarily related to increased head count and $1.3 million of R&D in the second quarter of 2022, as compared to the second quarter of 2021. KGS operating income and adjusted EBITDA included a more favorable revenue mix, including software and license-based revenues. Q2 2022 cash flow from operations was a use of $21.6 million with the use including an increase in receivables of approximately $27.1 million primarily related to future milestone and other contractual payments from customers and an increase in our inventory balances of approximately $10.5 million during the quarter, primarily in our Unmanned Systems, C5ISR, Satellite and Microwave Electronics businesses in anticipation of the ramps and production in the second half of the year and in part to secure additional safety stock and advanced buys in larger lot sizes to gain pricing benefits where possible, and to mitigate the impact of supply chain disruptions. In addition, operating cash flow also includes the continued planned investments in engineering costs in our Rocket Systems and Turbine Technologies businesses for new products and investments including the design and development of an affordable hypersonic vehicle Erinyes and a complementary propulsion system Zeus. For the first six months of 2022, our operating cash flow uses included $15 million of increases in receivables and increases of $25.8 million in inventories across all of our product-based businesses including Unmanned Systems, Space & Satellite, Microwave Products and C5ISR. In addition, we have made approximately $5.6 million in investments in non-recurring engineering costs for these new rocket products during the first six months of 2022. Our contract mix for the quarter was 72% of revenues generated from fixed price contracts, 23% from cost plus fixed fee contracts, and 5% from time and materials contracts. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 70% including revenues generated from contracts with the DoD, non-DoD federal government agencies and FMS contracts. In Q2 of 2022, we generated 12% of revenues from commercial customers and 18% from foreign customers. Now moving to financial guidance. Our third quarter 2022 financial guidance we provided today includes our current forecasted business mix, and our assumptions related to the expected continued impact of employee absenteeism, challenges related to obtaining and retaining qualified personnel, supply chain disruptions, inflation, and related expected costs and price increases and other COVID-19 related items that have and are currently expected to continue to impact the industry and Kratos. Throughout the first half of the year, Kratos experienced a significant increase in the intensity and effects of COVID-19 and the related impact to our employees' absenteeism, consultants, vendors, suppliers, customers, et cetera, which impact included loss of weeks of manufacturing and production functions in our Unmanned Systems, C5ISR and Microwave products businesses. We have assumed that these COVID-19 and supply chain related impacts to our business including increased inflationary costs, which significantly impacted our first half 2022 operations, will continue to impact the third quarter with an estimated impact of approximately $10 million to $14 million in third quarter revenues and $3 million to $5 million of our adjusted EBITDA. We are having some success with certain customers on building in cost and inflation escalators on new bids and new upcoming price options. And we expect to begin seeing certain benefits of these efforts in the fourth quarter of this year. However, since our contract mix is predominantly fixed price with certain of the contracts under longer period of performance terms, it will take some time to transition the contracts to those with increased pricing. As a result of each of these pricing and inflation factors that we are contractually obligated to absorb and the continued delay of our ability to produce and deliver certain products with the most significant impact to our third quarter forecast, which we had originally expected to significantly improve, we are adjusting our Fiscal 2022 adjusted EBITDA to $80 million to $85 million with the most significant impact to the forecasted third quarter margins with improvements expected in the fourth quarter, based upon the projected ramp and new large programs, which includes more recent cost leverage realized on the SG&A and overhead infrastructure and a more favorable revenue mix including more software based revenues driven largely by the three new OpenSpace programs that Eric mentioned earlier. We are forecasting increased revenues in the third and fourth quarters of this year with the trajectory increasing in the fourth quarter. We are also adjusting our revenue guidance up to $890 million to $930 million to reflect the expected contribution from the SRE acquisition, along with forecasted organic growth driven by our booking and backlog offset partially by continued revenue delays caused by supply chain disruptions. The growth expected in the fourth quarter of 2022 is largely driven by the forecasted execution and delivery schedules of five new programs, four of which have already been awarded, the three satellite program awards, GBSD, and an expected Valkyrie award from a new customer. In order to maintain our Fiscal 2022 estimated use from free cash flow estimate of $30 million to $40 million, we have adjusted our FY 2022 capital expenditure plan to mitigate where possible the additional uses of working capital that we have expended this year to bolster our inventory levels and advanced inventory purchases. Eric?

