Earnings Call Transcript - KTOS Q3 2025

Operator, Moderator

Good day, and welcome to the Kratos Defense & Security Solutions Third Quarter 2025 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Marie Mendoza, Senior VP and General Counsel. Please go ahead.

Marie Mendoza, Senior VP and General Counsel

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions Third 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 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 DeMarco, President and CEO

Thank you, Marie. Our Q3 financial results are representative of the increasing demand for Kratos' military-grade hardware and systems and software to support the national security of the United States and its allies. Also reflecting this demand, today, we have increased our full year 2025 revenue forecast, which now reflects 14% to 15% organic growth over fiscal '24. This is up from our original forecasted growth of 11% to 13%. Additionally, we have increased our full year 2026 organic revenue growth forecast to 15% to 20%, up from our previous 13% to 15% above expected annual 2025 revenue. And we are providing today a preliminary 2027 revenue growth target of 18% to 23% organic growth above the 2026 revenue range, which is 15% to 20% above 2025. Also importantly, we are projecting an approximate 100 basis point EBITDA margin expansion for 2026 above 2025 and another approximate 100 basis point margin expansion again in 2027 over 2026 as we scale the business and transition to more profitable contracts. We expect our EBITDA margins to expand even though we continue to make significant and potentially increasing bid proposal and related investments as the number of opportunities Kratos has continues to grow. I want to emphasize very importantly that none of these forecasts include the Orbit acquisition we announced today. We will include Orbit once that transaction closes, which is scheduled hopefully in Q1 of next year. Directly related to Kratos' accelerating growth trajectory, Congress, the administration and the Pentagon are all aligned to reform DoD procurement practices and rebuild the U.S. defense industrial base. This is represented in presidential executive orders, the Senate FoRGED Act, the House SPEED Act and the DoD's initiative to improve the acquisition process, each of which are expected to be good for Kratos. Additionally, the funding to support these national security initiatives for the United States and its allies is being put in place with an expected 2026 U.S. security spend of approximately $1 trillion. NATO allies are increasing their security spending from 2% up to 5% of GDP, and Pacific allies are expected to do the same. The United States, industry and Kratos are at the beginning of a generational recapitalization and rebuild of the West National Security apparatus to address the existing geopolitical threat environment and to deter and defeat our enemies. I believe that this global recapitalization and rebuild is structural in nature, both policy and threat-driven. This is not temporary or a one-off, and this will be a multi-year, multi-decade exercise. Directly related to this rebuild and increased opportunity set, Kratos is making significant investments in facilities, plant, equipment, etc., to rapidly scale and support major new program wins we have received and that we expect to receive. Importantly, Kratos does not build it and hope that they will come. Our investments are made with program contract or partner commitment line of sight and with expected ultimate rate of returns that are acceptable to Kratos' stakeholders. I will reiterate that the number of additional or new opportunities for Kratos is at a record level. It is increasing, and it has accelerated over the past few months, and Kratos is positioned to take advantage. The government this summer announced that Kratos' Valkyrie would become a program of record with the Marines under the MUX TACAIR program. We are now able to report that this program is officially underway and will include the Kratos Valkyrie aircraft with Kratos' incredible partner, Northrop Grumman Mission Systems. We, Kratos, and Northrop together expect to receive the initial formal contract award in the next few months. We had expected the award sooner, but similar to many awards across industry and Kratos, it has been delayed as a result of the federal government shutdown. The MUX TACAIR program is expected to progress from evaluation of various mission scenarios and the associated military methods of employment through low-rate production and then to full-rate production. We expect that Valkyrie systems under the program of record will include both RATO or rocket-assisted takeoff and conventional takeoff aircraft as well as multiple mission configurations. The joint Kratos-Northrop Grumman System will provide a state-of-the-art CCA capability at a price point that will enable the Valkyrie system to be procured, distributed, and operated in very high quantities, which addresses the consistent war gaming result for the need for affordable mass to provide an advantage and a win for the United States. MUX TACAIR CCA brings exactly this. I can now also officially say that Airbus has partnered with Kratos to develop a German variant of the Kratos Valkyrie CCA. And in the third quarter we just ended, we shipped the first two Valkyries to Airbus under this new contract. As a result of the pending European need, the opportunity space here is substantial, including as evidenced by the Ukraine-Russia war and the significantly increased defense spending committed by the European nations. The first Valkyrie opportunity in Europe will be with the German Air Force solicitation for their own CCA, and this is our joint initial focus with Airbus. The European CCA System will leverage developed and proven baseline Kratos Valkyrie configured with Airbus-specific German Mission Systems to satisfy the operational needs unique to the threats in that region...

