Edited Transcript of KTOS earnings conference call or presentation 7-May-20 9:00pm GMT

SAN DIEGO May 9, 2020 (Thomson StreetEvents) — Edited Transcript of Kratos Defense and Security Solutions Inc earnings conference call or presentation Thursday, May 7, 2020 at 9:00:00pm GMT

Kratos Defense & Security Solutions, Inc. – Executive VP & CFO

* Eric M. DeMarco

Kratos Defense & Security Solutions, Inc. – CEO, President & Director

* Marie C. Mendoza

Kratos Defense & Security Solutions, Inc. – VP, General Counsel & Secretary

Canaccord Genuity Corp., Research Division – MD and Senior Aerospace & Defense Analyst

B. Riley FBR, Inc., Research Division – Senior MD, Co-Head of The Discovery Group & Senior Analyst

* Peter J. Arment

Robert W. Baird & Co. Incorporated, Research Division – Senior Research Analyst

Ladies and gentlemen, thank you for standing by, and welcome to the Kratos Defense & Security Solutions First Quarter 2020 Earnings Call. (Operator Instructions)

I would now like to hand the conference over to your speaker today, Ms. Marie Mendoza, Senior VP and General Counsel. Thank you. Please go ahead, ma’am.

Marie C. Mendoza, Kratos Defense & Security Solutions, Inc. – VP, General Counsel & Secretary [2]

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions First Quarter 2020 Conference Call. With me today is Eric DeMarco, Kratos’ President and Chief Executive Officer; and Deanna Lund, Kratos’ Executive Vice President and Chief Financial Officer.

Before we begin the substance of today’s call, I’d like everyone to please take note of the safe harbor paragraph that is included at the end of today’s press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today’s call.

Today’s call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today’s press release, we have provided a reconciliation of these non-GAAP financial measures to the company’s financial results prepared in accordance with GAAP.

With that, I will now turn the call over to Eric DeMarco.

Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [3]

Thank you, Marie. Good afternoon, everyone, and thank you for joining us today. I hope this call finds you and your family safe and healthy as we work to address the many issues brought on by the global COVID-19 crisis. As a corporation, I can assure you that Kratos is focused on taking the necessary steps to keep our employees safe while remaining committed to delivering our systems, products and solutions to our customers to address their critical national security missions and requirements. Kratos has and will continue to implement protective measures consistent with CDC, state and local guidance including encouraging our employees where possible to work from home, distancing our office and manufacturing personnel including with split shifts and modifications for the workspace, providing and supporting the use of protective equipment by our employees and enhanced cleaning of our facilities. We have also been reaching out, communicating and working closely with our supply chain and vendor base including, where possible, procuring additional inventory for our key programs and other actions. I will comment more on COVID-19 later in my prepared remarks.

As we begin the second quarter, we believe that Kratos has demonstrated ability to rapidly develop, demonstrate and field affordable systems is an increasing demand by our customers, as reflected by our Q1 bookings, our increased backlog and the new large programs of record which we are now involved with, all of which provides us increased visibility and confidence in our future forecast and expected future growth trajectory. We firmly believe that the demonstrated affordability of Kratos’ systems and products will become even more of a competitive advantage going forward based on input from customers, Congress and program offices.

Kratos is continuing the successful execution of our plan of becoming an essential critical supplier and element of the United States Defense Industrial base and the DoD’s future, and we believe that the Pentagon views us as an important new competitor in our primary business areas.

Since our last call, there have been a number of key developments which we believe further position Kratos for industry-leading future growth, including Kratos’ C5ISR business was selected by Northrop Grumman to support the United States Air Force Ground Based Strategic Deterrent or GBSD Program where Kratos will provide highly complex missile and payload transporter systems. GBSD is an estimated $63 billion 20-year U.S. Air Force program to replace the Minuteman 3 intercontinental ballistic missile weapon system. And it could become one of Kratos’ largest future programs and organic growth drivers. Kratos’ C5ISR business is a recognized industry-leading system and subsystem provider for unmanned aerial, missile, radar, missile defense, high-powered directed energy, CBRNE, combat and other systems, and the business performed approximately as we forecast it would in the first quarter. C5ISR is expected to be one of our company’s strongest future organic growth generators, with the GBSD program expected to be a key contributor to this growth. And in the coming weeks, we are hopeful of receiving or announcing other large new strategic program system awards we have been pursuing.

Also, as an update, in early Q1, we told you about a $50 million contract award Kratos’ C5ISR business received which was protested by a competitor. This situation remains unresolved at this time and accordingly, we will continue to exclude any future potential financial contribution in our forecast from this program until the situation is resolved.

It was recently reported that the United States Air Force has completed a round of tests of a new first-of-its-kind, low-cost turbo jet engine. This engine is a Kratos engine, developed by our recent acquisition of TDI. We believe TDI is extremely complementary to our 2019 acquisition of Florida Turbine Technologies, with both companies focused on affordable leading technology engines for the expected to be very large future market for next-generation cruise and hypersonic missiles, unmanned aerial drones and tactical systems, including Kratos’. These Air Force experiments were part of the Gray Wolf program which has focused heavily on the demonstration of technologies that could enable the development of low cost affordable cruise missiles which will be filled in extremely large quantities.