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

Thank you. Our first question comes from the line of Michael Ciarmoli of Truist Securities. Your line is now open, Michael.

Hey good evening guys, thanks for taking the questions. Eric, just on the guidance, I guess two questions: for the current year you've got this bigger fourth quarter, how are you contemplating or thinking about a continuing resolution and then even just in the, it seems pretty early to be talking about 2023, given the range of unknowns and supply chain — are you thinking it takes some time for supply chain to normalize out and just, I guess you’re calling that 10% as a base case, but just maybe more thoughts on why throwing out that number now?

Right, on the first one, Michael, our fourth quarter is substantially all in 2022 or prior year money. So there's very little that's on 2023 in there, very little. On putting out a number relative to next year, Deanna kind of went through the big drivers: we have Sentinel, which is under contract and we've got the work plan laid out through at least 2023. The big space awards that we've won are target drone production schedules, primarily with the Air Force and the Navy — they're pretty much laid down out for the next 18 months. So we believe we have pretty good visibility and we understand the pricing and cost element in those, and as I went through, certain of those are new and so there have been inflationary factors built into them. So we feel pretty comfortable. The primary risk we have right now is hiring the people operationally, Mike; that is absolutely the primary risk. It's not winning new business. We're winning a lot of business. We're going to win a lot more in the next few months that we know, but hiring these people, particularly with security clearances, and not just engineers — manufacturing people that have security clearances on some of these programs we've won — that's where we've got to stay focused to achieve the top line.

Got it. Okay. Perfect. Thanks. I'll jump back in the queue.

Okay. Our next question comes from Mike Crawford from B. Riley Securities. Go ahead Mike. Your line is open.

Thank you. Eric, with the Skyborg looking like it may become a program of record in the next budget, what does that specifically mean for Valkyrie and what the ancillary to that is? What about these other myriad platforms that you've been developing over the years ranging from Thanatos on down? Thanks.

Right now, Mike, the primary focus of the customer set is on three platforms, and I believe it's because they're mature and they've all been flying for a number of years. It's Valkyrie, Mako and Air Wolf — that is where we are having the most significant activity with customers, and in particular the past couple of months. I believe, as I said in the prepared remarks, it's in part being driven by what's going on in the Russia-Ukraine war. I saw this just this morning that the Russians alone now have lost over 800 drones, including lots and lots of jet drones. And as I established, as the DoD is retiring the Global Hawk for survivability reasons, retiring JSTARS, you've seen the discussion around the Reaper which is excellent for asymmetric warfare, but survivability is limited. My opinion is the customer focus on Valkyrie right now, Mako and Air Wolf is because they're flying. They've proven. They've exercised things; they've deployed things and that's where the focus is now. That's where the money is.

Okay. And of course those are attributable expendable and disposable platforms. So it’s good. You have the whole mix there, and I guess maybe Air Wolf being runway independent — is that what gives it a leg up over say Gremlins?

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

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

We're in Phase 1 as is the other party and the down select or the move to Phase 2 is scheduled in Q4; I think it's October or November and so we're heads down and we're focused on that. As I did mention in the prepared remarks though, the nearer-term opportunity for meaningful revenue and profit margin increases for our company right now is in Valkyrie, Mako and Air Wolf. We've all been patient; we've waited a long time; we're doing everything we can to pull some of these in now that the geopolitical position has changed. That's where our focus is primarily.

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

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

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

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

All right. Thank you, Eric.

Okay. Next up we have Ken Herbert from RBC Capital Markets. Ken, your line is live.