Deanna Lund, Executive Vice President and CFO

Thank you, Eric. Good afternoon. As we have included a detailed summary of the third quarter financial performance as well as the initial fourth 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 today. Revenues for the third quarter were $346.7 million, above our estimated range of $315 million to $325 million, with overachievement of forecasted revenues across all of our businesses, with the single largest increase in our Unmanned Systems business, including a shipment of tactical Valkyries to an international customer, which received regulatory approval in the third quarter. As a reminder, when we provided our third quarter guidance, we had indicated that out of an abundance of caution due to the uncertainty of the timing of regulatory approval, we had forecasted this shipment in the fourth quarter. Additional notable organic revenue growth was reported in our defense rocket support and space training and cyber businesses with organic revenue growth rates of 47.2% and 21.2%, respectively. Adjusted EBITDA for the third quarter of '25 was $30.8 million, also above our estimated range of $25 million to $30 million, reflecting the increased volume, offset partially by continued increased subcontractor and material costs on certain multiyear fixed-price contracts in our Unmanned Systems business, revenue mix, and elevated bid proposal and other new opportunity pursuit costs. Unmanned Systems third quarter '25 revenue was up $23 million or 35.8% organically, reflecting the shipment of international tactical Valkyries. KGS' third quarter '25 revenues were up $48.7 million year-over-year from the third quarter of '24, with organic revenue growth of 20%, excluding the impact of the February 25 acquisition of certain assets of Norden Millimeter, Inc. Third quarter '25 cash flow used in operations was $13.3 million, primarily reflecting the working capital requirements related to the revenue growth impacting our receivables by approximately $25 million, increases in other assets of approximately $3 million, primarily reflecting investments we are continuing to make related to certain development initiatives in our Unmanned Systems business. Free cash flow used in operations for the third quarter of '25 was $41.3 million after reflecting funding of $28 million of capital expenditures. As we 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, hypersonic and jet engine businesses to meet existing and anticipated customer orders and requirements, and investing in related new machinery, equipment, and systems. Consolidated DSOs or days sales outstanding increased from 103 days in the second quarter to 111 days, reflecting the over 26% revenue growth and the timing of milestone billings. Our contract mix for the third quarter of '25 was 70% fixed price, 27% cost plus fixed fee contracts, and 3% time and material contracts. Revenues generated from contracts with the U.S. federal government during the third quarter of '25 were approximately 67%, including revenues generated from contracts with the DoD, non-DoD federal government agencies and FMS contracts. In the third quarter of '25, we generated 16% of revenues from commercial customers and 17% from foreign customers. Now moving to financial guidance. Our financial guidance we provided today includes our expectations and assumptions for our supply chain execution, the impact of the federal government shutdown and for employee sourcing, hiring, retention, and the related costs. We have increased our full year '25 revenue guidance from $1.290 billion to $1.310 billion to $1.320 billion to $1.330 billion, reflecting an organic growth rate of 14% to 15% over 2024, and maintain our adjusted EBITDA guidance of $114 million to $120 million, reflecting the expected mix of revenues and an elevated level of new opportunity pursuit costs and other investments. Our fourth quarter revenue guidance of $320 million to $330 million reflects an estimated organic growth rate of 11% to 14% over Q4 of '24, which growth is reflective of the elevated bid proposal and other investments we are making. 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 for which we are unable to seek recovery from the customer until the renewal of future production lot contracts occurs. We are continuing to aggressively manage costs where we can to minimize the impact on our margins. We are adjusting our full year free cash flow and operating cash flow estimates primarily as a result of the increased organic revenue growth we are experiencing and the related future contractual payment milestone and other expected customer payment dates and also reflecting Kratos making long-lead material purchases ahead of contract funding award to meet customer execution time lines, which has resulted in an increase in our customer accounts receivable balances. Additionally, the federal government shutdown and its impact on government program, administrative and other offices and functions has resulted in certain expected government contract receivable payment dates to be delayed, resulting in an increase in customer accounts receivable days sales outstanding. The collection of these receivables is expected in the future. It is only a timing-related matter of the expected collection date. Additionally, certain of the new facility, facility expansion, machinery equipment and other capital expenditures and investments we had planned for 2025 are now expected to be incurred in 2026, including as a result of our managing the company's cash expenditures to the degree that we can control, which has resulted in a reduction in our full year 2025 capital expenditure forecast. Kratos' operating cash flow guidance also assumes certain investments in our Rocket Systems and Unmanned Systems businesses related to the procurement of rocket and related systems and the completion of certain derivatives of our Unmanned Systems vehicle of approximately $28 million to $32 million.