The next generation new Kratos engine that powered an expendable test article from a large prime during the test flights, and we believe this new Kratos engine will also power other future expendable air launch systems, munitions and unmanned aircraft. The Air Force Research Laboratory or AFRL, which is responsible for the Gray Wolf effort, which is expected to be part of the Vanguard, Golden Horde, swarming drone and munitions program, recently released a picture of an F-16 Viper carrying the test flight vehicle that is available to you in the public.

A key focus of Kratos’ overall corporate strategy is to address the Pentagon’s objective to beat the cost curve the military expects to encounter in future conflicts by designing low-cost, expendable unmanned aircraft, missiles and munitions that can overwhelm enemy defenses without breaking the budget. Mass quantities of drones and munitions is a key element of the Golden Horde program, which Kratos is pursuing with several of our affordable engines, drone and tactical system programs and initiatives.

We currently have several new next generation engines running, which we are positioning to be designed in on a number of platforms and systems, including our Black Dragon program, which has made important progress towards first system flight over the past few months and, if successful, we believe could be a game-changer for our company. We expect Kratos Turbine Technologies, similar to our Unmanned Systems business, to be disruptive to the industry and be a significant future growth driver and value generator with thousands of missiles and UAVs requiring low-cost engines in this class forecasted for the future. KTT performed approximately as we expected in Q1 with EBITDA margins currently lower than the KGS average as we are in development on several engine programs and initiatives would typically carry lower margins and production programs.

In Space and Satellite, it was recently reported that the United States military’s push to link every object on the battlefield is moving forward, as most recently reflected by the release of a request for proposal or RFP, to build 20 tactical communication satellites by 2022.

Additionally, the year-old Space Development Agency or SDA, recently hosted an industry day to brief industry about its plans for a transport satellite layer essentially orbiting communication nodes to transfer data related to intelligence, battle management, navigation, timing and more. This new transport layer architecture will move very time-sensitive data from drones and satellites in low earth orbit and other sensors and will also be critically important for the hypersonic system tracking and defense. The transport layer opportunity, this architecture and this recent RFP are just the most recent examples of several large new opportunities Kratos’ Space and Satellite business sees as future growth opportunities.

Another large new space opportunity for Kratos’ Satellite business is the OPIR program or overhead persistent infrared, which Kratos is now under contract on. And we are forecasting OPIR to become an important financial contributor beginning later this year and increasing in 2021 and beyond. Kratos’ Satellite business had a strong overall Q1, including higher gross margins, increased R&D and overall higher EBITDA margins as we continue our transition to a software-based or defined model, and we continue to forecast future organic growth and expanding margins for this business.

Our expectation that Kratos’ Space and Satellite business will continue its strong execution and performance is a key reason we are confident in achieving both our EBITDA and cash flow guidance for the rest of this year as both the nature of and expected mix of our opportunity pipeline continues to both expand and improve.

In Kratos’ Drone business, there have been several new and positive developments since our last report to you. It was recently reported that the United States Air Force wants to replace the services fleet of Reaper attack drones with new drones that are capable of surviving a hostile airspace. Although highly successful in its current mission, the MQ-9 Reaper is relatively easy to shoot down, making it vulnerable in A2AD or battlefield protected by modern air defenses. As we have discussed with you previously, the Pentagon is shifting from potential smaller, low-end fights, for example, in Afghanistan, Iraq and elsewhere, toward larger, higher-end contest including with countries such as Russia or China, which is providing significant opportunities throughout Kratos, including in our tactical jet drones. Acknowledging the Reaper’s vulnerability to perform its mission in a contested environment, the Air Force is now planning to cut its buy of Reaper drones with the final drones purchased this year. The Air Force intends to lay out its vision for a reaper replacement, a drone that can operate in contested airspace in the 2022 budget. And we believe that affordability and the ability to perform its mission and survive will be important attributes for this new program.

It was also recently reported that the head of the Air Combat Command stated that the ACC is currently thinking through what is the fighter aircraft of the future and that a fighter mission will give way to attritable aircraft and Loyal Wingman unmanned drone aircraft, in addition to the manned fighters. It was also recently reported that the Air Force is looking at potentially replacing, retiring Block 25 and Block 30 F-16s in the next few years and replacing them with affordable unmanned drone aircraft.

And specifically related to the future for extremely large quantities of affordable drones and munitions, it was reported that the Air Force is planning experiments and briefing senior leaders on progress toward its arsenal plan initiative, looking at multiple aircraft options to fly with the large weapons cache, potentially including swarms of low-cost cruise missiles and drones to back up the strike assets.

We believe that each of these recent data points that I just went through: the Reaper replacement, the fighter of the future, the F-16 replacement and the arsenal plane, reflect the continued increase in building momentum and demand for rapidly developed, affordable attritable jet drones, of which Kratos has several tactical drone types flying today.

