Kratos Defense & Security Solutions, Inc. Q3 FY2023 Earnings Call

Good day, and welcome to the Kratos Defense & Security Solutions Third Quarter 2023 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 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 VP and General Counsel. Please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions third quarter 2023 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 defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or 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, and good afternoon. We've recently received additional interest in Kratos from existing and potential new stakeholders. As a result, I'll begin my remarks with a summary of our strategy. Kratos is a technology company focused on the national security, commercial and global markets, and we make targeted internally funded investments to be first to market with relevant products and software. The benefit of Kratos being both defense and commercial market focused is that we leverage our technology, resources, facilities, and production quantities, providing Kratos a competitive advantage, including cost and a unique rapid technology development and delivery aspect to our customers. Kratos utilizes existing leading edge technology, not yet developed bleeding-edge technology, which approach accelerates our development and fielding time while reducing our risk, schedule and cost elements. Kratos’ dual commercial and security market focus is most represented by our space satellite software and turbine technologies areas, representing approximately 50% of Kratos’ revenue today. Also consistent with making targeted internal investments in our first to market strategy at Kratos is affordability as a technology, with better being the enemy of good enough, ready-to-go today, which is becoming even more important in the existing budgetary and threat environment. As reflected in our third quarter and year-to-date results, Kratos' 2023 transition year, making targeted internal investments in high-growth market opportunity areas while also generating increased revenue, profit, and cash flow is on track. With this trajectory expected to continue in the future as an increased number of our programs and initiatives enter or see increased production or deployment. The Kratos team in every business unit is successfully executing our strategy and business plan in the light of day as a public company. We are competitively bidding on and receiving large contract and program awards and programs of record, generating revenue and cash flow while simultaneously managing significantly internal funded investments to further grow the business. This approach has positioned the company for sustained future year-over-year organic growth with increased margins along with potential transformational opportunities, including in tactical drones, software-based satellites, C2 and TT&C, turbine propulsion engines, hypersonics, and certain other system areas. As we complete 2023, we expect to achieve our forecast and we currently expect Kratos' base case 2024 revenue and EBITDA profitability to continue to increase. Kratos' base case forecast does not include any assumed tactical drone production contracts, which we will only forecast once assured. As the United States government, the defense industry, and Kratos currently operate under a continuing resolution authorization, similar to previous years, we will wait until we report Kratos' fourth quarter financial results in February to provide our detailed 2024 financial guidance. However, unless something significantly adverse occurs funding-wise at a high level, we are currently expecting at least 10% 2024 over 2023 base case organic revenue growth and increased EBITDA margins, with Q1 2024 similar to prior years being the weakest due to the currently ongoing CRA. Kratos’ recent program awards and our record backlog and opportunity pipeline, which are driving our demand for qualified personnel, are the primary reasons for our expected future organic growth trajectory confidence. Simply stated, Kratos has the right technology, software, systems, products, and solutions at the right price points, at the right time to address certain of the most mission and time-critical national security and commercial market requirements. We currently have about 400 open billable requisitions across our company on a base of approximately 3,800 employees, which is also indicative of the strength of our business and the demand for our offerings. Obtaining and retaining qualified workers, including those willing and able to receive a national security clearance, remain a primary operational challenge, including the continuing increased cost of these individuals which is impacting our margins. Recent Kratos business highlights include: The Air Force has now reported that an Artificial Intelligence Combat-enabled Valkyrie recently successfully flew at the Eglin Gulf Test and Training Range. As reported, AI algorithms developed and trained by the United States Air Force Research Lab autonomous air combat operations, use neural networks to fly the Valkyrie against simulated opponents, mission systems, and weapons. Also recently reported in a separate flight, Kratos’ Valkyrie successfully demonstrated all defined artificial intelligence-enabled high-performance unmanned aerial vehicle specified relevant functions. Kratos’ Valkyrie with the United States Marine Corps also continues to progress, with the Marines recently announcing the successful first flight of Kratos’ Valkyrie under the Penetrating Affordable Autonomous Collaborative Killer Portfolio Program, as Kratos was able to announce today. As reported, the Marine Corps partnered with the Office of Undersecretary of Defense for Research and Engineering, the Navy Air Systems Command, and the Naval Air Warfare Center Aircraft Division, with multiple expected additional funded future Valkyrie flights planned under the program. Kratos’ drones, including Valkyrie, also continue to progress under the Rapid Defense Experimentation Reserve program, including as related to the U.S. Marine Corps. The Valkyrie is the only high-performance stealthy jet drone in its