Kratos Defense & Security Solutions, Inc. Q2 FY2023 Earnings Call

Good day and thank you for standing by. Welcome to the Kratos Defense & Security Solutions Second Quarter 2023 Earnings Conference Call. All participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Marie Mendoza, Senior Vice President, General Counsel. Please go ahead.

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions second quarter 2023 conference call. With me today is Eric DeMarco, President and Chief Executive Officer, and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer. Before we begin the subject 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. Q2 came in better than forecasted, which provides us additional confidence in achieving our full year 2023 financial objectives, including increased second half profitability as our fixed price and other contract mix continues to improve. We are on plan for 2023 to be a transition year for Kratos, including reduced internally funded investments and increased year-over-year financial performance. Kratos' largest business, space and satellite communications, which includes our first to market software-based OpenSpace virtualized C2, TT&C, and ground system products, momentum continued, including additional new customer awards and several new opportunities we are now pursuing. The large number of satellites being launched into LEO, MEO, and GEO orbits is providing a macro-level catalyst for our satellite business, in both the commercial and national security areas. Our OpenSpace platform is a representative example of Kratos' strategy of identifying a potential opportunity area, working with the customer, and Kratos making the internally funded investment to be first to market with relevant system software and technology. Kratos' internal funding also enables us to own and protect the proprietary intellectual property we develop, which is an important element in protecting our market leadership position. Kratos’ OpenSpace architecture enables us to address both the commercial and the national security areas, providing us a larger overall total addressable market opportunity and the associated scale, cost leverage, and increased potential margins that come with it. We are also invested in and self-funded Kratos' owned and operated global space domain awareness or SDA network. Our SDA network monitors the behavior of space-based radio frequency or RF signals to identify critical information about satellites and objects in orbit, including their position, maneuvering health, proximity to other satellites, and more. Kratos' SDA network includes over 20 worldwide sites currently hosting approximately 150 fixed and steerable RF sensors and antennas, which are capable of detecting and tracking space vehicles and providing real-time data to our customers. It’s been recently reported that the U.S. Space Command is currently tracking and monitoring more than 28,000 space objects, of which only approximately 3,500 are acknowledged active satellites, with this growing volume of satellites and space objects contributing to Kratos' space domain awareness market opportunity. Kratos owned and operated one of a kind global SDA system is a clear differentiating technology-based capability of our company, and it's one of Kratos' most valuable assets. Also providing opportunity for Kratos is that a significant number of new satellites being launched are high throughput, software reconfigurable, spot beam enabled, and more—each of which requires a dynamic on-the-fly reprogrammable ground infrastructure and capability like Kratos' OpenSpace. Additionally, the customers' increased focus on not being vendor locked to the traditional satellite providers for their ground infrastructure is also providing opportunity for Kratos. The large growing and changing global space and satellite market is providing opportunity for every Kratos division, including individually and working together on programs, which has been a key aspect of Kratos’ overall space-focused strategic plan. We expect Kratos' space and satellite business to be one of our company's fastest growers with forecast future year-over-year increased revenue, profit margins, and cash flow. Kratos' engine and propulsion businesses are also in well-funded growing priority areas, with macro catalysts including increased demand for hypersonic systems, missiles, drones, powered and loitering munitions, increased range and power requirements, supersonic and space and satellite related propulsion and launch systems. Kratos' turbine technologies is a recognized leading technology disruptor in the propulsion field and we are under contract with certain of the most important highest priority, well-funded, and visible systems platforms and programs and initiatives including both in national security and commercially. Since our last report to you, KTT has reached customer agreement on a potentially very large propulsion system program, which if successful, is expected to be an important overall contributor to our company including a significant financial ramp beginning in 2024 for Kratos. Also, since our last report, a KTT space customer, which we are under contract with, successfully received the new manned lunar system program award which also could be a significant future contributor to Kratos. Related to drone engines, a subcommittee recently requested the Air Force to submit a report on the schedule and plans for funding development testing and establishment of high-volume manufacturing of Attritable Engine Technologies for CCAs. Kratos’ engine businesses are expected to be certain of our fastest future growers and increased margin contributors. Kratos’ rocket systems in our rocket motor, ballistic missile target, hypersonic and other system business are also well-positioned from a macro catalyst for priority and funding standpoint, including as related to the recapitalization of strategic weapon systems, the hypersonic ecosystem and strategic deterrence systems. Representative of our leadership position since our last report, Kratos' Rocket Systems business successfully launched a new hypersonic payload for a certain customer. Additionally, Kratos' Rocket Systems business successfully conducted the first static test fires of the Kratos Zeus 1 Solid Rocket Motor at Aerojet Rocketdyne's facility in Arkansas. Kratos' Zeus family of rocket motors is in direct response to the market need and demand for new affordable solid rocket motors of a particular size, class and nature for launch vehicle stages, hypersonic, ballistic missile target, research, and other systems and vehicles, as well as for Kratos' Erinyes and our Dark Fury hypersonic flyers. With a successful test of Kratos' Zeus 1 and the upcoming Zeus 2 test, we are planning for Kratos' Erinyes and Dark Fury hypersonic vehicle flights next year. Kratos' Zeus, Erinyes, and Dark Fury systems are additional examples of Kratos' strategy of proactively working with the user and customer community, making the internal investment to move fast and be first to market, far ahead of the traditional government funded competitors with affordable relevant product systems and technology to rapidly address the customer needs. As you know at Kratos, affordability is a technology, and we believe that Kratos’ Zeus, Erinyes, and Dark Fury and other Kratos systems are significantly less costly than any existing or planned future relevant systems. Missile Defense hypersonic testing targets and other vehicles are also certain of the highest priority well-funded areas in both the 2024 NDAA and the related fight up. Kratos' industry-leading target drone business is also being driven by the recapitalization of strategic weapon systems, including radars, missiles, directed energy, counter drone and other systems, all of which need to be tested and trained against threat representative targets. Kratos is the sole source or primary