Since our last report to you, multiple system integration efforts have continued with Kratos’ Valkyries and other tactical drones of Kratos, including for weapons, communications, electronic warfare, ISR and other systems as we move toward missionization, increased operational capabilities and ultimate fielding of these existing and flying Kratos drone aircraft. We remain on track with the 12 lot — 12 new XQ-58As we are in the process of producing in Oklahoma City, with the first expected to be completed beginning in Q1 of next year. We continue to take into consideration with our partners and the United States Air Force all the knowledge we have gained since our first tactical drone, manned, unmanned peening flights in 2015 as we move forward with Valkyrie and other Kratos tactical drone programs and initiatives. Kratos has truly appreciated a fantastic relationship with the Air Force Research Lab and the United States Air Force in the development and flight testing of the XQ-58A Valkyrie through the Low-Cost Attritable Strike Demonstrator program won competitively by Kratos. By approaching the LCASD and related programs in a partnership fashion with the Air Force, the ultimate and primary worldwide customer for high-performance tactical strike jet UAS, we have been able to design in from a blank sheet of paper the key attributes and capabilities needed by the USAF to enable their range of operational requirements. These requirements range from the runway independence capability, the physical size of the vehicle, the vehicle’s internal weapons bay capabilities, the system multi-mission payload capability and the unrefueled range and endurance and many other critical attributes. And by partnering at the inception of the vehicle design stage with the Air Force, a true design to cost approach was achievable with a United States built product, including subsystems and components, leveraging our proven low-cost, high-performance, jet composite firmly — family of unmanned aircraft, of which we currently produce over 100 annually, demonstrating our true low-cost capability every day.

This family of drones we are flying today, new drones we are working on which we will be flying very soon and our rapid design approach, is truly an example of the Century Series model for aircraft design and build cycles that Dr. Roper has consistently promoted as being key to the future of aircraft design, development and production in the U.S.A. And Kratos’ current and future tactical vehicle family, all being almost entirely sourced and produced in the United States, is a key contributor to the reinvigoration of the U.S. and the Department of Defense Industrial Base, and which is very important to our country, our company, employees and stakeholders.

Related to our increased confidence and support for what we are doing here in the U.S., it was recently reported that there is significant additional funding up to $125 million currently planned for the 2021 National Defense Authorization Act for the LCAT XQ-58A Valkyrie drone initiatives, which would be in addition to the over $100 million already included for LCAT attritable drones in the 2020 NDAA.

And also importantly, it was recently reported by the Air Force — the Air Force stated that they are ready to begin procuring new attritable drone aircraft in higher volumes this year under its Skyborg test and experimentation program.

I hope you can see we continue to make progress and move forward. The customers also continues to move forward. And we believe that we remain on track for significant Valkyrie contract or contracts this year. And based on the most recent information we have received, even more significant future Valkyrie related contracts.

We believe that we were close to a contract award just before the COVID-19 virus caused serious disruptions, but progress has recently been made. And we believe that the Air Force will be making several announcements very soon based on recent correspondence. We are more confident than ever that the drone-related Vanguard, Skyborg, Advanced Battle Management System or ABMS, and Valkyrie related programs and initiatives, each of which we believe are major DoD priorities, will be transformative future growth opportunity for our company, each of which we believe Kratos is uniquely positioned for. We also remain confident that the Gremlins program will transition from DARPA to one of the services with our plan for Airwolf and Thanatos to follow thereafter.

Flight schedules for Valkyrie, Gremlins, Airwolf and our initiative with AeroVironment, which we refer to as Rattlesnake, have moved to the right, with ABMS and other program flights now planned to occur beginning in Q3 due to delays from DoD COVID-19 related travel, distancing and other restrictions.

Kratos’ target drone business is performing as expected with full rate production for 2 programs and increased production for an additional program now forecast for either later this year or early next year based on the most recent customer communications and taking into consideration COVID-19 DoD work at home requirement-related impacts. Also importantly, we recently received expected contract awards for approximately 20 target drone systems, which, along with our Q1 unmanned business book-to-bill ratio of 1.5:1, provides us increased visibility and confidence in our forecast. And we remain on track to achieve our long-term target drone growth and profitability objectives.

Kratos’ Microwave Electronics business, one of our company’s highest profit margin and cash flow contributors, achieved solid performance in Q1, including a book-to-bill ratio of 1.9:1 for the quarter and a last 12-month book-to-bill ratio now of 1.5:1. This reflects the strong global demand for electronic warfare, attack, missile radar, SEAD, DEAD and other systems. Our Microwave Business’ Q1 performance, current record backlog and book-to-bill ratio provide us increased visibility and confidence in our financial forecast, EBITDA and cash flow objectives.

Kratos’ rocket system business also reported solid Q1. And based on recent communications with customers, certain ballistic missile defense target and other mission launches have moved to the right as a result of COVID-19 related DoD travel, distancing and other restriction impacts with certain missions now tentatively planned for later on this year, early next year. Since our last report to you, the number of opportunities Kratos’ Rocket Support business is pursuing has increased significantly, including certain hypersonic system programs with hypersonics currently being one of the strongest funded areas of the Pentagon budget.

