Kratos Defense & Security Solutions, Inc. Q3 FY2022 Earnings Call

Thank you for standing by. Welcome to the Kratos Defense & Security Solutions’ Third 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. Please follow the operator's instructions. And now I would like to introduce your host for today's program, Marie Mendoza, Senior Vice President and General Counsel. Please go ahead.

Good afternoon everyone and thank you for joining us for the Kratos Defense & Security Solutions third 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. In the third quarter, Kratos successfully executed on what we could control in an increasingly difficult operating environment, generating a 1.1 book-to-bill ratio, successfully executing a Valkyrie block to flight and receiving a recent new hypersonic system related program award MACH-TB or Multi-Service Advanced Capability Hypersonics Test Bed with our partner Dynetics, both of which we were able to announce today. We are currently positioned for additional upcoming milestones and significant contract awards, including another important new hypersonic related program we hope to announce by the end of this year, and the definitization of an approximate $250 million potential value microwave electronics C2 program award. Additionally, we expect two new Valkyrie related tactical drone system contract awards from two separate new customers for multiple aircraft. We have just begun discussions with a potential fourth new customer, also for multiple Valkyrie systems. Interest in Kratos tactical drone systems has recently increased and is gaining momentum, which I believe is in part due to the ongoing Russia/Ukraine conflict and the heavy use of drones, including jet drones. The reality is that quantities do matter, and that Kratos is the only company with affordable high-performance jet drones flying today, also with active production lines. Since our last report, we faced challenges, including being informed that a certain Kratos satellite program related to software products expected to be delivered in 2022 to an existing under-contract government customer has been delayed to a future period. We were also informed by another under-contract customer that additional funding is now unavailable for the continuation of a certain non-Valkyrie related Kratos tactical drone program we have been working on. Both of these were previously forecasted as important contributors to our fourth quarter. We have now determined that due to the incredibly tight labor market for qualified machinists and other skilled personnel, including those with security clearances, we will not achieve our previous forecast net increase headcount target needed to execute on our backlog and achieve our financial forecast. We have reflected the financial impacts of these related and other items in today's third quarter financial report and our updated fiscal 2022 forecasts, which Deanna will discuss later. We have been taking action to address these matters, including hiring a large number of qualified personnel, which is a top priority. Additionally, in our new bids, proposals, and contracts over the past several months, we are increasing labor and other costs which are making us more competitive in retaining qualified workers. We have adjusted the organization in certain areas to accommodate customer-related delays and other issues. These actions are in order to position Kratos to continue to compete for and win large new program opportunities, of which there are many, and execute significant growth trajectory and expanding margins in 2023 and beyond. We remain confident in our mission of being the disruptive technology company in the national security market, evidenced by our continued success, including having a 1.2 to 1 LTM book-to-bill ratio and a 1.1 to 1 Q3 book-to-bill ratio, with multiple large new programs both received and ramping like MACH-TB. Additionally, we forecast base case full-year 2023 revenue growth of over 10% compared to 2022, along with increased margins and potential accelerated growth in the tactical drone space, satellite, rocket, and hypersonic system areas. Importantly, we have started to see some improvement in the labor market, and Kratos had a successful job fair with multiple qualified hires related to a key manufacturing location. We believe we may have seen the bottom of things starting to turn around in the labor market. Kratos remains an industry leader in virtually all our business areas. Our proprietary new and first-to-market Zeus and Erinyes affordable launch and hypersonic systems continue to progress, with initial flights with our customers planned for next year. This is expected to provide us with new program opportunities in addition to our current family of flight systems and vehicles. Kratos' industry-leading performance in space and satellite business, our largest, is critical to our forecast organic revenue, profit, and cash flow growth trajectory. We are currently forecasting approximately 12% to 15% growth for this business in 2023, with significantly expanding margins supported by recent unexpected program awards. The thousands of new satellites forecast to be placed into orbit over the coming years for both national security and commercial missions are expected to provide a large, rapidly growing market and opportunity set for Kratos. Our C5ISR business is also positioned for future organic growth with expanding margins, with key growth drivers including IFPC, IBCS, SHORAD, and the Sentinel programs. On the Sentinel program, we expect to see a significant ramp in 2023. Our microwave electronics business has similar growth potential, focusing on well-funded mission-critical national security areas. Additionally, our turbine technologies and engine business had a very strong third quarter and is looking strong for 2023 with a focus on drones, missiles, powered munitions, and strategic platforms. Our target drone business is also very well positioned as the U.S. and our allies recapitalize strategic weapons systems that require testing and training against the highest performance, most threat-representative target drone systems in the world, which are Kratos targets. Future program drivers for our target drone business include the SSAT program with the U.S. Navy, which achieved full operational capability in Q3, and we expect full-rate production to continue to ramp. We have a sole source $100 million contract award with a U.S. government agency expected soon, along with several new international contract awards driven by the Russia/Ukraine conflict. In the tactical drone or collaborative combat aircraft space, we are seeing developments from the Air Force, announcing a competitive fly-off in 2024 which indicates a future with hundreds or thousands of drone systems of varying capabilities and cost points. Kratos remains the only company with a family of low-cost, expendable, disposable, and tradable drones flying today. As reported, Block 2 Kratos Valkyrie production aircraft has recently demonstrated extended capabilities. Simply stated, our tactical drones continue to mature and progress, and we remain on track to complete the initial Valkyrie 12 production lot next year. We are also considering a subsequent Valkyrie serial production run. Kratos' Ghost Works had a successful test of a new system at the Burns Flat range complex, with additional tests planned. We are confident that this new system will significantly expand our existing platform capabilities and affordability. The macro and geopolitical backdrop for the national security industry is strong and is expected to remain so, including important growth for innovative and disruptive technology companies like Kratos. I believe we are at the beginning of a long-term recapitalization of strategic weapons systems globally, where quantities, affordability, speed, and survivability will matter. We are not planning on making acquisitions, as we have received a number of large new program awards and expect to receive several more in the coming months. It has been challenging the last couple of years with COVID, supply chain issues, inflation, and the labor market, but these issues will pass, and Kratos is determined to overcome them. With that, I'll turn it over to Deanna.