high-performance jet target drone provider to the United States Air Force, Navy, Army, other agencies and numerous international customers. Reflective of Kratos' industry-leading target drone position, since our last report to you, we have received a $95 million single-award contract from the United States Army, and both the U.S. Navy and the U.S. Air Force have indicated to us that they will in the future be procuring increased target drone quantities. We are also now awaiting a new target drone system-related contract award that we have been informed we have been successful on with our teammate and our partner. In the tactical drone area, we recently announced that Kratos and Shield AI have teamed up to rapidly integrate Shield's artificial intelligence into Kratos' Valkyrie. The Kratos' Shield collaboration is another representative example of Kratos' unique disruptive technology-focused business model, which also includes working with venture-backed private and commercial entities like Shield to move faster than traditional government contractors and be first to market with relevant systems. We work with a number of smaller technology and software-focused companies like Shield, Peregrine Defense, and others, which provide Kratos with access to unique disruptive capabilities. Also in the artificial intelligence area, yesterday, the United States Air Force announced a successful three-hour sortie demonstrating the first-ever flight of artificial intelligence agents or algorithms controlling Kratos' Valkyrie. This mission proved out a multilayer framework on an AI/ML-flown aircraft, Kratos' Valkyrie, and demonstrated the AI/ML agents solving a tactically relevant challenge problem during actual airborne operations. The flight on the Eglin test and training complex was the culmination of the previous two years of partnership that began with the Skyborg Vanguard program. AI will be a critical element of future warfare. It is evolving at an incredible pace, and Kratos, the Valkyrie, and certain of our other tactical jet drones and other Kratos systems are leaders in relative artificial intelligence enabling areas. The Air Force announcement of AI successfully piloting Kratos' Valkyrie is another publicly available representative milestone of the progress that Kratos' tactical drones continue to make with the customer community. Kratos' Valkyrie progress under the Marine’s Collaborative Killer program similarly continues to progress. Since our last report, we have now reached agreement with a new national security-related customer for payload and mission system integration into Kratos' Valkyrie, and we have recently received the contract. This is a new initiative that is highly confidential, and if Kratos and our partner are successful, this program could be a significant contributor for Kratos beginning next year. We have now also reached agreement with an additional new national security customer, and we expect to have contract documents definitized with the contract's office by the end of the government fiscal year 2023. We also now expect to receive an additional Valkyrie-related customer contract award by the end of this year, and based on the marked 2024 NDAA, we are now hopeful to receive a separate additional largest to-date Valkyrie related customer program award next year. We have government customer-funded flights with Kratos' tactical jet drones over the next several months, and I encourage you to visit the recently released Air Force Research Lab, Future of Artificial Intelligence Dominated Air Combat video to see Kratos' Valkyrie in-flight in action. All of the Valkyries in the AFRL video are actual real drones; they’re not computer-generated animations, renderings, cartoons or simulations that certain of our competitors like to propagate. We also have flights scheduled for later this year and next with a new customer that is potentially looking for a future purchase of Kratos Valkyrie in 2024. The Valkyrie production run continues with the most recent data indicating continuing Valkyrie unit cost reductions as we progress through the build and down the learning curve. I am confident based on the customer and competitive information that we have, that Kratos' cost points for high performance jet drone aircraft are significantly lower than anything existing, planned for in PowerPoints that the competition may have. Directly related to cost, a half subcommittee has marked the 2024 NDAA specifically stating that there will be three categories of drones and not to exceed flyaway cost points. These include expendable at $3 million, Attritable, which is my favorite at $10 million, and exquisite at $25 million. If this NDA mark is finalized in the 2024 budget, which it is expected to be, then these drone classifications and cost points will become law. As a reminder, approximate Kratos tactical drone cost points are currently Air Wolf Tactical Firejet at $500,000 or less, Mako at $2 million or less, Valkyrie at $6.5 million or less, which each of these drones' costs expected to be much lower in quantities, and our new highly capable fully missionized system which is at $10 million. Kratos' Ghost Works continues to work on the new system, and we are scheduling a capstone event for this system for either later this year or early next, depending on range availability. We announced today Kratos’ newest, most capable Valkyrie for the United States Marine Corps will be at the Miramar Air Show in September here in San Diego, along with several other Kratos high-performance jet powered drone aircraft. These will be the actual aircraft that will be at the show. We are planning on producing approximately 150 jet drones all in the United States of America this year, including Targets, Valkyrie, Mako, Air Wolf, and others, and we are now positioned to double production to approximately 300 drones annually in 18 months, assuming we receive contract awards and customer funding. We are ready to go now, and we are clearly and routinely communicating this to the customer community. As I mentioned before, Kratos affordability is a technology, and maybe better, maybe someday in the future, at some hoped-for hypothetical price. That's the enemy of good enough and ready to field now and today. We believe that Kratos' approach is particularly relevant in the tactical drone area, with the value of affordable mass and quantities having a quality all of their own is clear. Kratos to C5ISR and our microwave business are both positioned for a strong second half of 2023, with the demand for space, satellite, missile radar and other systems contributing to the demand for Kratos' products and systems. We've received a large number of new program awards over the past several months, and we have a record consolidated backlog and an opportunity pipeline at record. Accordingly, we are focused on internal execution, organic growth with forecasted future year-over-year revenue, EBITDA and cash flow increases, with no acquisitions of size expected. Our primary operational challenge continues to be obtaining, training, and retaining qualified employees, and the related high labor costs for these specialized personnel, including those that can obtain national security clearances. These and other items were included in our decision to affirm and not to increase our financial forecast, with the potential contribution mix shift between KGS and KUS possible due to potential award and execution timing. In closing, Kratos' priorities include supporting the United States National Security, the U.S. industrial base, science technology engineering map or STEM opportunities for the United States and for Kratos' workers, developing dual commercial national security offerings like Kratos' OpenSpace, which drives value for all Kratos' customers, and value generation for all Kratos' stakeholders, including the DoD, the taxpayer, Congress, our employees, and our investors.