Kratos’ Turbine Technologies and C5ISR businesses are also positioning for certain hypersonic opportunities. Kratos’ training business came in below our expectations in Q1 as a certain Kratos sole source contract option was unexpectedly not renewed in February by an international customer that has significant COVID-19 travel related and other restrictions. However, late in March, we did successfully receive an extension on the U.S. Navy RSNF training program, which was also in a protest situation, which Deanna will walk through in her prepared remarks.

As of today, Kratos has experienced no production facility or manufacturing plant closures as a result of the COVID-19 virus. And we have approximately 200 job openings across our company, also supporting our financial forecast. To date, we have not experienced any material supplier or vendor disruptions and we routinely communicate with our supplier and vendor partners, our customers and the government.

As we move forward, our employees’ health and safety are our #1 priority. And as I mentioned previously, we are following the safety measures, distancing and cleaning recommendations suggested by applicable federal, state and local government authorities to the absolute best of our ability. The application of these government restrictions and recommendations has resulted in a large number of Kratos employees telecommuting and working from home where possible, split or staggered shifts at certain Kratos production facilities and limitations or restrictions in our employees’ ability to travel to certain customer sites and locations to perform their work, including as related to target drone, tactical drone and other planned exercises.

Though taking the safety steps is required and the right thing to do, obviously, they are adversely impacting production, execution, flight testing and overall operational efficiency to some extent. We have also recently begun to see some delays of certain supplier deliveries and the reduction in demand from certain of our commercial aero and power customers, primarily with Kratos Turbine Technologies and our Microwave Electronics business and our Space and Satellite Communications business recently saw one of our customers, OneWeb file for bankruptcy. We have attempted to take all of these factors, current and forecast, in our updated forecast we are providing to you today.

Deanna?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [4]

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Thank you, Eric. Good afternoon.

Kratos’ first quarter 2020 revenues of $168.9 million were at the higher end of our estimate of $160 million to $170 million, with particular strength in our Unmanned Systems segment which reported revenues of $42 million, up 20% from first quarter 2019 revenues of $34.9 million. KGS reported revenues of $126.9 million, up from $125.5 million in the first quarter of 2020. Organic revenue growth in the first quarter of 2020 in our Microwave products and Rocket and Ballistic Missile Defense businesses and a full quarter’s financial performance of KTT in 2020 were primarily offset by expected declines in our training solutions business, Satellite Communications and legacy government services business. Our adjusted EBITDA of $16.3 million exceeded our estimate of $12 million to $16 million due to a favorable mix of revenues and execution, primarily in our Space and Satellite Communications and Unmanned Systems businesses. Our adjusted EPS of $0.09 was also at the high end of our forecast of $0.05 to $0.09 per share for the quarter.

In the first quarter, our Unmanned Systems segment generated adjusted EBITDA of $2.3 million, up from $2 million in the first quarter of ’19. The adjusted EBITDA margin rate remained fairly consistent year-over-year due to the mix of development programs which are typically lower margin programs than production programs. This increased mix of development programs is expected to continue into 2020 until certain new production awards or increases in existing production programs are received.

KGS generated adjusted EBITDA of $14 million or 11% of revenues, down from $15.5 million in Q1 of ’19 and operating income of $9.3 million, down from $11.4 million in Q1 of ’19. A more favorable mix of operating margins and adjusted EBITDA margins in the company’s Space and Satellite, C5ISR and Microwave Products businesses in Q1 ’20 were offset primarily by expected less favorable margins in the company’s training solutions business as a result of the completion of a large international fixed-price contract at the end of 2019.

Our Q1 consolidated operating income was $4.7 million, down from the first quarter of ’19 operating income of $8.2 million, primarily due to an increase in noncash stock compensation expense of $2.1 million and increased depreciation expense of $800,000, primarily due to the capital investments we have made in our Unmanned Systems business over the past few years. Our adjusted EBITDA for the first quarter is from consolidated continuing operations, including net income or loss attributable to noncontrolling interest and excludes noncash stock-based compensation costs of $4.7 million, foreign transaction loss of $400,000 and acquisition and restructuring related items and other of $500,000. On a GAAP basis, net loss for the first quarter was $200,000, which includes a tax benefit of $1.4 million and loss from discontinued operations of $400,000.

Moving on to the balance sheet and liquidity. Our cash balance is $158.6 million at March 29. At quarter end, we had 0 amounts outstanding on our bank line of credit and $5.7 million of letters of credit outstanding. Debt outstanding was $295.3 million at quarter end, and net debt was $136.7 million. Our LTM adjusted EBITDA was $76.5 million with a net leverage ratio of 1.8:1.