class flying today, continues to mature in actual flights with funded customers, including with artificial intelligence and other relevant mission systems as the Department of Defense progresses towards the future large-scale deployment of high-performance jet-powered drone UAV systems. We have now executed Phase I of an expected five-year funded contract initiative with the new National Security entity for Kratos' Valkyrie B version mission capability expansion, which initiative is very confidential. We have also now completed negotiations and expect to receive in the fourth quarter a Valkyrie-related contract in the tens of millions of dollars from a separate National Security entity for a Valkyrie version A category. Additionally, we have recently received an entirely new tactical system-related contract award, which we are unable to discuss further in any detail at this time. Separately, we are in negotiations with the customer related to Kratos’ Thanatos tactical drone system, a version of which is flying today, with multiple Thanatos systems expected to be performing funded mission capability demonstration expansion flights with this new customer in the future. We have also recently been discussing with the customer regarding Kratos’ Athena drones system, which is now flying, and we hope to be under contract next year. Since our last report to you, Deputy Secretary of Defense Kathy Hicks announced the new Replicator initiative to field thousands of attributable autonomous drone systems over a few years. Similar to the reported completely separate Air Force CCA program, where it has also been reported that thousands of CCA drones are expected to be fielded, I am unable to say anything more on either Replicator or CCA at this time. However, Kratos is the only company with low-cost high-performance expendable and attritable jet drones, both in production and flying today, including Air Wolf, Mako, Valkyrie, Thanatos, Athena, and others. Assuming the fiscal 2024 budget is approved as we expect and the fiscal 2025 NDAA and FITA typically released by the Pentagon in calendar Q1 are also as we expect, late next year, we hope to receive our largest to-date Kratos tactical drone-related contract award, which once again is not included in Kratos' base case financial forecast. In addition to recent developments with Thanatos and Athena, Kratos' Ghost Works continues to make progress on a separate new system, and assuming the range scheduling holds, we expect to demonstrate this system later this year. Kratos’ Ghost Works has also recently been focused on a large new prime program opportunity, which includes the rapid design and build of an additional separate new system requiring significant Kratos funded NRE, BNP, and other costs, which we expect to incur through Q4 and into Q1 of next year. We recently acquired Sierrea Technical for approximately $25 million in Kratos stock if all earn outs are achieved. Sierrea is a long-time partner of Kratos, and this was a one-on-one negotiated stock exchange merger with Sierrea's husband and wife founders. Sierrea recently received an approximate $77 million single award contract for two stealth jet drone fifth-generation aerial target aircraft, or 5GAT, with initial period of performance of approximately three years and then expected production thereafter. For competitive and security considerations, I am not going to comment any further on Sierrea related to future growth expectations, other than to say that Kratos has big plans for the 5GAT stealth drone, and also an additional opportunity Sierrea is working on that is highly confidential along with Kratos' Ghost Works. Our primary focus is to successfully execute the 5GAT program and be first to market with a fifth-generation aerial target drone system. We are working with Shield AI with Shield’s artificial intelligence pilot integration into several of Kratos' high-performance jet drones, including Valkyrie. The Shield-Kratos relationship is exactly consistent with Kratos’ first to market with relevant system strategy, with Kratos flying drones and Shield flying Hivemind AI pilot. We believe Shield will have a clear market advantage over its primary competitor as Shield has access to Kratos' family of flying today jet drone systems and its competition of power points, ground models, simulations, or propeller points. The Kratos-Shield flights are occurring at the Oklahoma Burns Flat Facility, which I completely endorse, that the competition does not know what Kratos and Shield are up to, as Shield AI is expected to be advanced through these flights and also at a separate additional range facility. We continue to come down the learning curve on the 24 Valkyrie serial production run, currently with three separate Valkyrie variants A, B, and C underway, and a fourth variant we are currently considering based on recent customer interest. We are internal resource planning, balancing, and phasing the Valkyrie production pace and Kratos’ capital allocation against other new customer funded tactical drone programs we have recently received and potential opportunities. We have also now submitted a large quantity ROM, or rough order of magnitude, to a government customer for a significant Kratos tactical drone production run, which production planning and preparation we have completed along with our existing in-place critical suppliers. The demand for Kratos’ target drones is strong, and we expect to continue for the foreseeable future as the global recapitalization of weapon systems and the need to test and train on these weapon systems increases, as recently demonstrated in the vigilant live run test last week. In the Space and Satellite area, almost every aspect of a satellite ground station can now be converted from hardware and software, lowering cost, accelerating technology advancement and deployment time, and increasing the ability for an operator to immediately react to changing conditions and requirements, which is the large new and growing addressable market Kratos is pursuing. New satellite space vehicle technology and requirements providing Kratos market opportunity include software-defined payloads, high throughput spots being