Kratos Defense & Security Solutions, Inc. Q2 FY2025 Earnings Call

Thank you for waiting, and welcome to the Kratos Defense & Security Solutions Second Quarter 2025 Earnings Conference Call. I will now pass the call to Marie Mendoza, Senior VP and General Counsel. Please proceed.

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions Second Quarter 2025 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, financial guidance, and other forward-looking statements made 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. Eric?

Thank you, Marie. The Annual Global Defense and National Security expenditure in 2024 was approximately $2.5 trillion. This $2.5 trillion figure does not take into account the expected increase in the United States National Security spend to over $1 trillion this year or planned NATO increases in its defense expenditures from historically approximately 2% up to 5% of GDP, and this is also before the recent announcement from non-NATO U.S. allies in the Pacific that they would also be increasing their defense expenditures to 5% of GDP. There is truly a generational global recapitalization of weapon systems and related infrastructure currently underway, and we believe that Kratos is one of the few qualified defense technology companies positioned to address it and take advantage of what is truly an industry inflection point. The Trump Administration through recent Executive Orders is working to streamline the U.S. DoD procurement, purchasing, and deployment processes to significantly improve efficiency, make the deployment of new systems and technology to the war fighter faster and prioritize new rapidly developed and fast-to-field hardware and systems. Additionally, both the Senate through the FORGED Act and the House via the SPEED Act are similarly looking to streamline the defense procurement and acquisition processes, including a focus on first-to-market relevant technology, hardware products, and systems. We are also at the beginning of a rebuild of the U.S. defense industrial base, which has been dormant for several decades, and we believe this rebuild will require hundreds of billions of dollars of investment and take many years to complete. Kratos is realizing the positive impact of these factors, including our Q2 organic revenue growth rate of 15%, our bookings with an LTM book-to-bill ratio of 1.2:1, our backlog, our record level bid and proposal pipeline of $13 billion and also our previously communicated 2026 forecast base case organic revenue growth of 13% to 15% over '25, which is now substantially covered by on-hand programs and contracts. Additionally, after our second quarter ended, we were informed by a government customer that we have been successful on a large new program of record opportunity we call Poseidon, with the formal contract award to Kratos as prime expected shortly. Poseidon is expected to be a single award to Kratos. It's a military-grade hardware and system program with an approximate total potential value through production of approximately $750 million, which should begin ramping for us in mid-'27 once the required program-specific new facility we will be standing up is complete. The Poseidon win is expected to provide Kratos another large steady-state future revenue, profit, and cash flow engine, further enabling our aggressive growth pursuit, including in the drone, hypersonic, jet engine, microwave, and SATCOM areas, while also generating profitability and cash flow. Additionally, Kratos was also informed after the Q2 close that our team with a key Kratos partner has been selected on another program of record opportunity, Kratos cold-named DMOS, with contract award expected shortly. As a result of these and other expected contract awards, we currently forecast that Kratos' third quarter bookings could be particularly strong. Since our last report, Kratos' confidence has increased in our 2026 forecast base case margin or EBITDA rate increase of 100 basis points to 150 basis points with additional increases expected in '27 and beyond as new higher-margin programs begin to ramp up and certain lower-margin contracts are renewed with the customers at expected higher margin rates. Our tactical drone business was recently reported that both the U.S. Marine Corps and the Office of the Secretary of Defense stated that the Valkyrie is becoming a program of record and will be the first CCA in production and fielded for the Marines. Additionally, Airbus recently announced they have partnered with Kratos for a European mission-focused Valkyrie, specifically targeting the German Luftwaffe with the current expectation for fielding no later than 2029. As you know, Kratos' base case financial forecast does not include any assumed tactical drone production, which we will only include in our revenue forecast once we receive a contract award as the potential financial impact to Kratos when we receive tactical drone awards could be very significant. For example, if in 2026, hypothetically, Kratos receives an initial order for 15 Valkyries at $10 million each, we could have an immediate revenue increase over our base case financial model and forecast of $150 million with profit as the Valkyrie is currently in production and we could have 15 aircraft ready to deliver immediately upon contract award in my example. Both the Marines and Airbus opportunities were made possible due to Kratos making the investment to begin production of 24 Valkyries, several of which have been delivered to customers in advance of a program or contract award with approximately 15 to 20 of which can, are, or will be completed and available for sale next year. Kratos made the decision to begin serial production of 24 Valkyries ahead of contract award so that we would be first to market, allowing potential customers to visit the factory, see their aircraft being built and see the actual cost data for the aircraft. We believe this was the correct business decision. Kratos took the same first-to-market approach of making internal investments to design and develop certain of our other product offerings, including Erinyes and Dark Fury, our hypersonic flyers, our Zeus 1, Zeus 2, and Oriole solid rocket motor stacks, our family of jet engines for drones and missiles, our OpenSpace C2 and telemetry systems, and many others, each of which we believe will drive Kratos' future