Cash flow generated from operations for the first quarter was $4 million less CapEx of $6.4 million for free cash flow use of $2.4 million. During the quarter, we utilized $9.5 million for the acquisition of Technical Directions, Inc. or TDI, a turbine technology company focused on tactical unmanned aerial drone and other systems which Eric discussed previously.

In addition, $4.7 million was paid during the quarter for deferred purchase consideration related to the FTT acquisition that we closed last year. Also during the quarter, we collected $1.9 million related to the retained working capital of the legacy PSS business that we sold in 2018, bringing in the total receipts we have collected to $5.6 million since we sold the business. Our contract mix for the quarter was 78% fixed price, 17% cost plus and 5% time and materials. Revenues generated from contracts with the U.S. federal government were 74%, including revenues generated from contracts with the DoD, non DoD federal government agencies and FMS, which were approximately 9%. We generated 8% from commercial customers and 18% from foreign customers.

For our forecast, we are providing initial second quarter guidance of revenues of $160 million to $170 million and adjusted EBITDA of $12 million to $16 million. We are affirming our full-year 2020 adjusted EBITDA guidance of $72 million to $78 million, and we are affirming our free cash flow from operations guidance of $7 million to a use of $18 million, including capital expenditures of $40 million to $45 million. Since the company does not have many progress payment type contracts, the changes recently made by the DoD to increase percentage of such payments from 80% to 90% due to COVID-19 does not have a material impact on the company’s FY ’20 expected cash flows. We are adjusting our full year 2020 revenue guidance from $740 million to $780 million to $720 million to $760 million, primarily to reflect the currently forecast impact of COVID-19 on our business, including our vendors, suppliers and customers, including access to customers and customer sites, the nonrenewal of an option on the sole source training contract by an international customer partially offset by the extension through the beginning of 2021 of the U.S. Navy, Royal Saudi Naval Forces trading contract. Our affirmed adjusted EBITDA guidance reflects an overall forecasted improved revenue mix and profitability in our DoD and National Security business areas, including in our space, satellite, unmanned systems and microwave electronics operations.

Our fiscal 2020 guidance excludes any potential contribution from expected Valkyrie or other tactical drone production or system contracts with expected orders to be taken into consideration in our financial forecast adjusted once such contract orders are received and the related financial contribution can be estimated. The 2020 capital expenditure forecast currently includes expected outlays of $15 million to $17 million associated with production of 12 Valkyrie aircraft prior to receipt of expected customer awards and, therefore, reflected as company-owned tactical drone until receipt of the related customer award, at which time, the costs incurred will be transferred to project costs and approximately $3 million to $5 million related to production of company-owned aerial target drone systems in preparation of fulfilling forecasted customer requirements. Kratos will adjust and/or reduce these initial forecasted capital expenditure outlays once expected customer orders are received and the related financial contribution and contractual terms can be estimated.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [5]

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Thank you, Deanna. We will now turn it over to the moderator for any questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question comes from the line of Pete Skibitski with Alembic Global.

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Peter John Skibitski, Alembic Global Advisors – Research Analyst [2]

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Glad to hear you are doing well. On the sole source international training contract that fixed price-one that didn’t get the option renewed, could you just size that for us?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [3]

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Yes, that’s roughly about $8 million to $10 million per year.

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Peter John Skibitski, Alembic Global Advisors – Research Analyst [4]

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Okay. Okay. And then on just the expectation, I guess that 2Q will be kind of the low revenue quarter for the year. Is the underlying assumption essentially that COVID is impacting, and maybe once we’re through the worst of this, then things improve in the back half of the year. Is that kind of the driving assumption?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [5]

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Yes. That’s part of the impact, yes.

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Peter John Skibitski, Alembic Global Advisors – Research Analyst [6]

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Okay. Okay. Last question for me, and I’ll get to the back of the queue. On the Valkyrie, so let’s — if we assume you get a contract later this year, do you start to book revenue on a percentage of completion basis? Or is it we wait until 2021 and you book the revenue on unit deliveries?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [7]

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So it depends, Pete, on the type of contract. If it’s a production type contract, then yes, it would be on a percent complete basis for the cost incurred. If it’s a services contract, then that would be based on what services are provided. So it really depends on the makeup of the contract.

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Peter John Skibitski, Alembic Global Advisors – Research Analyst [8]

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Okay. And that’s still uncertain right now is what’s going on?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [9]

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It could be both, yes.

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Peter John Skibitski, Alembic Global Advisors – Research Analyst [10]

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Okay. Okay. Okay. So I guess the services contract, is that similar to what you do with targets? I know you sort of lend target services to some of the European countries. So you think it could be similar to that maybe?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [11]

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No. What we mean by that is — and I’m just giving examples here. We could get — we could receive a contract for units that we’re selling. We could get a contract to continue to integrate weapon systems, command and control systems and other systems into the Valkyries. We could get a contract or contracts where Kratos-owned Valkyries are involved in missions, like the ABMS mission or some other missions or demonstrations. It could be in a very — in my opinion, right now, I think it’s going to be sum of each.