Thank you, Eric. Good afternoon. As we've included a detailed summary of the third quarter financial performance and fourth quarter and full year 2022 financial guidance in the press release published earlier today, I will focus on the highlights. As Eric mentioned, the operating environment remained challenging with continued supply chain disruptions, inefficiencies, an extremely tight labor market, and inflationary impacts. As a result, our third-quarter revenues were impacted with $11.3 million deferred into future periods, with approximately $5.9 million of associated operating income. In addition, our operating results included a charge of approximately $3.4 million related to certain non-recoverable costs, including rate cost growth items, resulting from an inability to hire the required planned direct labor base internally and by our subcontractors. For example, while we successfully hired over 96 new skilled staff this year, we are down a net 14 staff members since the beginning of the year due to attrition related to retirement and competitive employment conditions. As Eric mentioned, we have recently seen more success in hiring and stabilization in retention. Our operating cash flow continues to be impacted by more than $27 million in advanced inventory purchases year-to-date to mitigate supply chain disruptions, which now includes lead times for certain critical parts exceeding 52 weeks. The conversion time from inventory to product sales is not expected to occur until next year. Included in cash flows used in operating activities is approximately $7 million in investment for non-recurring engineering costs related to new rocket systems and products, including for Kratos Zeus and Erinyes systems. Our contract mix for the quarter was primarily fixed price at 69%, with cost-plus fixed fee contracts at 26% and time and materials contracts at 5%. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 69%. In Q3 2022, we generated 11% of revenues from commercial customers and 20% from foreign customers. Now moving on to financial guidance. Our fourth quarter for fiscal year 2022 financial guidance includes our current forecasted business mix and assumptions related to impacted employee absenteeism, challenges in obtaining and retaining qualified personnel, supply chain disruptions, inflation, and COVID-related items that have been affecting our business. Throughout the first nine months of the year, we faced a significant increase in impacts from supply chain disruptions, including increased costs for materials and delays. We expect these issues to impact fourth-quarter revenues by approximately $79 million and adjusted EBITDA by approximately $46 million. Additional increased costs we've absorbed this year include merit increases exceeding our historical norms. Given our fixed-price contract mix, we are required to absorb these additional costs. Our previous expectations for the second half of 2022 and specifically Q4 assumed significant net headcount additions, but we have been unsuccessful in achieving this target. Accordingly, this delay in the ramp of our net headcount, along with supply chain delays, has resulted in a reduction of approximately $12 million to $13 million in forecasted FY 2022 revenues from our business. The recent notification about delays in certain satellite program related software deliveries has also impacted our Q4 forecast, with these deliverables expected to contribute around $5 million to $6 million of revenue. Therefore, we have reflected the impact of these customer notifications in today’s revised financial forecast.

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

Certainly. Please follow the operator's instructions for questions. Our first question comes from the line of Mike Crawford from B. Riley. Your question please.

Thank you. Given these delays in the tactical drone space, do you think that it's getting harder to cross the so-called valley of death? Or maybe one of them didn't make it, or are we really focused on the new iterations coming down the pike?

No, it is not harder to get across the valley of death, Mike. We still have a number of platforms that we've talked about previously that are still flying. As indicated in my earlier remarks, I think it started after the Reagan forum last year when the Secretary discussed two new classified programs. All of the other programs will be feeders into those, and it’s challenging to talk about them without getting approval. That’s one reason we managed to put the Valkyrie announcement out today. There’s a lot going on in the CCA or tactical drone area. It’s accelerating, especially due to the ongoing situation in Ukraine with Russia. It’s become a war of attrition.

Okay. Thank you. Is there any takeaway from the change in leadership at the U.S. Space Force? Is the software delay related to the continuing resolution or something else?

It is not, as we understand, related to the continuing resolution; that program is classified, and it's related to a separate item. Regarding the changes in personnel at the space force, I don't believe it has an effect on the trajectory in the industry. There will be fewer geosynchronous orbit satellites launched, replaced by many MEO and LEO satellites. More birds in the air are beneficial for Kratos and our ground equipment.

Thank you, Eric.