growth and value. In addition to the U.S. Marine Corps and Airbus Valkyrie-related opportunities, we have two new additional Valkyrie opportunities with two different customers, both of which I believe Kratos is currently in a sole-source position. As a result of recent Valkyrie-related progress, we have begun the process of pricing out with our already in place and performing qualified suppliers for long lead purchasing and the program planning for an expanded production run of at least 24 additional Valkyries, which would sustain and build on the current learning curve from the initial 24 and would bring the total Valkyrie serial production run to 48 aircraft. Across the potential increased Valkyrie production run, we would produce several variants including runway independent, combined runway independent runway capable, CTOL, a European-focused variant and potentially two additional variants, all specifically customer-focused. By maintaining the Valkyrie production line with a potential additional 25 aircraft, we will continue to improve production efficiencies and reduce costs as we come down the manufacturing learning curve, establishing Kratos' leadership position with actual aircraft and real known cost points. I can also report that we expect to receive a sole-source contract for the Kratos Air Wolf tactical jet drone by the end of this year, which could lead to a production contract in late 2026. And Kratos' Athena tactical drone recently had multiple successful flights as we progress with this customer-funded program. Kratos' Ghost Works is currently working on a new fifth-generation jet drone with expected first flight in the first half of '26. Ghost Works is also working with Kratos Turbine Blade Works and our Rocket Systems Chaos team on a new hypersonic system named Icarus. Kratos' Israeli-based Microwave Electronics business successfully completed its move into our new manufacturing facility with less operational downtime than expected, and we are positioned for further increased organic revenue growth with the expanded capacity, including with key partners Rafael, Israeli Aerospace Industries, and Elbit. Kratos' Jet Engine and Propulsion Systems businesses are among our strongest revenue growers and highest operating margin businesses with growth expected to accelerate in the second half of '26, as LRIP quantities of certain drones and missile programs increase, with additional revenue increases expected in '27 and also in '28. As you would expect, Kratos' military-grade air defense, missile radar, and counter UAS systems business is very strong and expected to be a key future organic revenue growth driver for Kratos, including with our incredible partners Northrop, Lockheed, and Raytheon, who innovate, develop, and integrate some of the best weapon systems in the world, as demonstrated globally in combat. Kratos' space, training, and cyber business is turning around, led by our government and national security offerings with expected 2026 growth and increased profit margins accelerating into '27 based on programs and the current new opportunity pipeline. The Reconciliation Bill and the Trump Administration's policies have become evidently significant for space and satellite capability, which is reflected in our government satellite business. In summary, with the Trump Administration's focus on space, including Golden Dome and Kratos' proven expertise in delivering scalable software-defined ground systems combined with the open architecture approach of OpenSpace, this positions Kratos to rapidly integrate a diverse set of next-generation satellite constellations and defense capabilities for U.S. government missions. Kratos' track record of cost-effective agile solutions and deep customer partnerships ensures that we can meet evolving mission requirements faster and more efficiently than other companies in the satellite area. Kratos' space and satellite business, technology, and capabilities are, in my opinion, the gold standard of the industry, and we're seeing that with Kratos Space being one of the most valuable businesses in our company. Kratos' Anaconda, our Helios, Nemesis, Hermes, and certain other initiatives are tracking, and we hope to be successful on Anaconda and Helios by the end of the year. Kratos' Prometheus partnership with Rafael is on track. Certain key energetics-related production equipment has been ordered and key employees, including the Chief Operating Officer, have been hired. We remain optimistic that Prometheus will be a $1 billion-plus business once at full rate production. Similarly, Kratos' GEK small turbofan initiative with our outstanding partner GE Aerospace is on track. The GEK production facility location has been identified, and we expect GEK to also be a $1 billion business once at full rate production. I want to pass on to our shareholders that we are routinely told by our customers and partners that Kratos' affordability and our approach, technology, military-grade manufacturing facilities, and products and capabilities are invaluable and virtually nonexistent in any other defense technology company. A primary differentiator we are routinely being told more often, including now in Europe, is that Kratos doesn't merely promote our plans. At Kratos, we've already executed them. For example, Valkyrie has flown with effectively every fighter in the United States inventory. Valkyrie has flown from multiple U.S. sites in various scenarios. Valkyrie, identified by the Office of the Secretary of Defense and the Marines as a CCA, has collaborated with multiple manned military aircraft and has directly cooperated with multiple Valkyries. All of these flights and events have occurred in coordination with our military customers. Valkyrie is real. This is why Airbus partnered with Kratos. They want to work with the company that has real flying products and aircraft that have passed rigorous testing, not just claims. Key reasons why Kratos is seeing increased program opportunities, partnerships, and competitive positioning are evident, and we expect this momentum to continue as national security and defense priorities ramp up. At Kratos, we recognize our company's value, especially for United States National Security, and we are focused on execution and rebuilding the U.S. industrial base while generating value for our stockholders. Deanna?