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Operator [12]

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Your next question comes from the line of Sheila Kahyaoglu with Jefferies.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division – Equity Analyst [13]

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Eric, you mentioned the Reaper replacement maybe in the 2022 time frame. How do we think about that just because it’s a group 5 much larger drone versus your offering? How could the Air Force shape that?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [14]

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Right. So I think, Sheila, some of them are actually group 4, they’re not in group 5. Group 5 are things like Global Hawks. And I will — I can only pass on in this forum what has been publicly announced by the DoD. And as I said in my remarks what the DoD has said is that they’re planning on ending production of them this year because they cannot perform in contested environments their missions. They’ve been phenomenal in the terrorist mission and the asymmetric warfare mission. But the Air Force has come out and they said they want drones to replace them that can survive in an anti-access area denied environment. And we — as you can imagine, we believe we’re very well positioned for this as we have a number of drones that are actually flying today, certain of which we believe could fill that mission admirably. So that’s all I should say on this now.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division – Equity Analyst [15]

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Okay. No worries. And then I might have missed this in the prepared remarks. I know you said a few flight tests were pushed to the right. Can you just go over the latest on the Valkyrie? I think you had your fourth flight test in January that was successful. Kind of just a quick update there because I don’t know if you mentioned dates.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [16]

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Absolutely. So just — either yesterday or the day before yesterday, the Air Force announced that the next ABMS flight, Advanced Battle Management System flight, which we are scheduled to participate in with the Valkyrie and several other of our jet drones, it has expanded now, is currently planned for either August or September of this year, and they announced that just this week.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division – Equity Analyst [17]

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Okay. Got it. And then in terms of the additional funding on the Valkyrie potentially in ’21, can you go over what we need to see what next steps are? Obviously, the first round I’m funding first, but kind of the puts and takes there?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [18]

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Sure. And so what is out there publicly is that the Chairman of the Senate Armed Services Committee, he made some remarks and those are publicly available. And in those remarks, he said that because of the progress that we’re making, because of the Valkyrie flying today and its capabilities, that he was supporting an additional $125 million in the 2021 NDAA to continue moving forward with attritable drone aircraft. So that’s what the Chairman said a few weeks ago.

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Operator [19]

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Your next question comes from the line of Peter Arment with Baird.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division – Senior Research Analyst [20]

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Eric, just following up on the Valkyrie. So if you have another test flight in August, September, maybe you could just shape how you’re thinking about like the timing of potential contract. What’s the roadmap look like there once you have another flight test?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [21]

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I believe that they’re mutually exclusive. I believe, and I’ll go with what the Air Force announced a month ago. The Air Force announced a month ago that they were going to move out post-haste on — relative to Skyborg, that was the context that they were talking in relative to Skyborg on getting some information out relative to contracts for production this year. And as I said in my prepared remarks, recent correspondence and communications, the Air Force, and I’m not putting words in their mouth, in my opinion, they could be announcing something very soon.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division – Senior Research Analyst [22]

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So it’s potentially before the flight. Okay. Just wanted to confirm that.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [23]

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Yes, yes.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division – Senior Research Analyst [24]

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And then could you give us your latest thoughts on — I know Project F is now Airwolf. When — those flights will also be around a similar time line? Or is that on a different schedule?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [25]

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They are currently scheduled for Q3. So they are scheduled for Q3. I believe Gremlins are scheduled for Q3. Rattlesnake with AeroVironment is now scheduled for Q3 along with ABMS and other Valkyrie flights that we have not talked about in detail, we can’t. And this all has to do with the DoD travel restrictions, number one, and social distancing relative to being in the command and control modules relative to the flights.

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Operator [26]

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Your next question comes from the line of Ken Herbert with Canaccord.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division – MD and Senior Aerospace & Defense Analyst [27]

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Eric, I just wanted to ask you about TDI. Is it possible to maybe give us a little more detail on the revenue contribution from that acquisition this year? And then bigger picture, I mean, it clearly sounds like based on your prepared remarks, you’re fairly optimistic about — as you plan TDI in with KTT, and you go after what you — what looks like a pretty substantially extending market in missiles, cruise missiles and things like that. Can you help maybe with sizing that market a little bit or just a little bit of the sort of the parameters you’re targeting now on the engine side?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [28]

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Absolutely. So for this year’s contribution, it is — it’s not material because they do not have any production contracts right now. They are in development. They have a number of development programs, I mean, the one that’s publicly out there, of course, is the one we talked about today with Gray Wolf. And so this year’s contribution is not material. However, if things go according to plan and they are tracking right now with number of engines running, we see our Turbine Technology business potentially next year with — tied into 2 engines in particular. They could become — begin to become material financial contributors next year. The market opportunity, as you indicated, is very, very large. As we’ve talked about before, the technologies that are out there right now are ’70s or ’80s technology that we’re using the buildup of the missile systems in the ’80s. And with what’s going on in the South China Sea and in the Pacific, extended range is significant. And that’s why you see things like LRASM-ER, extended range or JASSM-ER, extended range; or Harpoon ER or extended range. And there are several others. And for competitive purposes because this is competitive, I’m not going to get into many details. But as I think I’ve said before relative to KTT, there’s a handful or so of programs that we’re looking at getting designed in that we’re working on getting designed in on. And that handful, assuming we get a portion of that market, it’s like $800 million over 5 years.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division – MD and Senior Aerospace & Defense Analyst [29]