Thank you, Eric. Good afternoon. As we have included a detailed summary of the second quarter financial performance as well as the third quarter full-year 2023 financial guidance in the press release we published earlier today. I will focus on the highlights in my remarks today. Revenues for the second quarter were $256.9 million, up from $224.2 million in the second quarter of 2022, reflecting a 14.6% increase. Revenues came in above our forecasted range of $230 million to $240 million and most of our KGS businesses, with the most notable increases in our space and satellite, turbine technologies, microwave products, and C5ISR businesses. Excluding the impact of the SRE acquisition, which contributed $13.1 million in revenues in the second quarter of 2023 as compared to $4.1 million in the second quarter of 2022. Kratos' consolidated revenues grew organically 10.7%, including a 17.1% organic revenue growth rate in our KGS segment with organic growth across all businesses within KGS. Cash flows generated from operations for the quarter were $23.6 million, included cash collections resulting from favorable milestone payment terms, which accelerated receipts into the second quarter, partially offset by working capital required to support revenue growth and continued advanced purchases of inventory in an effort to mitigate potential supply chain disruptions and delays. Also included in our working capital uses are continued internal investments of approximately $3 million related to nonrecurring engineering costs to complete new rocket systems and hypersonic and related products, including for Kratos' Zeus, Erinyes, and Dark Fury Systems and continued development of certain software products supporting our OpenSpace platform. Free cash flow generated from operations was $28.7 million after funding capital expenditures of $11.2 million and receipt of $8.3 million of proceeds for Valkyries that were built as capital assets prior to contract award. Our contract mix for the second quarter of 2023 was 67% fixed price, 27% cost-plus, and 6% time and material. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 69%, including revenues generated from contracts with the DoD, non-DoD Federal Government Agencies, and FMS contracts. In the second quarter of 2023, we generated 11% of revenues from commercial customers and 20% from foreign customers. We continue to make progress in our hiring and retention of skilled technical labor, including in our C5ISR business, with a notable net increase in C5ISR headcount of 37 since the end of last year, including 18 in the second quarter, plus an additional 12 recently clearing the pre-hire process. Kratos' overall total increase in consolidated headcount this year is 152, from 3,645 at year-end 2022 to 3,797 at the end of the second quarter. Moving on to financial guidance, our third quarter and a firm full-year 2023 financial guidance we provided today includes our current forecast business mix and our assumptions related to the expected impact of our continued operating challenge related to obtaining and retaining qualified technical personnel, as well as the lingering impact of supply chain disruptions, inflation, and related expected costs and price increases that are currently and expected to continue impacting both the industry and Kratos. Our revenue guidance range for the third quarter of 2023 reflects an approximate 5% to 13% organic increase over the third quarter of 2022. Based on the current budgetary environment, we are expecting to be in a continuing resolution for the fourth quarter which is reflected in our affirmation of our full-year revenue guidance. Based upon funding, production, delivery, and execution schedules, our third quarter 2023 revenues are expected to be fairly consistent with the second quarter based upon current production and delivery schedules. We expect margins to expand in the fourth quarter based upon the expected mix of revenues including new fixed price contracts, which include more recent cost estimates and more software-based content. Estimated incremental ramps in production in the second half of 2023 are expected to be driven by a handful of key programs in our space, satellite, training, C5ISR, and unmanned systems businesses. Operating cash flows are expected to be stronger in the fourth quarter, driven by the expected expansion in margins and the expected conversion of inventory builds from FY 2022 and the first half of 2023 and based upon estimated milestone payment schedules.