Yes. Hi, good afternoon Eric and Deanna.

Hi Ken.

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

Ken, this is Deanna. So obviously we're not giving any guidance on 2023 at this point. But the ramp in the second half we would expect a portion of that in the third quarter and then a more significant ramp in the fourth quarter. And remember a lot of these are license-based so it'll be a much more favorable mix from a margin perspective.

And Ken, your question kind of dovetails into Michael's question on why we gave some initial thoughts on growth rate between 2022 and 2023. With these contract wins, they're bolted in, they give us pretty good visibility into our Space and Satellite business — our company's largest in 2023 — which is a layer of comfort of what we're looking at next year.

Okay. That’s helpful. And I guess considering the risks around not only this year, but next year, when you look at hiring, operationally what are you doing differently now to try and accelerate that to the extent you can? I know you're in different parts of the country, but what levers do you have to pull besides just salary perhaps as you look at addressing that issue? Because it's an issue obviously across the industry.

It's different in certain of our different business areas. In our Unmanned area, we're finding it much easier to bring people in because they like the work, it's exciting and they get to work on a new airplane every two to three years. They are not stuck on the B-2 Bomber for 30 years. So there's that group and we're having better success in that area. We're also having better success in the hypersonic area because that's exciting work; there aren't very many people doing it. In our C5ISR business, that's different — that's very challenging where you have very skilled machinists that work on all types of exotic and unique materials to build weapon systems and platforms. There's an incredible demand for that in the industry right now as the entire industry is ramping up and doing the pivot away from the war on terrorists to protecting against peer threats. That's very difficult and that is money. It's trying to take people from other companies; we can do some of that through relationships. We have referral programs that we've rolled out; we're doing that. We have mentorship programs we've rolled out. And Deanna, what's the name of the programs with the colleges we've partnered with?

It's both high school and college internships.

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

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

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

Perfect. All right, thanks, Deanna.

Okay. Next up, we have Josh Sullivan from The Benchmark Company. Josh, your line is live.

Hey, good evening.

Good evening, sir.

Good evening.

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

On the aluminum and castings, it has not improved at all for us. And you can imagine both aerospace and defense, the demand that's going on there. So that is not good. On the composite side and certain resins in that area, Josh, it's become challenging. We are reaching out not only to the supply base but to other companies that do composite structures that we have great relationships with, and we're having some luck with some of those that have a significant amount of inventory available. We just hit it with one company very well last week where we got some. So that's choppy. I don't expect that one to get worse, but it's choppy. Josh, what was the third part of the question?

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

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

And then on the $54 million low-cost jet engine development contract, what are some of the timeline issues there — timelines and maybe milestones you're looking for?

We've already received the initial funding of several millions of dollars, so we're off and running. In my opinion this effort by the AFRL is directly related to programs like Golden Horde and swarming munitions that need very small, low life, which means low cost turbojet engines for missiles and powered munitions. So we're off and running with that. I expect that to ramp up between now and the end of the year, and then that's going to be a significant contributor next year. I wouldn't be surprised if we see more of those coming our way as a result of all of the new missile systems, weapon systems and powered munitions that are on the drawing board. To be specific, you've seen Lockheed Martin talk about Speed Racer — we are on that one. They rolled out a whole new family of small aircraft they're planning on bringing out in the next few years; that is perfect ground for Kratos Turbine Technologies in our engine business. Northrop Grumman announced they're working on a jet-powered loitering munition that can get there quickly — another area right up our sweet spot. So I see a lot of inertia in this area that ties into the thesis we've been talking about: affordable mass.

Got it. Thank you for the time.

Next up we have Austin Moeller from Canaccord Genuity. Austin you are live.

Good afternoon, Eric and Deanna.

Good afternoon.

Good afternoon.