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Okay. It’s very helpful. And if I could, just one other question from me on Valkyrie. As I listened to your prepared remarks, I mean, you’re clearly outlining what sounds like and what was a very close collaborative effort with the Air Force as you develop the aircraft and the technology. There’s certainly other companies that seem to be looking at this market with a lot of interest. Can you just talk and remind us again about the competitive advantages of the Valkyrie? And why you’re in the pole position? And how you think you can maintain that relative to what some other firms may be looking at doing as these move forward?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [30]

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Absolutely. So we believe one of our strategies is first to market is critical and proven affordability is equally critical. As I mentioned and as you know, in 2015, we flew jet high-performance drones with manned aircraft, manned to unmanned teaming. So that was what, 5 years ago, 4.5 years ago, we did that. We have a number of drones flying today. They’re all 100% substantially sourced in the United States, made in the United States. We believe that that’s a competitive advantage. We are working with the United States Air Force, as I said in my prepared remarks, the premier institution in the world globally for aircraft, remotely piloted aircraft, manned piloted aircraft, et cetera. The number of drones we have that are flying today were integrating weapon systems and other systems into operationalizing them today. These aren’t PowerPoint presentations or like little models, these are flying today. The market, as I went through, is accelerating now and is moving rapidly. And on affordability, as I mentioned, we’re building well over 100 drones a year right now, demonstrated cost points, $250,000 cost point for certain of them, $500,000 for others, $1 million for others, and on the Valkyrie, obviously, we know what we’re targeting there, $2 million, $3 million. So we’ve demonstrated it. We believe that those are all critically important competitive differentiators and we just need to continue to execute and move forward.

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Operator [31]

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And your next question comes from the line of Michael Ciarmoli with SunTrust.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division – Research Analyst [32]

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Glad to hear you guys are safe and healthy. Eric, maybe going back, I think it was Sheila’s question on the Reaper replacement. Certainly, if we think about how the Air Force, how they develop their roadmap, I mean, are there other opportunities for you outside of a complete drone solution? You were just referencing TDI and some of the development programs. I mean could you potentially be a partner and provide Turbine Technology? Or is this — or are you going after it with a complete platform solution? Maybe any color you could provide there?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [33]

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Sure. So we are in competimate land, Mike, competimate. We are competing head on head with the competitors and we are teaming with many of them on programs. We are — we have incredible teaming relationships with Lockheed, incredible teaming relationships with Northrop, with Raytheon, they’re just — they’re phenomenal partners. They are also ferocious competitors. So it’s core.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division – Research Analyst [34]

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Okay. Okay. And then on the ABMS drones, you said you’ve got more in addition to Valkyrie. Can you tell us which other of your drones are participating in that?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [35]

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I cannot, because I do not believe that, that has been disclosed yet other than what I said. I’m sorry.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division – Research Analyst [36]

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Okay. On Valkyrie, are you still expecting orders in the range of 30 or so? Has anything changed? Certainly, it sounds like there’s going to be more funding, but what’s sort of the general outlook in terms of number of units you expect to secure?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [37]

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I’ve got to — I don’t want to comment on this, Mike, because if things are going to happen, if you go with what the Air Force has publicly talked about in the last 3 or 4 weeks, and obviously we have some information as well. The next several weeks, couple of months, let’s just watch this play out. I will though go with what I believe it was Dr. Roper said where he — where I believe he — in an interview, he said that we are looking to begin buying these in quantity this year. I believe he said that.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division – Research Analyst [38]

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Got it. Last one for me. You obviously narrowed down or took down the revenue guidance. You held the EBITDA. It sounds like you’ve got some higher margin business flowing through. Can you tell us what percent of revenues you’re deriving today from more of the higher margin software type sales?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [39]

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Deanna, what’s — how is our — the vast majority of that is in the space side?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [40]

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It is. Yes, it’s based in our space. And we don’t really quantify the percentage on software.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [41]

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Yes. But it’s — the majority of it, Mike, it’s in our space business. It’s in our space business, but it’s also in the Microwave business. The Microwave business is just a weapon right now relative to electronic warfare systems.

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Operator [42]

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Your next question comes from the line of Mike Crawford with B. Riley.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division – Senior MD, Co-Head of The Discovery Group & Senior Analyst [43]

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Eric, you mentioned the Black Dragon program was in going for system flight. Is that with a smaller TDI engine or the bigger KTT engine?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [44]

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It’s a KTT program.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division – Senior MD, Co-Head of The Discovery Group & Senior Analyst [45]

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Okay. And then you also — you talked about air launch initiatives, didn’t really talk about railroads initiatives, including your container deployment system that you’ve shown can help reach A2AD environment. Is there any progress update there?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [46]

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We are planning on completing and having ready for delivery, the first containerized rail launch systems middle of this year, next few months. We’re working hand in hand with the Air Force.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division – Senior MD, Co-Head of The Discovery Group & Senior Analyst [47]

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And there’s orders in place for those?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [48]

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We can’t talk about that right now.