enabled and other advanced system payloads and laser optical and other capabilities. Kratos' first to market OpenSpace software platform is the only software networking solution specifically designed to address and advance this new software and commercial technology focused paradigm, connecting dynamic space to a dynamic virtualized ground system. We recently announced that Kratos’ OpenSpace platform is the first commercially available fully virtualized satellite ground system to achieve MEF 3.0 Carrier Ethernet Certification. The MEF Carrier Ethernet standard is the same industry standard adopted by global terrestrial and mobile network carriers, meaning Kratos’ OpenSpace makes satellite service networks seamlessly interoperate with terrestrial and cellular transport networks. The CE standard achievement is representative of Kratos satellite team's successful and methodical execution of our global satellite software-based virtualization strategy led by Kratos’ first to market OpenSpace system. The total addressable market opportunity for Kratos OpenSpace, both commercially and for National Security, is expected to remain strong with thousands of additional satellites planned for launch in the future. Kratos’ Turbine Technologies or KTT and our TDI Engine business, we believe similar to our tactical drone business, is well-positioned for the expected significant growth in drones, cruise missiles powered munitions, high-performance loitering munitions, and other systems, all of which need engines. Kratos’ first to market made in the USA engines are flying today and are designed into several new program systems, including as recently reported with Kratos TDI engines and the Boeing Powered Joint Direct Attack Munition. For engines, motors, and propulsion systems, the time to get successfully designed into the vehicle's munitions and system is now with working engines, not improving startup technology and photo renditions, and Kratos is taking advantage of our first to market positioning. Since our last report to you, we have received a contract to integrate Kratos’ running engines into certain of Kratos’ jet drones, both target and tactical. Once integration is complete, we believe that Kratos will be one of the only companies in the world vertically integrated, building both the jet aircraft and propulsion system, significantly reducing cost and supply chain risk, while also increasing system performance for our customers with new technology provided by Kratos’ engines. We will also have the same vertical integration with Kratos’ Zeus rocket motors and our Erinyes and our Dark Fury aerial flyers. The Kratos Turbine Shadow Works development team has also been working on a separate new class of turbo fans, Kratos code name Blade, for new larger drones. I hope to be able to provide an update on our tangible progress with this initiative in the future, as the total addressable market size for this larger engine class is incredibly large as represented by recently published reports. The demand for Kratos’ turbine products technology and solutions is strong across the portfolio, including in turbo fans, space propulsion, hypersonic, and other classified areas. The microwave electronics business with a record backlog and opportunity pipeline is also performing well, including our team's successful penetration of the new microwave Space and Satellite market. In addition to Space and Satellite, the global recapitalization of air defense, drone counter UAS, missile radar, powered and loitering munitions, and C5ISR systems is providing a large and growing market opportunity for Kratos’ microwave business. The Kratos Rocket Systems business, or Kratos Zeus, Erinyes, Dark Fury, and other rocket-related systems, have also recently had a very successful mission with our government partners at the Vigilant Wyvern exercise, with multiple Kratos rocket system ballistic missile targets and multiple Kratos unmanned drone system targets utilized, with all Kratos systems being successfully tracked, intercepted, and destroyed by the USS Carl M. Levin. The Vigilant Wyvern exercise is a recent example of Kratos programs, systems, and products from multiple Kratos business units, providing mission-critical solutions to our customers for United States National security. I encourage you to watch the videos of Vigilant Wyvern when you can, as you can see your company's products in action. Importantly, the Kratos rocket system team recently met with the L3 Aerojet team, and I can assure you that L3 is 100% mission and customer-focused, including as related to Kratos Zeus systems. Kratos recently ordered numerous Zeus rocket motors from L3 related to upcoming Kratos Erinyes and other missions. Kratos’ C5ISR product, hardware, and systems business is expected to be one of our strongest future organic growth generators for the next several years, with important contracts and programs of record, including Patriot, THAAD, Enduring Freedom, integrated air and missile defense battle command (IBCS), short-range air defense (SureRAD), and many others. Kratos' C5ISR team's professionalism, facilities, classified assets, past performance qualifications, and mission focus and execution have positioned Kratos C5ISR as the go-to relevant hardware product and system provider in the industry. Past performance qualifications are incredibly important in the National Security Software Systems and Product business, and Kratos provides a significant barrier to entry to new or startup potential entrants. There are also a number of cross-Kratos division programs, including where our C5ISR team and our space, defense, rocket, and hypersonic businesses together are providing a complete integrated system solution to the customer. We're focused internally on organic growth and on increased profit margins with no significant acquisitions planned. We are balancing our increased future EBITDA profit objectives against a significant number of new program opportunities that we are and expect to pursue, many of which are right in Kratos' wheelhouse that have recently presented themselves. Now is the time to win these and get designed in for these new significant opportunities.