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

Thank you. Our first question comes from Joe Gomes with Noble Capital. Your line is open.

Hi. Good afternoon. This is Josh Fazilple filling in for Joe Gomes. He's just on another call. I wanted to start off with congratulations on the quarter, you guys. It seemed like hitting the nail on the head and even more so with the growth. So, I just wanted to start off just actually just kind of going into the growth rate as well. Obviously, you guys thought it'd be right around a 3% or 7% increase over the last quarter and obviously came in at really 15%. So like, what was kind of like, obviously, the big impact behind that large growth?

Yes. So it was organic growth literally in every business unit within KGS across the board. Space satellite training, C5ISR, microwave products, turbine technologies, air and defense rocket, all across the board.

Perfect. And so I just wanted to see, you guys mentioned last quarter that you guys had, enduring shield was going into kind of LRIP in the back half of 2023. When do you guys expect that, again, more towards the third and more towards the fourth?

We're collaborating with Dynetics on this project, and they are the lead contractor. We're working on the ground infrastructure for the enduring freedom project. My discussions with them confirm that everything is consistent with our previous updates, and there have been no changes. We anticipate starting in the second half of this year, but I want to be careful not to get ahead of the lead contractor. Everything is on track, and I just want to show respect for the chain of command. So please follow up with Leidos and Dynetics for the specific details.

Okay. That'd be fine. And then, just lastly, you guys sounded like you’re really hiring a good amount of people. It seems like well over 100, at least. So, has the market been just favorable towards that for you guys as well? Like, has the retention for those employees been extremely positive?

It's the market for the type of employee we're looking for continues to improve over the past several months. It is still difficult on a cost standpoint. It's very costly, especially for individuals that want to and will obtain and retain a security clearance. So it's getting better; it’s one of the reasons we're feeling better about the business in the second half of this year and 2024. But it's still expensive for people with very specialized capabilities. So that's the nature of it right now. And yes, we have a lot of openings. If we could fill all the openings we have based on our existing backlog and not just the backlog, the programs we have where we're going to get options exercised, and we're going to win some big opportunities. As I mentioned, we've been told we've won some, and they're going to be coming out soon. Our growth rate organically, which we're laser-focused on, could be substantially higher. It really could be, but we just can't get the people right now in the industry.

Okay. And I'll jump back in the queue, but once again, great quarter guys.

Thank you.

Thank you.

One moment for our next question. We have a question from Pete Osterland with Truist Securities. Your line is open.