Thank you, Eric. Good afternoon. As we have included a detailed summary of second quarter financial performance and initial third quarter and modifications to full year 2025 financial guidance in the press release we published earlier today, I will focus on the highlights in my remarks. Revenues for the second quarter were $351.5 million, above our estimated range of $300 million to $310 million, with overachievement of forecasted revenues across all businesses, notably growth in our defense rocket support due to timing of hypersonic missions and in our C5ISR businesses with organic revenue growth rates of 116.6% and 25.4%, respectively. Adjusted EBITDA for the second quarter of '25 was $28.3 million, also above our estimated range of $21 million to $25 million, reflecting the increased volume, offset partially by continued increase of contractor and material costs on certain multiyear firm fixed-price contracts in our Unmanned Systems business and a less favorable mix in our Space, Training and Cyber business. Unmanned Systems second quarter '25 revenue decreased by $12.6 million due to the prior year comparable, including $17.4 million from an international target drone delivery, offset partially by increased tactical drone-related revenues. KGS second quarter '25 revenue was up $64 million year-over-year from the second quarter of '24 with organic revenue growth of 27.1%, excluding the impact of the February 2025 acquisition of certain assets of Norden Millimeter. Second quarter '25 cash flow used in operations was $10.6 million, primarily due to working capital requirements related to revenue growth impacting our receivables by approximately $36 million, and increases in inventory and other assets of over $18 million, reflecting increases in our microwave electronics and rocket systems businesses due to anticipated future deliveries and ramps in production as well as investments related to certain development initiatives in our Unmanned Systems business. Free cash flow used in operations for the second quarter of '25 was $31.1 million after reflecting funding of $20.5 million of capital expenditures. As planned, we are continuing to make investments to expand and build out certain of our manufacturing and production facilities in our microwave products, rocket systems, and hypersonic businesses to meet existing and anticipated customer orders and requirements, as well as investing in related machinery, equipment, and systems. Consolidated Days Sales Outstanding (DSOs) decreased from 104 days in the first quarter to 103 days at the end of the second quarter, reflecting revenue growth and the timing of milestone billings. Our contract mix for the second quarter of '25 was 65% fixed price, 31% cost-plus, and 4% time and material. Revenues generated from contracts with the U.S. government during the second quarter were approximately 71%, including revenues generated from contracts with the DoD, non-DoD federal government agencies, and FMS contracts. In the second quarter of '25, we generated 12% of revenues from commercial customers and 17% from foreign customers. An operational priority remains the hiring and retention of skilled technical labor across the company, with total Kratos headcount of 4,316 at the end of the second quarter compared to 4,226 at the end of the first quarter. Now moving on to financial guidance. The guidance provided today includes our expectations and assumptions for our supply chain's execution and for employee sourcing, hiring, retention, and related costs. We have increased our full year '25 revenue guidance from $1.26 billion to a range of $1.285 billion to $1.310 billion, reflecting an organic revenue growth rate of 11% to 13% over 2024. We have increased our adjusted EBITDA guidance from $112 million to a range of $114 million to $120 million. Our third quarter revenue guidance of $315 million to $325 million reflects an estimated organic growth rate of 12% to 15% over 2024. Our guidance continues to include the impact of increased material and subcontractor costs on certain of our multiyear fixed-price contracts, specifically in our Unmanned Systems target drone business, where we have experienced cost growth from certain ancillary materials on our targets and cannot seek recovery from the customer until renewal of future production contracts occurs. We are continuing to manage costs aggressively where we can minimize the impact on margins. Our forecasted second half ranges include the sale of certain products that are completed and ready for delivery once we receive certain government approvals. Out of an abundance of caution, we have not included contributions from these expected revenues and related profits until the fourth quarter. If the necessary government approvals are received earlier, it's possible these contributions could be made in the third quarter. Since quarter-end, we have paid off our entire term loan balance of approximately $180 million, so any interest expense should be minimal in the second half of 2025. Our $200 million revolving line of credit remains undrawn except for approximately $10 million of outstanding letters of credit.