Thank you, Eric. Good afternoon. As we've included a detailed summary of the third quarter financial performance as well as the fourth quarter and 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 third quarter were $274.6 million, up from $228.6 million in the third quarter of 2022, reflecting a 20.1% organic increase. Revenues came in above our forecasted range of $240 million to $260 million, with organic growth in our space and satellite, turbine technologies, microwave products, C5ISR, training solutions, and unmanned systems businesses. Our KGS and Unmanned Systems segments grew organically 22% and 13.4%, respectively. Cash flows used from operations for the quarter of $100,000 included working capital requirements associated with funding the sequential revenue growth of $73.7 million from the second quarter. Consolidated days sales outstanding continued to improve from 120 days in the second quarter to 117 days in the third quarter, with the increase in receivable balance in the third quarter of $14.8 million driven by the sequential increase in revenues. In addition, advanced purchases of inventory to mitigate potential supply chain disruptions and delays continued as well as increased production to fulfill scheduled future deliveries, resulting in an increase of $3.7 million in inventories for the quarter, representing a reduced pace from the first half of 2023, with a total use of working capital for the nine months of $23.7 million related to increased inventory levels. Free cash flow used from operations was $14.3 million after cutting capital expenditures of $14.2 million. Our contract mix for the third quarter of 2023 was 72% from fixed price contracts, 22% from cost-plus fixed fee contracts, and 6% generated from time and material contracts. Revenues generated from contracts with the US government during this quarter were approximately 68%, which included revenues generated from contracts with the DOD, non-DOD, Federal Government Agencies, and FMS contracts, and 12% of revenues generated from commercial customers and 20% from foreign customers. Moving on to financial guidance. Our fourth quarter and updated full year 2023 financial guidance we provided today includes our current forecasted business mix and current delivery schedule and our assumptions related to the expected impact of our continued operating challenge related to obtaining and retaining qualified technical personnel, and the related increased cost for these employees and across our labor base, as well as the continued impact of supply chain disruptions, inflation, and related expected cost and price increases, including increased personnel costs associated with hiring new qualified technical personnel that are currently expected to continue impacting both the industry and Kratos. Our revised full-year 2023 cash flow guidance reflects the ongoing impact of working capital requirements to fund revenue growth, including the continued increase in inventory balances, which was previously expected to begin reducing and converting to cash in the second half of 2023, as well as the shift of certain milestones on a handful of projects, primarily in our Training Solutions and C5ISR businesses, which has impacted expected cash receipts of approximately $16 million to $17 million shifting into 2024.