Hey, good evening. I'm on for Mike Ciarmoli tonight. Thanks for taking the question. First, I just wanted to ask, given that you maintained full year outlook after putting up a pretty strong quarter, was there any pull forward in demand versus what you originally expected or any maybe unexpected easing in the supply chain. Just what drove the outperformance versus what you originally expected Q2 to look like?

Yes, it's not really the supply chain. The supply chain is as expected and it continues to be challenging, right? Maybe a couple of things moved forward a little bit, a couple, but the team is executing very, very well. And as I tried to allude to in my prepared remarks, the fact that Q2 came in better than we had hoped gives us higher confidence in the full-year, but frankly, it takes some pressure off of the year. Right now, obviously, you guys, if you do the math at least on the revenue side, Deanna talked our mix is getting better and better why margins are going to be up. We continue to do $250 million quarters Q3, Q4, we're going to drill our guidance. So there's no ramp. There's no hockey stick. And as Deanna mentioned, as we all know, we're probably going to have a continuing resolution. We expected that, but what I'm starting to worry about is, is it going to be worse than a continuing resolution? Will the government shut down for a period of time? And so we're factoring all those things in where we just don't want to get ahead of ourselves. We have a lot of good things going on here across the company. We want to deliver on what we say. That's where our heads at.

Great. That's very helpful. And then, there's a follow-up, just as we think about the opportunities internationally for target drones, have you seen any signs of increased momentum for demand on that front? Either from orders or conversations with potential customers? And just how are you thinking about the growth trajectory for that business over the next couple of years?

Yes. International target drone business is continuing to ramp. It's going to continue to ramp. However, as I think I mentioned on the previous call or two, the big three target drone users in the world are the United States Navy, the United States Air Force, and the United States Army. Obviously, we have all of them. Then there's the UK Ministry of Defense. That's our customer too. And then just looking at defense budgets globally, target drone by country drops off precipitously after that. So we're going to book and we're going to be able to announce a lot of international target drone wins over the next several months and quarters. But the quantities are nice, but they're not the big needle movers like the U.S. stuff. They're just not. The award that I mentioned in my prepared remarks that we've been informed we've won and hopefully it's going to be definitized in the next few weeks. That can be a needle mover in 2024 or 2025. And I can't say much more about it. But that's a good one.

Great. Thanks for taking the questions.

Yes.

We have a question coming from Mike Crawford from B. Riley Securities. Your line is open.

Thank you. Eric, you talked about a new payload and mission integration system customer potentially for Valkyrie. And I know you have a number of customers within the DoD, maybe ministry and defense, but would you be able to supply Valkyrie say to another prime?

Yes. We would be able to provide the Valkyrie to another U.S. prime. There is no prohibition on us doing something like that if the opportunity arose.

And is that something you would consider to be beneficial given maybe their channels?

Yes, we would definitely consider it. We're committed to doing what's best for the business and for our shareholders. At Kratos, we operate with multiple models. One key principle is that it's better to have a part of something than none at all. If we can secure a significant portion of an opportunity like the one you mentioned, rather than taking a high-risk route on our own, we would carefully evaluate those factors before making a decision. So, the answer is yes.

Okay. Thank you. And then you talked about a plan and Steve Finley was actually quoted about this and even further to double production of drones from 150 target and tactical aircraft this year to 300 within 18 months. And I know that you have space to do that given the Oklahoma facility where I think you're on your second Valkyrie production path right now. But what will this require from a human capital standpoint in terms of increased number of employees to execute on that plan?

Right. So, Mike, related to that, and I did not say this in my remarks, we have acquired an additional autoclave specifically for tactical drones. Our team got an incredible financial deal on it and we've got it and it's going in. On the people side, that is something we're always focusing on. Thinking additional for what you'd what you just framed up and what Steve said. And I know what you're talking about. Think another approximate 125 people.

Okay. Thank you. And then I have one final question. So your solid rocket motor partner Aerojet Rocketdyne is now part of L3Harris and what if any concessions or assurances do you have, or not have from L3 regarding your ability to continue to get ready access to a merchant supplier of solid rocket motors for some of your vehicles?

Right. So, I obviously can't talk about any direct communications that we may or may not have had with anybody you are talking about. However, L3Harris executive leadership immediately upon the close pledged. This is public. They made a pledge that they're going to invest in the business. They're going to be a merchant supplier, and someone sent me a letter where they communicated to the Department of Defense that they are not going to play any favorites, and they are going to continue to treat us all as equal partners. So, that's what my friends at L3Harris have said publicly. To the other part of your question, we of course are very prudent when we're always looking for second sources or backup plans. And that's across the company and across the business, and we'll continue to do that, including now in the rocket motor area.