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

Not yet, but over the next several weeks and couple of months, we have a number of meetings scheduled with these potential customers and certain existing customers to talk exactly about this. Austin, if things go as I currently see them, I'm hopeful by the end of September, October we're going to have the data points and we'll have received certain things that will give us the confidence to pull the trigger, order the engines in the long leads and get going on the next lot. To give you a data point on this Austin: on engines we get price breaks on lots. If we order six we get a price break; if we go to 12 we get a better price break; if we go to 18 or 24 we get an even bigger price break, which drives the unit cost lower and gives us a quicker slot to get them. Those are the dynamics we're thinking through with the customers.

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

I'm glad you asked that. As you know, the Air Force's definition of attritable is $20 million and below for a fully missionized aircraft. The Marine Corps' fully missionized price point is substantially less than that — I'll throw out $10 million fully missionized as a marker. Because of our target drone business and the quantity that we produce, our tactical drones use substantially the same composites, avionics, electronics, flight control — we're getting leverage there and a lot of that's made in America. So the price increases there haven't been terrible yet. I am very comfortable that for the aircraft and the full mission systems — and I can't get into much more than that — we're going to be well within those price points. Mission systems can be $3 million, $6 million, $8 million. We're beautifully positioned because of how low cost our flying truck is. In my opinion any of the other players, even if they ever do get anything flying, they can't practically get anywhere near us on price or cost. They're not designed to do it.

Okay. That’s very helpful. And then one last if I could: I think you mentioned in your remarks that the Air Wolf has a radar cross section or signature that is considered interesting to the customer.

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

Okay. Thanks for the call, Eric. Appreciate it.

Okay. Next is Noah Poponak from Goldman Sachs. Noah, your line is open.

Hello, everyone.

Hello.

Hi.

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

I'm glad you asked that because I can clarify and add some meat to what I said. Our 10% base case growth that we're looking at year-over-year 2023 to 2022 does not include any significant production of tactical drones. To clarify, it doesn't include it. If things occur, that’s where I said we could substantially beat it. The base case is driven by our space business, target drones, GBSD which has come online now, and the LOI on that microwave program I mentioned — we're going to be under contract by the end of the year and that contributes as well. Those are some of the big drivers.

Okay. That’s helpful.

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

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

When the Secretary of the Air Force, Mr. Kendall, came in late last year he announced two new classified drone programs. The Secretary used the term that virtually all of the other drone programs to date would be feeders into these two new programs. In my opinion a significant amount of funding on the other programs were feeders into those two new programs and I believe they sucked the air out of the room. As we saw at Farnborough three weeks ago, the Secretary has now canceled one of those two new drone programs, the loyal wingman for the B-21 bomber — reportedly because it would take too long and be too expensive. So a lot has happened in the last six to eight months and really in the last four weeks. There's been a lot of change in the landscape.

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

My opinion is that's what's been going on for the last year or two: they wanted to assess and figure out exactly what they wanted, which makes total sense. Things have changed — the Navy Admiral recently talked about Valkyrie and what it would be used for; the Air Force leaders and four-star generals in the Pacific have been saying that the only way to deter China is if they have hundreds or thousands of low cost affordable jet drones. That's recent commentary. I don't know if they have decided exactly what they want to buy, but I know what their narrative is and I know what has been specifically going on with our company, and we're doing everything we can to respond to them.

Okay. I appreciate all that. Thanks for taking the questions.

Next question comes from Sheila Kahyaoglu from Jefferies, LLC. Sheila, your line is open.

Thanks so much. Good afternoon, guys. Just on Noah's line of questioning, Eric, you mentioned the customer potentially coming in in Q4. How do we think about Valkyrie options into 2022? Is it contributing $100 million? Does it go to $150 million in 2023? What are the range of options for Valkyrie?

I'm going to be very conservative. I'll assume we continue to execute on RDT&E and S&T funds; I assume we continue to do demonstration flights of different capabilities, carrying different payloads and different mission packages. I assume we continue to sell or lease a handful or two a year — that's one scenario. The upside scenario is that given the Ukraine losses and what we're seeing in the Taiwan Strait, a decision is made to field affordable mass with the capability we have today and we get significant production runs next year or the year after. But I'm focused on the conservative scenarios.