Eric DeMarco, President and CEO

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

Operator, Moderator

Your first question comes from Sheila Kahyaoglu from Jefferies.

Ellen Page, Analyst

This is Ellen on for Sheila. Maybe to start, you noted that the German Air Force is procuring Valkyrie. Can you give us a little bit more color on the international opportunity for that program? And any thoughts on the revenue contribution from Valkyrie in the next few years would be great as well.

Eric DeMarco, President and CEO

Right. So specifically, Airbus procured the Valkyries. Airbus has procured the Valkyries specifically related to a CCA opportunity initially with the German Luftwaffe. However, as I alluded to in my prepared remarks, because we have flying aircraft and now they're in Europe with Airbus, we're going after a number of additional tactical drone or CCA opportunities in Europe. And we have the advantage here because, again, we have actual flying aircraft that have been flying since 2019. Also, as I mentioned in my remarks, in our financial forecast, the only revenue that we have for anything we said for Valkyrie is for RDT&E and S&T, like the two we just sent to Airbus. We are not including any production level forecasted revenue in our numbers until, as I said, we have absolute clarity programmatically on funding and delivery dates, so we have no false starts.

Ellen Page, Analyst

Great. Sorry about that on Airbus. And can you tell us a little bit more about the revenue synergy opportunities from Orbit? Congrats on that acquisition.

Eric DeMarco, President and CEO

Yes, it's competitive, but let me share this. Most antennas available right now are either parabolic or fixed to their hardware. Kratos' Microwave business specializes in AESA's silicon-based and other types of radar enhancement technologies that are currently being implemented. We see significant opportunities here. I believe that one plus one equals three, but with our technology, Orbit's technology, their existing installations, and their customer base, it will likely be one plus one equals five.

Seth Seifman, Analyst

I wanted to ask about the Valkyrie progress with the Marines. And you talked about kind of moving up to full-rate production and looking at a level of a fleet size that could really bring affordable mass. And so how do you think about that ramp-up over the next several years and what they might be looking at?

Eric DeMarco, President and CEO

What we are witnessing is a standard program of record, which involves near-term, mid-term, and long-term strategies. In the near term, we are establishing the infrastructure necessary to support the production of Valkyries for deployment with the customer. While I can't disclose many specifics, this is a typical program of record. The government is currently identifying, allocating, and budgeting personnel for this project. The necessary launch, recovery, and communication equipment, as well as logistics, spares, and training, are all part of the infrastructure that is being developed. This process has already begun. During this time, there will be Valkyrie sales with Northrop Grumman Mission Systems so that they can begin using the aircraft. In the mid-term, we will move into full-rate production once the required infrastructure is established. Looking further ahead, I anticipate that full-rate production will continue for several years, initially involving many aircraft due to their affordability, low cost, and the specific mission objectives they are designed to meet.