Okay. thank you, Eric. Thanks a lot.

You’re welcome.

Thank you. We also have a question from Ken Herbert with RBC Capital Markets. Your line is open.

Hey Eric. Good afternoon.

Hey Ken. Good afternoon.

Hey, I wanted to start off, congratulations on the AI Valkyrie flight. Coming out of that flight, the Air Force specifically commented that they see direct transferability or applications of this flight and the technology to the CCA program. Can you provide any more color on how you see Kratos' involvement in the CCA program playing out? Any maybe milestones, incremental milestones we should be thinking about. And specifically, how you see the technology sort of risk initially as you look to transfer this into or the Air Force looks to transfer this into CCA amongst other areas in the future.

Ken, I apologize. I cannot say anything at all about that program. I'm sorry. I can't do it.

Okay. Fair enough. Can you provide any comments on the test flight and maybe any of the lessons learned in particular or how it completed the flight relative to initial expectations?

From my perspective, from our perspective, the Valkyrie absolutely knocked it out of the park over the three-hour flight. And our customers continue to applaud the Valkyrie; they applaud the aircraft. Ken I mentioned the video, the Air Force Research Lab Video. If you may have had a chance to take a look at it. For those of you that haven't, I encourage you again to please go take a look at it. It will address and answer a lot of the questions raised by the government, by the Air Force that Ken is asking that I'm just not comfortable talking about publicly. Ken, we continue to make incredible progress in the tactical drone area. As I said about a year ago, I thought everything was going to become more classified and I was going to not be able to talk much anymore, and that's where we are. Which is why I'm now, wherever I can, pointing to or identifying what the government is saying. They’re not endorsing, but what they're saying to try to keep the investors as up to date as possible. So we're with the U.S. Marine Corps, we're doing great. I know it's out there. I saw a public thing out there now. We're involved with the Office of the Secretary of Defense. That's moving forward. Obviously, with the Air Force and multiple areas, we feel the government moves on their own timeline. We will not get ahead of ourselves, but we have a whole family of airplanes flying today. And I mentioned the cost points. I mentioned new stuff. We're ahead of everybody. And our plan is to stay ahead of everybody. A very important person said to me in the past couple of weeks, you need to have strategic patience. For those of you who know me, you know that's very difficult, but I'm happy to have strategic patience. And we will win.

Thank you. I appreciate that. I have a question for Deanna. In the second quarter, it seems that working capital, particularly accounts receivable, contributed positively to our cash flow. The guidance suggests a strong improvement in cash generation during the second half of the year. Was there anything specific in the quarter related to working capital that provided a boost, and how should we view the potential for our full-year cash expectations?

Sure. There were some favorable milestones in the second quarter that did accelerate some receipts that we had originally anticipated in the third quarter. So that was favorable in the second quarter. In my prepared remarks, I highlighted Q4 where we expect to see working capital to be beneficial as well in the fourth quarter based on scheduled milestone payments as well as our expected conversion of some of the inventory builds that we've been building throughout 2022 and thus far through 2023.

Perfect. Thank you very much.

Thank you.

You’re welcome.

Thank you. We have a question from Seth Seifman with JPMorgan. Your line is open.

Thanks very much. Good afternoon. And congratulations, again, on the latest Valkyrie flight, at the risk of asking a question about something that's difficult to talk about. Just following up on that, maybe hopefully this is high level enough that is something you can talk about. When we think about the path forward, with Valkyrie and things that need to be developed in order to see demand really ramp up I assume that some of it is the artificial intelligence capability, being developed kind of outside the company. When you think about the pace of that and how that happens and how that development path relates to the demand profile for Valkyrie, how do those two things kind of link together and where are we in that now?

Right now, the Valkyrie, as a low-cost affordable minimal viable product, is ready for four specific missions. That's why I've mentioned it in the last few calls, including today. Payloads are being integrated, and relevant operational flights are taking place. This minimal viable product is substantial and I believe it surpasses anything our competitors have. It's fully prepared, and I’m working on the artificial intelligence integrated with a strong, proven augmented autonomy system. We first demonstrated manned-unmanned teaming in 2015, and you can see in the video how manned Harrier fighters deployed Makos for various operations. We’ve been developing a robust augmented autonomy system for several years. The Air Force's recent announcements and our work with SHIELD show that this capability has become much more advanced, particularly with the artificial intelligence aspect. Based on these developments, I believe we are ready to deploy nearly all of our tactical drones, with the exception of the newest one. We've integrated augmented autonomy systems with various payloads and weapons across our tactical drones, and progress is happening rapidly. While I can’t speak for our customers, the Air Force's recent announcement, along with other forthcoming updates, indicates that artificial intelligence is advancing quickly. I'm uncertain when our customers will feel ready to proceed; it could be tomorrow, in a month, or in a year. This is the dynamic landscape we're navigating. Does that help?