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

Deanna?

GBSD, the continued ramp of the space programs — there are three of those — and some of the production in our target drone business as well.

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

I don't believe that Rolls-Royce has disclosed exactly what we're doing, but in general we are one of the industry leaders in building the ground rigs for jet engines for test and evaluation purposes, and we have expertise in exotic materials used in engines. Those are the types of areas a company like Rolls would come to us on. We just received the initial contract; it is growing and expanding. It's a big program for us and it's expected to begin ramping in Q4 and then ramp in Q1, with some big materials work in Q4 and Q1.

Okay, great. Thank you so much.

Next question comes from Peter Arment from Baird. Peter, your line is open.

Thanks so much. Good afternoon, Eric and Deanna.

Good afternoon.

On the space business Deanna mentioned a lot of it’s in licensing, which is obviously better on the margin. What do we think about the margin opportunity when we're looking at space compared to what you report today?

It'll be different for government versus commercial because there are certain limitations on the government side that aren't on the commercial side. Our mid and long-term view is mid-teens profit margins for our space business. We're moving to more of a software model — there's significant R&D and continued development on next versions. Also, we manufacture sophisticated antennas which can have a lower margin than software; those antenna deliveries can be lumpy. So think of blended mid-teens in the space business.

That’s helpful. And then just regarding your space business being your largest business: how long do you expect it to be your largest business? When do you think unmanned could overtake it?

In my conservative view, unmanned will not overtake space for the next several years because our space business is ripping. We're first to market with total software-based virtualized ground system and we're two or three years ahead of everybody else. The first three big programs we pursued, we won, and we're lined up to win more. In the base case, space continues to be the lead horse; in the upside case, the drone business in a couple of years could pass it.

That's helpful. And just related to your drones, any updates on programs we don't hear as much about recently — can you give us your thoughts?

I have to answer it this way: most, if not all, of the previous drone programs have become feeder programs into other programs that are all classified.

Next up is Pete Skibitski from Alembic Global. Pete, your line is open.

Hey, good afternoon guys.

Good afternoon.

You have pretty solid revenue in the quarter. I wanted to understand Deanna's comments about the reduction in operating income guidance. Obviously you had the $5.5 million charge in the quarter. Is the rest of the balance all due to inflation or were there any other negative EAC adjustments that impacted that guidance?

All due to inflation.

Primarily in Q3, because we're substantially on firm fixed-price contracts, and we can't pass it on in the existing contracts and the existing priced options. So we just absorb it.

And in terms of recovering that inflation through the contracts: you have positive mix in the fourth quarter, but is it reasonable to assume that the first half of 2023 you'd still be kind of in the process of repricing your contracts? So hopefully by the back half of 2023 is when you make up the inflation we're seeing this year?

Yes. It's a process as existing contracts or options priced over one or two years transition off and new negotiated ones or new wins come in.

On the $5.5 million charge on the training program — does that impact go-forward revenue from that customer? I think it sounds like maybe international targets — any color you could provide there?

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

You hadn't generated revenue there for a while on that one?

That's correct.

Last one: on OpenSpace. I feel like you've been developing it for a long time. Is the core development of OpenSpace completed or do you have to do some bespoke R&D every time you get a new customer? Can you describe the business model?

Think of it like an operating system, like iOS on your phone. The operating system for space ground infrastructure is substantially complete, if not complete for the existing customers. R&D now is for the apps on that operating system — think modems and hardware turning into software. Instead of having a rack of different modems, you have code. The R&D is for the apps; each customer is a little different so there's some R&D — maybe 10% to 15% — to modify the OS for a specific customer. But the core is substantially done, as you can see with the program wins.

That's really helpful. Thanks guys.

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

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

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