Ellen Page, Analyst

Excellent. Very good. Cool. And then as we think about the EBITDA progression over the next couple of years, and we think about when we kind of flip over to cash positive or as the cash burn starts to narrow, I know probably not a good time to give specific guidance in that regard. But just in terms of maybe a framework for people to think of more qualitatively about how that evolves along with the EBITDA growth.

Eric DeMarco, President and CEO

Yes. So we have absolute line of sight now, Seth, on when the business will turn cash flow positive and then how it will start to ramp. We have line of sight on it. We can see it, okay? The flex point here is the number of program opportunities that continue to come to us and they're increasing. And let me dig into this a little bit for you so you understand what's going on here. This started 6, 9, 12 months ago, and it's been accelerating, where if the government customer has a viable alternative to what I'll frame as a traditional in certain areas, they're giving that viable past performance-qualified company, Kratos, a chance. Take a look at the last couple, 3, 4 months, okay? We won Helios, a multiyear decade program. We won Anaconda, a multiyear decade program, okay? We won Poseidon, which I had not talked about previously, it's classified. We won that, okay? We are being encouraged to bid prime on very large program opportunities, and it's accelerating. So based on the hand of cards we have right now, we have line of sight on this in a few years. However, the opportunity set of multi-hundred million dollar, billion dollar opportunities continues to increase. This is one of the reasons our EBITDA margins, I expected them to be up higher; they're not because of the bid proposal and the capture costs because these are big programs we're spending. So we can see where those lines are going to converge, but they may move out a little bit if the opportunity set continues to come at us and the strength it has been.

Michael Ciarmoli, Analyst

Nice results. I don't know, Eric or Deanna, the accelerating organic growth in the guidance for '26-'27, definitely encouraging. Can you give us maybe a little bit more detail around what specifically is driving that acceleration? I mean I know, Eric, you just mentioned some of the program wins. Is that the driver? And then can you maybe parse out the growth between KUS and KGS? And maybe just back to the question Seth was asking on Valkyrie with the Marine Corps. Is that baked in there or not?

Eric DeMarco, President and CEO

The Valkyrie program with the Marine Corps is not included in our current projections. When it does happen, it will lead to significant growth. Regarding your first question about our hypersonic franchise, it will be a major growth driver for the next two to three years. This encompasses more than just MACH-TB; we are involved in several programs that we cannot disclose. For instance, we have ongoing projects with Lockheed Martin, many of which are either just initiating or ramping up. Additionally, the hypersonic franchise ties into our rocket system business, which includes ballistic missile targets and suborbital vehicles, though I can't provide more specifics on that. We are the industry leader in these areas, particularly in missile defense, which operates at hypersonic speeds. In KTT, we are developing engines for various hypersonic weapons, but due to nondisclosure agreements, I can't share details, although they are set to enter production in '26 and '27. The hypersonic franchise is indeed expanding. It’s feasible that in the next two to three years, our Rocket System business could become the largest division in the company, surpassing our space operations. Our Space business has also experienced a turnaround over the past six to twelve months, particularly since the challenges faced by commercial sectors have been overshadowed by advancements in national security, especially in classified projects for Kratos involving ground systems for command and control operations. The growth rate for this business, which is valued at approximately $400 million, is projected to hit around $500 million next year, boosted by recent program wins adding around $100 million. Moreover, our microwave electronics business, both internationally and domestically, is essential for almost everything we have discussed. Engines are another focus area, specifically for missiles and drones, although these do not include hypersonic engines; they consist of turbojets and turbofans. Finally, our C5ISR business is also thriving, as we provide hardware for nearly every major missile, radar, and air defense system, acting as a merchant supplier of military-grade hardware for air defense systems. Companies like Northrop, Lockheed, and Raytheon utilize our systems. We have a clear view of our programs, which is why we are anticipating growth between 15 to 20 next year and 18 to 23 in 2027. No, that kicks in. So that facility is going to come online in '27. So that's going to be, hopefully, this time next year when we're giving '28 target, that's going to be one of the big step-ups in '28.