Yes, absolutely. Thanks. And then, obviously, another key milestone, we saw it in the quarter. Was the Zeus, the static test flight. It seems, I guess, can you take us through kind of where things go from here and how you see the hypersonics opportunities playing out? I mean, it seems like if we think back several years ago in terms of where hypersonics was supposed to be big picture for DoD. It seems like maybe some of that hasn't panned out and maybe some of that because costs are high. And so, this is something that's moving in a different direction. But when you think about gaining further acceptance of this with the customer and what future milestones are? Kind of how do you think about that?

As I mentioned, I can't provide many details since our last call, but Kratos recently achieved a very successful hypersonic launch for a government customer. Developments related to hypersonics at Kratos are accelerating rapidly. This is largely due to our affordability and cost-effectiveness, as demonstrated with our low-cost ballistic missile targets, which reach hypersonic speeds upon re-entry. The maneuverability we've achieved is also a factor. I believe that low cost will prevail because customers prefer a test-fail-test approach, allowing them to learn quickly rather than waiting years to determine the results of an expensive test. Our low-cost model is one reason for our success with our partner in winning the MACH-TB Test Bed program. While I can't share many specifics, I expect this will be a significant growth driver for us starting next year. Zeus I and Zeus II are major contributors to our success, along with Erinyes, which I believe is significantly more affordable than competitors' options. We're set to launch first with Dark Fury following closely behind. Dark Fury is highly capable. Our strategy here is akin to what we did with tactical drones by adapting proven technologies for our needs. We’re leveraging our ballistic missile target capabilities, including motors like Oriole, Terrier I, and Terrier II. We've specifically designed our systems with Aerojet but retain ownership on Zeus I and Zeus II. As I understand, we may be one of the few companies that has both the stack and front-end capabilities globally. Additionally, starting next year, we'll begin integrating our engines into some of our target drones, marking a step toward vertical integration in the drone sector. Our engines represent about a third of the total cost, allowing us to improve our margins. We will be one of the few companies building both the aircraft and the engines. We are also establishing an organization to handle casting, milling, machining, and 3D printing for our engine components, eliminating our reliance on external supply chains. This initiative will be operational next year as well. I know that was a lengthy response, but it relates closely to the vertical integration question you posed, and it outlines our vision moving forward.

Great. Thanks very much.

Thank you.

Thank you. We have a question from Sheila Kahyaoglu with Jefferies. Your line is open.

Thank you. Good afternoon, Eric and Deanna. Eric, first off, Happy birthday.

Thank you.

So I have a few questions for you. So, on the budget, you mentioned a few things you're looking for on the unmanned side. What would be two things we should look for in the fiscal 2024 budget when it comes to Kratos?

I want to name some things that I think you can see. You want to definitely take a look at target drones, target drones. So, look at PEO 208 Program Executive Office 208 on the United States Navy on their target drones. And so this is unmanned, unmanned aerial systems in strike where target drones are. They're also going to be doing some other things in there. We are heavily involved in that line. Take a look at the target drone line of the United States Air Force. You heard me mention in my prepared remarks that a lot's going on in the world. And so a lot more target drones are going to be needed. So I would take a look at the target drone areas. That, you'll be able to see and you'll be up, I think in the narrative under the program element lines, you'll be able to see narrative that’s specifically related to Kratos. I think you'll be able to see under the United States Marine Corps, I think it'll be narrative that'll call out attritable aircraft, attritable unmanned aircraft, expeditionary aircraft, that's one to look for too relative to what we're doing with the United States Marine Corps.

Thank you for that. And then my second question for you is on KGS great quarter, grew 17% organically. You called out basically every business area. And you even mentioned, like, if you had the labor there, you'd be hires. So, obviously, the budget is not growing 17%. Are you taking share? What are some of the key areas where contributed to that growth?

Yes. Let me address the programmatic aspect, and then Deanna will cover the numbers. We are certainly gaining market share, particularly from two main competitors. Our strategy has focused on this, as traditional and legacy companies tend to avoid innovative approaches and new product development out of fear of harming their existing offerings. This reluctance prevents them from pursuing advancements in virtualized software, command and control systems, telemetry, tracking, and communication modems for space. They lack the incentive to innovate because it risks cannibalizing their current products. Disruption is necessary—such as the emergence of software-defined satellites, high-definition satellites, and high-throughput satellites—which demands a new generation of ground equipment, providing us an opportunity to gain market share. We are committed to continuing this trajectory.