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

Thank you. Our first question comes from Seth Seifman with JPMorgan. Your line is open.

Thanks very much. Good afternoon and nice quarter. I guess, one thing that stood out to me as we look at the rest of the year and we look at what the guidance is for the fourth quarter and what's implied with regard to sales and EBITDA margin versus Q3. What accounts for the step-down there and what's usually a pretty seasonally strong quarter?

Primarily, Seth, this year the CRA, which we had built into our plan, as you know from the beginning, and we anticipated we would have one at least for the quarter. And we sell, as we've discussed previously, a lot of software that comes in either Q3 and/or Q4. We received several of those orders in Q3, we may not get them in Q4. That's number one. Number two, I mentioned there are a number of new opportunities that we are pursuing. Where we are incurring very significant bid and proposal, nonrecurring engineering, and other costs, we're actually building some things that have to go into the air. And that's also something that's been factored into Q4. So we're trying to balance. We're making sure we meet or beat our numbers. We'll also position ourselves to go after and win some of these new opportunities.

Great. Thanks. And then, maybe when we think about where things are ending up for the year on OpenSpace versus kind of what you thought coming in. And then the prospects into 2024 and beyond, if you could update us there, that would be great.

Yes, absolutely. OpenSpaces, I said, continues to make progress. It is not making as fast a progress as I had hoped. But my expectations, as you know, as the CEO, are very, very high. But the business is killing it, literally killing it. And as I mentioned, even in the remarks or in the release, we're in source selection on a very large opportunity right now. And there are a number of very large opportunities that we're pursuing that we believe we're going to win because we're the only ones that have the virtualized software element. So we believe we've got a tiger by the tail here, Seth. We got a tiger by the tail. And we're going to hit an inflection point. In my opinion, it will be late 2024 or 2025, and that inflection point is when we cross the lines of development against production and deployment and sales. The production, deployment, and sales aspect of that curve are rapidly going up. When they cross that development cost and maintenance cost number that we have to maintain, then we're going to see significant margin expansion. And that's what's coming. So the business is doing phenomenally well. I mean, they're first to market with new technology. The leaders are focused. The whole team is focused, and they're doing it. Thank God at Kratos, we have a number of other things that are coming up that are hitting all cylinders. So if it's a little if it's a quarter or two later than I hope, all is going to be fine.

Okay, very good. Thanks very much.

One moment for our next question. Our next question comes from Michael Ciarmoli with Truist. Your line is open.

Hey, good evening, guys. Nice quarter. Thanks for taking my questions. Hey, Eric, just, I mean, you had good margins in the quarter, especially adjusted EBITDA margins. I think highest since maybe second half 2021. Are you starting to see or get that expected pricing and flow through from some of these newer contracts that you had kind of anticipated?

We are starting to, but, Michael, the costs of labor continue to be significant, especially in the specialty areas. I think turbomachinery engineers, software engineers, and system engineers. As I mentioned, we have about 400 open requisitions on a 3,800 person base; we’re a product company. So that tells you the amount of revenue we've got sitting there ready to convert and those are expensive people. So good news, we're growing. And at some point, regardless of what the cost increases are, the growth is going to overcome it. We're really going to have a step function in margin increases. But it's not going to be for the next few quarters because of the reasons I said.

Okay. Got it. And then, the color on 2024 and the 10% growth, can you give us maybe your underlying assumptions? I know it's hard, but is it the budget environment, whether we get sort of a full year of the sequestration? And then maybe even just directional growth within your different lines of business. And I think you said you didn't include any tactical drones in there?

Yes. If we have a full year CRA, we will not achieve 10%. It's not just due to a lack of new contract awards but also because we have no new increases in existing production, even though several programs are ramping up. If we can secure something by the end of the year or in January or February, I feel optimistic about reaching the 10%. Key drivers include our C5ISR business, where we are currently producing several programs and starting production on IBCS and SureRAD. The Sentinel ESG phase is also ramping up significantly this year, and we have a strong partnership with Northrop Grumman on that. Our collaboration with Dynetics on Enduring Shield or EFPIC is expected to see considerable activity, and it's been publicly stated that the units we are working on will be delivered next year. Our engine and turbine businesses are performing exceptionally well, with numerous open positions for programs in space propulsion, turbo fans, turbo jets, and hypersonic systems, including the major B52 re-engine initiative. Growth in our engine sector is anticipated next year. Additionally, our Microwave Electronics business is significantly ramping up, as we are engaged in Iron Dome and Arrow, and we've been featured in the news regarding our work on radars and related systems. Our rocket systems business is also well-funded, focusing on ballistic missile targets and hypersonic system testing, with a solid launch manifest for next year. We expect an uptick in the drone sector, mainly driven by target drones required for weapon systems currently being sold by partners like Lockheed Martin, with an emphasis on target drones and ballistic missile targets. Overall, we see programs indicating substantial growth and margin expansion. We're approaching tactical drones with caution and aren't making any assumptions until we see concrete developments, but I hope my commentary indicates we're getting close.

Got it. Just one other one. The downward revision to cash flow sounded like just working capital support growth, but I think you also talked about some milestone collections maybe flipping out. I guess you don't want to talk to next year, but I think we've all been waiting for some cash generation. What's sort of the thought around cash flow?

Yeah, I don't want to comment about next year at this point, Michael, but the milestones were about $16 million to $17 million on a small number of projects, but they obviously were fairly significant in our Training Solutions and our modular systems business. We expect to collect those in 2024.