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

Our first question comes from Michael Ciarmoli of Truist Securities.

I guess, Eric or Deanna, just on the guidance, I mean, even the results, it sounded like you've got broad-based strength. I don't know if there was any pull forward, but the second half implied revenues down versus the first half. I know you just talked about maybe some potential delays, but anything to read into that?

Nothing to read into it. There was the timing of a hypersonic mission that was originally anticipated later in the year, and that occurred in the second quarter.

Okay. Got it. And then just if you could, with the Valkyrie being tagged as a program of record, you've got multiple production lots. Can you just walk us through the mechanics of when you get a contract, what might happen? I mean, I don't know if you've disclosed pricing, but presumably, you can take immediate recognition of revenue and you would seemingly get a good cash tailwind. So is that something we should expect in the near-term with all the progress that Valkyrie is having?

I'll address your question regarding the process and how that occurs. You're correct that when we receive a contract award, we are currently on the second production lot of 12. If we receive a contract, using the hypothetical example Eric provided, say an order for 15 at $10 million each. If all those are fully complete, revenue would be recorded at the contract signing of $150 million. If they are 50% complete, then $75 million would be recorded. As the build-out continues, revenue would be recognized until completion.

Okay. Got it. Last one, and I'll jump off. Eric, you didn't mention MACH-TB. I think there was $400 million in the Reconciliation Bill. Does that give you even greater confidence? I know that was anchoring the growth in '26?

Absolutely. And you're correct. There is nearly $400 million in the Big Beautiful Bill for MACH-TB. Our hypersonic franchise, including MACH-TB, is going to be a major contributor over the next several years. So we feel great, and we're coordinating now with the supply chain for a very significant ramp in '26, accelerating into '27.

Our next question comes from the line of Peter Arment of Baird.

Congrats on all the wins you're stacking up. Eric, can you maybe talk about your target drone business just in the scope of Golden Dome? I know there's an Industry Day going on in Golden Dome, so there's not a lot of details out. But how should we think about how Golden Dome impacts your target drone business?

Yeah. Hi Peter, I'm glad you asked the question. In my opinion, I'm the CEO, I drink the Kool-Aid. There's no company in the country better positioned for Golden Dome than Kratos, including target drones. Let me summarize why. In the Space segment, we will be involved with the ground command and control and telemetry tracking and control on space. We are under contracts for projects related directly or tangentially with Golden Dome, and that's going to increase. We are the hardware merchant supplier on radars, battle command systems, and interceptors for every prime for virtually every platform. So we're going to be involved there. Once Golden Dome is operational, it will need testing. This will involve hypersonic targets, cruise missile targets, jet drone targets, ballistic missile targets, all of which Kratos is the market leader for. We see this as a significant boost for our company, particularly in our target drone business.

Appreciate that. And then just last quarter, you kind of stack ranked for us. You mentioned a 3-year outlook, positioning hypersonics as one and engine franchises as two microwave electronics. You said tactical drones would wait for customer decisions. But it sounds like those decisions are being made. Does that change your view on the rankings?