Thank you. One moment for our next question. Our next question comes from the line of Noah Poponak from Goldman Sachs. Your question please.

Hey guys. It's Gavin on for Noah. Can you hear me?

Hey, Gavin. Good afternoon.

Yeah.

In terms of the 10% revenue growth target next year, I think you'd mentioned that it doesn’t consider too much upside in tactical drones. What are you expecting there for tactical drones? How much visibility do you have into that business returning to growth?

You're right; the base case does not include significant production orders for tactical drones. It focuses on RDT&E and S&T initiatives that we're currently involved in. We're not getting ahead of ourselves; we have the right aircraft at the right price points at the right time. We will remain engaged until we secure these contracts.

Got it. What timeframe do the non-recoverable costs cover?

Gavin, that does not take into consideration future cost growth; those are current period growth that we are not passing through to contracts, and we are absorbing that in the current period.

As we've discussed previously, we're primarily involved in firm fixed price contracts. The Pentagon issued a letter reiterating that we cannot submit requests for equitable adjustment to recover inflation-related costs. However, we have been successful in securing numerous contracts, building escalators to capture future increases in labor and indirect rates. We expect to see this shift happening in Q1 or Q2 of next year, unless inflation increases drastically.

That's helpful. Thank you.

Thank you. One moment for our next question. Our next question comes from the line of Sheila Kahyaoglu from Jefferies. Your question please.

Hi guys. This is Ellen on for Sheila.

Hi.

Hi, Ellen.

Looking at the 10% growth next year, can you clarify any specific programs that drive that growth?

Absolutely. Sentinel comes to mind immediately. We're in development on Sentinel, ramping up alongside our partner Northrop Grumman. The SSAT program is also ramping significantly, and we are experiencing traction with several space and satellite programs that we can’t publicly discuss. We're optimistic about growth from various programs including hypersonics, where we aim to lead in efficiency and speed as activity increases.

What about profitability and the path back to double-digit margins?

Yes, there's a clear path back to double-digit margins. The government on new contracts is open to cost increases, which we are incorporating in our bids. As our contract mix shifts toward newer contracts, we are confident that our margins will improve as we adjust to current market conditions.

Appreciate the insights. Thanks.

Thank you. One moment for our next question. Our next question comes from the line of Joe Gomes from Noble Capital. Your question, please.

Good afternoon, Eric.

Good afternoon, sir.

Quick big picture question: with recent announcements regarding contracts that have been pushed out or lack of funding, where do you see the business related to self-driving trucks and similar products?

We're progressing in that area, and revenue will start to become material to Kratos in 2023. Our focus is on converting existing trucks and vehicles to unmanned systems at a low cost. We are addressing the growing driver shortage in various sectors, such as agricultural and mining, with our technology.

Thank you for that, Eric.

Thanks for asking the question.

Thank you. One moment for our next question. Our next question comes from the line of Pete Skibitski from Alembic Global. Your question, please.

Good afternoon, Eric and Deanna.

Good afternoon.

Can you talk about the sensitivity of your guidance related to further delays in the 2023 budget? We have a CR through mid-December, and it could extend into January. How does that impact guidance?

If the 2023 budget is approved in its current form by the end of December or early January, we're okay. However, if there are significant changes and we encounter another six-month continuing resolution, we'll need to analyze what that budget looks like and how the timing of obligations impacts our forecasts.

What is the current status of your labor target and how far off are you? I thought I heard you mention people leaving due to COVID compliance.

Our specific target focuses on our C5ISR business. We aimed for a net increase of 100 heads by year-end, but we’re currently down a net 14. That target is now pushed out into the first quarter. While we’ve been able to hire about 96 people, we still see a net reduction due to various factors.

The challenge lies in training our existing workforce, and then we face attrition, causing inefficiencies which drive up costs. We'll adjust on new bids to remain competitive in the hiring market. Companies pursuing cutting-edge projects attract higher pay, but we’re focusing on retaining a skilled, trained workforce.

Is GBSD a key driver for the hiring needs in C5?

It's a factor, but it's not the only one. Multiple programs require high-security clearances, and we're facing challenges in hiring individuals willing to obtain those clearances.

Thank you for the insights.

Thank you. One moment for our next question. Our next question comes from the line of Austin Moeller from Canaccord Genuity. Your question please.

Hi, Eric and Deanna. Good afternoon.

Hi, Austin.

Hi, Austin.

On tactical drones, the Valkyrie and Air Wolf are getting closer to potential production contracts. Is there a chance we see a contract awarded or is it being pushed to future budgets?

I am cautious and not expecting anything until we have contractual approval. Customer behavior has been erratic, but we are involved in several classified programs, ongoing discussions. This area is active; significant developments are expected.

Was the satellite program delay related to one of the big contracts necessary for the guidance?

Yes, the program delay was part of one of those larger contracts that are now deferred.

Are we expecting Sentinel revenues in Q4?

Yes, we expect some revenues from Sentinel in Q4, though not as much as originally forecasted.

Thank you for all the details.

Thank you.

This concludes the question-and-answer session. I would like to hand the program back to Eric DeMarco for any further remarks.

Thank you. Good afternoon. We'll talk to you shortly.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.