Michael Ciarmoli, Analyst

Just to continue on that hypersonics discussion. If you look at like any other provider like say a Castelion, which has its low-cost Blackbeard hypersonic missile. When they do testing, that's got to be on one of your MACH-TB or MACH-XL vehicles, yes?

Eric DeMarco, President and CEO

Okay. I cannot talk about Castelion, but I can tell you that it was recently announced by two separate companies, you can go look, that they're going to be launching things on Kratos' systems. I'll give you a specific one that happened yesterday, Mike. Take a look at hypersonics with an X down in Australia. They just closed the funding round. They have the DART hypersonic drone. We have exclusive rights for that in the United States. That specifically will be launched on Kratos' Zeus. There's a lot of information on that because of the funding round they just closed. The spirit of what you said is correct. I just have to be careful on NDAs I'm on.

Jan Engelbrecht, Analyst

Eric and Deanna, congrats on a really strong print. I'd like to get some more details on Valkyrie. Just if we look at the '26 presidential budget request, that was $58 million for the prototype. That's a 12-month contract, but then in the reconciliation bill, there's $270 million for sort of, I'll quote it, the development, integration and production of Marine Corps unmanned combat aircraft. And to my knowledge, Valkyrie is sort of one of one. So just wanted to get your thoughts there. And then also just the recent Marine Force Design Update in October. They said there were going to be 2 more flights this year. Is this for calendar year 2025? Or is it government fiscal year '26?

Eric DeMarco, President and CEO

Yes. Yes. So on the first part of your question, on the budgeting and what you saw in the reconciliation bill and your takeaway on that is absolutely correct. Absolutely correct. And that is one of the areas on how that will be spent over fiscal '26 and '27. That is something that's being ironed out real-time, it's kind of delayed now with the government shutdown. So that's what's going on there. Your question on Marine Force structure, I cannot, for obvious security reasons, get into flight schedules. However, I'm glad you brought that up. I did not mention it in my prepared remarks. You may have seen the paper the Marines put out last week on their force structure and their priorities. And on two of the critical capability areas, the Valkyrie was specifically called out, which ties into they're moving out on their program of record.

Andre Madrid, Analyst

Eric and Deanna, you previously mentioned, earlier on the call, you said that hypersonics could be the largest single franchise within the business. And then I think on a note back in early October, you said that this would be a multibillion-dollar franchise for Kratos. Obviously, there's a big difference between being the biggest business and multibillion dollar. When might you see it reach the $1 billion range? And what are the puts and takes of that growth across the BUs? I get that that's a lot, and I know there might be the issue of NDAs, but at least what needs to happen for that to occur?

Eric DeMarco, President and CEO

I believe by 2028, Kratos will be a business franchise generating over $1 billion. This is contingent on the current global peace situation remaining stable. That's the main point.

Deanna Lund, Executive Vice President and CFO

It's primarily in the KGS business, specifically at our integration payload facility in Indiana. The timing of construction will mainly occur in 2026, along with our advanced manufacturing facility in Birmingham. The GEK facility we're building in Oklahoma was not scheduled to start until 2026 anyway. So, it mainly involves those two initial projects I mentioned.

Eric DeMarco, President and CEO

I'm very comfortable with our current position. Considering the opportunities available, we could achieve results similar to what we've experienced in the past. That's my current perspective on the situation.

Operator, Moderator

There are no further questions at this time. I'll now hand back to Mr. DeMarco for any closing remarks.

Eric DeMarco, President and CEO

Great. Thank you all for joining us. Appreciate the Q&A. I look forward to speaking with you all when we report Q4 at the end of February. Thank you.

Operator, Moderator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.