Right now, the rankings remain our hypersonic franchise, no question. I'm going to go with my base case. Number two, our air defense missiles systems, radars, and battle systems are now #2. The orders we are seeing, and that are coming are staggering. You can read about the systems in the press. Again, we're the merchant supplier on these. Third is going to be the engines. LRIP for '26 is closing in, and full rate production expected in '27 on numerous engines for new low-cost cruise missiles and drones. If and when tactical drones occur, they could leapfrog to the top of the rankings. But that's not in our base case or forecast.

Our next question comes from the line of Josh Sullivan of The Benchmark Company.

Clearly, it's been a very strong year for drones between Executive Orders, the memo, and industry air shows highlighting low-cost drones. Kratos models obviously align nicely with these trends. One question we keep receiving from investors is about the Air Force. Should we think the Air Force drone posture will lean more on exquisite systems while the other branches will lead on low-cost options? Or do you anticipate any changes soon?

I have to be careful. I'll never speak for the customer. I'll say that recently, Air Force representatives have publicly commented that perhaps a focus on less exquisite and more affordable systems in higher quantities is a better strategy than those that haven't even flown yet. So we're seeing hints of this.

A follow-up on U.S. Golden Dome target needs. Given the investment in Europe and defense posturing over there, should we expect a similar need for target drones in Europe? Would those carry higher margins?

Yes, and yes. They would likely be either FMS or direct commercial because the Europeans are increasing their defense spending toward 5% of GDP. I don't know if that will happen, but they are definitely increasing it. They will be purchasing U.S. systems. Consequently, Kratos’ target drones will accompany those systems, and our margins on those will be significantly higher than in the U.S. due to being FMS or direct commercial.

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

If you have to rank certain missile programs you are involved with in microelectronics, is Patriot at the top or SM-3, or is it all of the above?

I can't speak specifically, but Kratos is involved with Patriot, indirect fires, SHORAD, and more. We are involved in virtually every key program and associated radars.

With all the new facilities you're establishing in Oklahoma and Israel, are they on track as originally guided for LRIP and potential full-rate production, or have there been changes?

It's going to depend on some of the build schedules and construction. So right now, we still have them reflected in our '25 numbers projections, but some may slip into '26 depending on construction timelines.

And will we expect you to start another Valkyrie spiral before award, or will you get awards before needing to do that again?

I'm not going to comment on that right now.

Our next question comes from the line of Jonathan Siegmann of Stifel.

You commented on the Big Beautiful Bill and MACH-TB being listed. However, it also listed $1.5 billion for low-cost cruise missiles, $600 million for solid rocket motors, and $270 million for the Marine Corps unmanned combat aircraft. It seems very relevant for you. Can you confirm that, and are there competing programs that might affect the incremental budget dollars?

I confirm exactly what you said. For low-cost cruise missiles, think Kratos low-cost jet engines.

Just one more question on your partner Prometheus. They likely consumed a lot of their missiles in defense in Israel last June. Are those interceptors relevant to the JV you’re building?

They are absolutely relevant. The indication from our partner is that for multiple tens of thousands of motors and energetics, Prometheus will be building for exactly what you mentioned.

Is there an opportunity to accelerate capacity given the global demand signals?

It's slow because we've ordered most of the main mixing and other equipment we need. It's coming. While we're actively engaging in discussions with Rafael and other primes on what Prometheus will be building for them, additional expansion is on the table but not significant at this time.

Our next question comes from the line of Colin Canfield of Cantor Fitzgerald.

We've addressed manufacturing scaling and JVs across production quantities, but how do you view going to market with a services component for the X-58, especially concerning force protection, intelligence, and communications?

I'm not sure I fully understand your question. Are you asking how I perceive the Valkyrie in terms of offering services? Internationally, what we're seeing is that customers prefer acquiring U.S. aircraft that are operational and ready to fly, integrating their mission systems thereafter.

Understood, thank you. As we consider company-wide factors, how do you approach securing supply for rare earth minerals and metals?

For the past couple of years, we have reviewed our sourcing of rare earth materials. We scrub through inventory and safety stock related to these materials along with our suppliers to stay informed regarding our supply chain.

I would now like to turn the conference back to Eric DeMarco for closing remarks. Sir?

Excellent. Great. Thank you, everybody, for joining us. Great questions today. Great interaction. We really appreciate it, and we look forward to chatting with you again when we report Q3.

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