Mike, let me give you a little more color on that. I want to. We're standing up an engine production line. We're going to be standing that up. It'll be done by the middle of next year. Because we're anticipating going into production on at least one engine. So we're standing that line up. We've stood up a new line in the tactical drone area for something that will be stood up by the end of Q1, middle of Q2. These are for programs that are funded, so we're spending some money to establish these. We've won these programs. We've won development, and they’re going into production. We're standing these up, and that's going to take some capital as well.

As well as the second lot of the Valkyrie production that we announced that we started earlier this year. So that will be ongoing throughout 2024 as well.

One moment for our next question. Our next question comes from Mike Crawford with B. Riley Securities. Your line is open.

Thank you. And thanks for providing some color on some of these other drones under development in addition to Valkyrie, like Thanatos and Athena. Another one that you won a couple of years ago, a AFRL award for the offboarding sensing station, the OBSS contract, which is I think, the derivative drone out of that is your Demogorgon. Is that one that's still featuring in your plans?

It is. We are not involved with OBSS at this point, Mike.

Okay. And you also mentioned the three year $77 million 5GAT contract. I imagine that there's no reason you wouldn't come to execute on the same playbook you've used with targets in the past and develop the fifth generation, actual tactical drone out of the 5GAT. Is that a process that’s already starting or something you are going to decide on next year?

I'm sorry, Mike. I can't comment on that. I'm sorry.

Okay. That's fine. Just maybe switching gears to OpenSpace. So you're first to market with this virtual networking solution that goes way beyond tracking and telemetry and control. Are there any bottlenecks that you see with your solution? Will it be a data radio or something else that when you're trying to connect all these disparate networks?

I do not believe so. The team that Phil has pulled together and created are incredible. These are some of the if not the greatest technologists, not only in the company but in the entire industry. The speed at which they have developed OpenSpace to address existing hardware elements on the ground to virtualize them to interface with space, the speed at which they have mastered the technology of the RF or analog signal coming down, converting it to IP, means it’s virtualized. So now the entire backbone can be virtualized, which is incredible to me. I do not believe there's an issue, Mike, relative to what you asked.

Okay. Thanks, Eric. I will leave it there. Thank you.

Okay. Thank you.

Our next question comes from Ken Herbert with RBC Capital Markets. Your line is open.

Hey, good afternoon. Eric and Deanna, nice results this quarter.

Good afternoon, sir.

Hey, Eric. Maybe just to start off, I wanted to see if you could level set us on maybe the revenue run rate for the Turbine Technologies business? And how much of growth in 2024 can that perhaps contribute? And then maybe more importantly, you've had some nice wins there recently, but can you talk about the pipeline in that business in particular? Because it sounds like it's expanding pretty rapidly.

Right. So level setting that business, think of it going from approximately $70 million to $75 million to over $100 million in 2024. That's the trajectory that it's on. Programmatically, the big programs are in no particular order, with our partner Rolls Royce on the B52 reengine. I'm not allowed to say the name, but we're involved with companies that are doing lunar landing and maybe beyond the moon, those types of engines. We're involved with agencies for engines for drones, and KTT's engines are being integrated into drones right now. We have a program with Boom; we're designing a supersonic engine for Boom Supersonic. That’s a big one. We have a number of programs with the Air Force and the Air Force Research Lab that we are working on turbo jets and turbo fans for drones, cruise missiles, and loitering munitions. We have a powerful aspect of that business that's an MRO for helicopter engines that is doing phenomenally well. If you're designed in on legacy systems right now, there are very few new starts in certain areas, which means legacy systems have to survive and keep flying for years. If you're in some of those niches on certain helicopters that we are, that business is very powerful because there are no replacements coming.

Okay. Very helpful. And if I could, just one follow-up on the slower pace of EBITDA growth into next year. The margin pressure you talked about from staffing and specifically the specialized people you need, it seems like this has obviously been going on for quite a while as the industry goes through substantial growth. How much are you looking at maybe other geographic locations or significantly changing maybe where you're recruiting or other approaches to that, because it seems like that's clearly holding you back a little bit. It has for quite a while in terms of some of the opportunities.