Okay. And maybe one last one, unless Deanna's going to comment on the numbers. Five years from now, how do you think about the fighter programs?

Sheila, after you discussed the different platforms, there was a moment of silence, and then you resumed. Could you please reiterate the question clearly?

Sorry about that. No, just five years from now, how do you think about like the biggest fighter program contribution to Kratos? I know you couldn't answer Ken's question, so I'm asking it slightly differently.

I'm going to be very aloof on that, and I'm going to answer it this way. We are seeing in Ukraine that quantities matter, especially when it comes to drones. Hundreds if not thousands of drones are going to be used. Now people are saying, all those are propeller planes. And yes, I get that because it's a land war. But in the Pacific, take a look at the recent Rand report that came out last week. In the Rand report, specifically laid out that to deter and defend Taiwan against somebody, the best way to do it is to use hundreds, if not thousands of high-performance jet drones to give the bad guy a hell of a targeting problem. They have to respect them all, and they're an incredible threat. So, you flip the cost curve on them where they have to fire something more expensive at you than the drone. I also encourage people, three-star General Heino just retired three weeks ago. Go take a look at his most recent interviews regarding what he sees the drones are going to be needed in the next three to five years for the Pacific. And so with that as the backdrop, Sheila, I believe that the most important from an aircraft standpoint for Kratos is going to be our tactical jet drones, specifically in the expendable and the attritable areas. And we intend to be one of the leaders there.

Great. Thank you.

And it looks like our last question comes from Jan-Frans Engelbrecht with Baird. Your line is open.

Good afternoon, Eric, Deanna, and Marie. Congrats on a good quarter. I'm on for Peter today. Just like to talk. Good afternoon. So you mentioned in the release, your bid and proposal pipeline of $10 billion. Can you just talk more about the potential for new space awards and maybe a little bit of information about the adoption of OpenSpace that’s going with customers?

If you could see me, you'd notice I'm smiling for the first time. Our OpenSpace team is incredible—technical, sales, and business development teams are all doing excellent work. We've equipped them with a cutting-edge tool, our command and control TT&C modem system, which is perfectly timed for the current satellite market. I believe we're three to four years ahead of our competitors for reasons I previously mentioned. Our expectations for the satellite and space business are exceptionally high, and this sector is our largest and fastest-growing, with significant margin expansions already emerging. Next year and into 2025, as the software license model under OpenSpace takes effect, growth will really accelerate. Regarding vendor lock-in, satellite operators are now reluctant to be tied to companies building satellites and their associated ground equipment indefinitely. They prefer to work with us as the independent supplier of ground equipment that can connect with LEO, MEO, and GEO satellites. We might just have something big here. I encourage everyone to visit Intelsat's website, where they've posted a video showcasing what Kratos' OpenSpace is doing for them and how it's setting them apart. That will give you insight into my enthusiasm about this. We're optimistic, and a significant part of our pipeline, crucial to our business, revolves around space and satellite communications through OpenSpace.

Perfect. Thank you. And if I could just have a quick follow-up, sir. So there's been some questions about, in Valkyrie and the ability to scale production. But if we could just return to your comments on the doubling of production, and I know we have to assume funding comes in if you want to move from 150 to 300 jet drones, but can you just touch sort of an Air Wolf maker and Valkyrie, sort of the lead times that you would experience to sort of ramp production, are the differences between that?

Currently, the lead time for the Valkyrie is between 12 to 15 months due to engine issues, which I'm actively working to resolve. While all models face engine-related delays, the Valkyrie has the longest wait. Other models should be ready within six months. The engine is the major factor in our timeline, which connects to Kratos' broader engine strategy and explains my confidence in the performance of our engine-related businesses in the coming years. For the last 20 to 25 years, our focus was on combating terrorism, and while range and electrical power were not prioritized before, they are crucial now for drone operations. The new engines will play a key role in that plan.

Thank you. I appreciate it. I’ll jump back in the queue.

Thank you. And I'm showing no other questions at this time. I'd like to turn the call back to Eric DeMarco for closing comments.

Great. Thank you everyone for joining us. If you have any follow-ups other than what we went through, please don't hesitate to shoot Deanna or I a note. And we'll plan on chatting with you when we report Q3.

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