Yes. So on the first part of your question, I want to clarify that in our base case, assuming we get a budget in a reasonable amount of time and we do 10% year-over-year growth, we're going to expect our EBITDA margins to increase at a greater rate than that. We're expecting significant EBITDA margin growth. I'm saying it's being held back by the cost inputs, including labor. We are studying everything that you mentioned: different geographics, educational areas, technical schools. Ken, this is a supply-demand problem. There is no supply of qualified people or people that want to get qualified. People that want to get a security clearance can, but it's not there. The recapitalization of strategic weapon systems is occurring for the obvious reasons. In addition to that, we have new space companies that are hiring these people because they want to go to Mars or Venus. There’s just an incredible demand, and there's not enough of them and they're being bid up. We're putting a significant amount of money into robotic machinery, 3D printing, and automation. We're standing up a center of excellence to produce very, very unique elements for our engines. We're making significant capital investments to address that. We can't get the people, so we're going to automate the heck out of it. I would say we are on the leading edge in the industry, including the big guys on a relative basis, of robotics, 3D printing, and automated manufacturing. We're doing all those things, and it’s another reason why our CapEx is going remain up because we're trying to offset the labor issue we have.

Great, Eric. Appreciate the color and good luck there.

Yes. Thank you.

One moment for our next question. Our next question comes from Peter Arment with Baird. Your line is open.

Yes, thanks. Good afternoon, Eric, Deanna. Hey, Eric. Where are you in the development of engines for your own drones? Have you, I know you had talked about that was one of the areas that you had focused on way back when, but what can you say on that?

We have received a contract from a US government agency to integrate Kratos engines into some of our tactical and target drones. This work is currently underway and will continue throughout 2024. Ideally, by the same time next year, we will be the only company in the world fully vertically integrated with airframe, electronics, and engine on flying aircraft. We've made significant progress and are under contract to integrate Kratos engines into our aircraft.

Yeah, that's helpful. That's very nice. And then on just in general on Valkyrie. Do you still anticipate that this is just going to be another year of a lot of test flights? I mean, you still continue to be kind of in this lead position, but just like the Marine program, PAC program, I mean, that's a new development, and they’re going to continue to test flight. How do you see this kind of playing out?

I learned my lesson in 2019 and 2020. Despite customers publicly stating they would start ordering Valkyrie or other Kratos planes in large quantities, due to changes in personnel, government, or policy, it did not materialize. I will be very cautious moving forward. However, the optimistic point is that we are currently flying with multiple customers. We are the only ones flying and the only ones with aircraft, conducting various mission systems, including artificial intelligence. I believe this will come to fruition. Replicator is just another indication of this happening. We will be ready to participate when it does, but I will remain cautious.

Yes, I just wanted to ask. Regarding the target side, should this business continue to grow considering the national security implications related to missile defense and other activities? Do you anticipate that it will become a larger business?

Yes. You will see 2024 will be a significant increase in our unmanned systems revenue, primarily from target drones at multiple customers that are ramping up their utilization. In addition, our rocket business, ballistic missile targets and other rocket-propelled targets, are also going to see significant increases. I believe we have the orders in for 2024, which again ties into my optimism that we're going to generate the growth we have. Our target business is really ramping, and obviously, it’s because of what's going on geopolitically in the world.

Makes sense. Thanks for the comments.

Yes, sir.

One moment for our next question. Our next question comes from Josh Sullivan with The Benchmark Company. Your line is open.

Hey, good evening.

Good evening, sir.

Just as far as the Sierrea acquisition, how much of the $77 million 5GAT contract is yet to be consumed as the deal closes here?

Is yet to be incurred? Yeah, the vast majority. They received the contract approximately 60 days prior to us acquiring them. As I mentioned, we've been partners with Sierrea and the family that owns it for a long time. The significant majority of that program we will execute with the Sierrea team.

Got it. And then just as far as the new Thanatos or Athena customer that you mentioned in the opening remarks, are you able to say if that customer is a government service branch or another defense contractor?

I am not able to say. I'm sorry.

Congrats on the quarter and thanks for taking my questions.

Hey, Joe. Good afternoon.

Afternoon. So, Eric, in the previous question, you were talking about geopolitics. And I'm just wondering on the great quarter you just posted. The events in Ukraine, is that helping boost the revenues for you guys? Have you seen anything material coming from there?

I can't comment on what we're doing over there. I'm sorry.

No worries. And then if we put aside the continuing resolution and labor issues for a moment, what else do you see as kind of the biggest challenge to achieving the growth you're hoping for in 2024?

Just putting aside tactical drones, just talking our base case and putting aside people, which is absolutely number one, two, and three operational challenge right now. We have to build a lot of stuff. Our space team has to do a lot of software delivery of OpenSpace. It's just a lot. We are ramping across the company. With ramp comes risk and challenge. Just that ramping, we have to get those engine factories set up. We've got to do that. We've got to do it seamlessly and efficiently. We have to make sure we do it in conjunction with the applicable program office. Those types of operational execution types of things are the biggest drivers. I'll say this one. I don't see it being an issue, but I want to mention it specifically in our space business. That’s an international business. We’ve got some very big well-known customers across the globe that we have large and midsize proposals in. If those get delayed, two or three months here, two or three months there, that could move some things out of next year into 2025. That could be a risk too, totally outside of our control, but those types of things happen internationally.

Right. And one last one from me. On the Sierrea acquisition, I think they're based at an airport in California. I was wondering, is there opportunities to do some of the same things there as you do in Oklahoma? Could that be a potential additional benefit to that acquisition?

That, Joe, that's a great question. The facility is in Tatchapine. It is actually on the runway. It's on the air base with the hangars. Absolutely unequivocally, that was a strategic element of our plan here.

One moment for our next question. Our next question comes from Pete Skibitski with Alembic Global. Your line is open.

Hey, good afternoon, guys.

Hey, Pete.

Eric, can you help me understand the nuances to the extent you're able to on Replicator a little bit more? Because you mentioned in your remarks that Replicator is distinct from Air Force CCA. But I thought Replicator wasn't really a funded program of record. I thought it was more so kind of a, I don't know, a concept or an umbrella program. What's the right way to think about that?

Right. Replicator is not a program of record. Replicator is an initiative. That is what Secretary Hicks calls and Schuh, ID Schuh, an initiative. It is part of the Office of the Secretary of Defense. It is going to be managed by the Defense Innovation Unit out of Silicon Valley, and who is in charge of it, I believe, is the Vice Chair of the Joint Chiefs of Staff. That is the ultimate decision-maker. Air Force officials have very clearly stated that Replicator is completely separate from their CCA program, which has been reported. These are two complete initiatives. I believe it's also been publicly reported that the people involved with Replicator have said that they’ve identified the funding. I know something about this, so that’s why I’m choosing my words very carefully. They’ve identified the funding and how they want to deploy thousands of these in the next few years. That’s how I would frame it up. They’ve talked about the RDER funds. I mentioned the RDER funds; you should take a look at that. That is a tidbit that’s out there on this. There are some other ones where you can connect the dots, and I think you can see where the money is coming from.

Okay. But I guess most importantly, it's not a program of record, but there's money behind it, which is, I guess, is what matters.

That is what OSD is saying. Absolutely.

Okay. Okay. Last one for me. Just on this powered JDAM, I guess your press release was the first time I heard about that. But are we kind of early days in development of powered JDAM, and maybe it'll be a few years before production would start? Is that the right way to think about that?

You could see if you could see me, buddy, I'm smiling ear-to-ear. I cannot get ahead of our Boeing partner. I cannot. However, we're standing up a production factory, as I mentioned, to do some things, and I'll leave it at that.

One moment for our next question. Our next question comes from Sheila Kahyaoglu with Jefferies. Your line is open.

Good afternoon, guys. Thank you. I know it was somewhat asked, but I wanted to get into more detail. Eric, can you talk about the tactical drone programs showing some of the biggest promise here with Valkyrie, Mako, and Air Wolf? Can you just talk about potential scenarios for ‘24 on those three programs?

Yes. The potential scenarios I'm comfortable talking about, Sheila, as we will continue to work with our customers and test and evaluation and mission development, flights, and scenarios. That is what we modeled in for 2023, and it worked out, and that is what we're going to model in our base case 2024. We will continue to sell drones two here, three there, four here for test and evaluation, RDT, and S&T, but no we will not assume any production until it happens.

Cool. And then Thanatos, you had an image in the press release on that one. I think you brought that back. You haven't talked about those two since August 2022. So, maybe just what brought those back into the fold and just near-term milestones there?

Yep. Good question. Customer interest, Sheila, it's that, that's what it is. It's customer interest and customer funding. As I said, we're in contract negotiations/discussions. I'm confident these will turn into contract awards mid-next year or so, and then we're going to go fly under funded contracts. Your question is indicative of a lot going on and accelerating in the low-cost and attritable drone area. I believe it's because of what's going on in the world.

Thank you. That concludes the question-and-answer session. At this time, I would like to turn it back to Eric DeMarco for closing remarks.

We appreciate you all joining us this afternoon and your interest and support in the company. We'll be chatting with you after we close out the year. Thank you.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.