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Michael Roy Crawford, B. Riley FBR, Inc., Research Division – Senior MD, Co-Head of The Discovery Group & Senior Analyst [49]

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Okay. And the last one. Ducommun announced, let’s follow that it was targeting some UAV opportunities, I think, related to electronic systems. Can you say whether you’re working with Ducommun maybe on engines or else otherwise?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [50]

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Ducommun is an important partner of ours in our drone business.

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Operator [51]

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And your next question comes from the line of Josh Sullivan with Benchmark & Company.

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Joshua Ward Sullivan, The Benchmark Company, LLC, Research Division – Senior Equity Research Analyst [52]

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Just on GBSD, are you able to provide some color on what you’re going to be supplying on the program?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [53]

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I am — other than the ground transport and missile transport systems, which is what Northrop has announced, we are unable to provide because, obviously, we’re under an NDA with Northrop and they’re a great phenomenal partner. We cannot go beyond that. So pull up the (inaudible) and take a look at the ground transport equipment, the missile erector systems and the missile transport systems, and that will give you an idea of what’s been disclosed, what we’re doing.

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Joshua Ward Sullivan, The Benchmark Company, LLC, Research Division – Senior Equity Research Analyst [54]

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Got it. And then just a question on TDI and the Golden Horde program. The mass quantities you referenced on the low-cost engines. Will TDI have the capacity to do that? Do you need a partner? Can you do that at your Oklahoma facility? Or one of the KTT facilities?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [55]

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So TDI, we — with the TDI acquisition, we acquired a very small, next leading technology, additive manufacturing, engine production company. That’s one piece. KTT has significant next-generation engine manufacturing techniques and technology. We believe with the hand we have now, the hand of cards, we are in phenomenal shape for production runs, low cost, very quick, very simple next generation engines. We feel we’re in good shape of what we got.

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Operator [56]

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And your next question comes from the line of Seth Seifman with JPMorgan.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division – Senior Equity Research Analyst [57]

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Just kind of curious so with the revenue guide for the second quarter, the implication, I guess, is that in the fourth — in the run rate for the second half, we’re going to get up to a record level kind of 200-plus of sales. Talk about what kind of gives you the confidence in that level of step-up?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [58]

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The book-to-bill ratio, the bookings in the first quarter were phenomenal. Our — as I said in the prepared remarks, our Microwave business has a record backlog. Our Unmanned business right now is — backlog is just under a couple hundred million. All right? We have very good visibility right now on what’s going on.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division – Senior Equity Research Analyst [59]

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Excellent. And then just on the training business, just to make sure I understand kind of the different pieces there. So we’re talking about 2 separate international contracts. One in option was not exercised. That is a headwind in Q2 sequentially, and I would assume for the rest of the year as well along the lines of the size that you talked about with Pete’s question. On the flip side, you did get an extension on the Saudi FMS contract with the U.S. Navy. And kind of how long does that extension last? And what is that due versus what you kind of had in the guidance previously?

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [60]

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Yes. So there’s a couple of pieces. So there is the nonrenewal of the international contract, but we did — we were awarded the bridge contract on the previous contract that we had discussed in the prior quarters. There was also one contract that was a new bid that we lost, that we — a new one that’s under protest that was lost in March. So netting all those 3 items, it’s about a net $3 million to $5 million shortfall from where we were the last time we provided the estimates.

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Seth Michael Seifman, JP Morgan Chase & Co, Research Division – Senior Equity Research Analyst [61]

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Right. Okay. Okay. Got it. Okay. Very good. And then is that Saudi on the U.S. Navy FMS, is that now in extension in that — this is now a Kratos contract again? Or is this kind of a temporary extension while there’s adjudication of protest?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [62]

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It’s a Kratos contract through the end of the year.

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Operator [63]

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And your next question comes from the line of Noah Poponak with Goldman Sachs.

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Noah Poponak, Goldman Sachs Group Inc., Research Division – Equity Analyst [64]

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Eric, last quarter, when you gave the initial outlook for 2020, initial 2020 guidance, you emphasized that you had excluded or significantly factored down multiple items that could come your way in the year. And Deanna just went through the moving pieces there in the guidance, and it’s kind of a small number of contracts and a small amount of revenue. And I understand that…

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Deanna Hom Lund, Kratos Defense & Security Solutions, Inc. – Executive VP & CFO [65]

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Noah, that was just for the training piece, so that was a specific question that Seth had asked on because there is other pieces. So if you — the prepared remarks that we talked about, the commercial aero impact in our KTT business and in our Microwave Products business, that’s about $10 million to $12 million.

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Noah Poponak, Goldman Sachs Group Inc., Research Division – Equity Analyst [66]

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No, I understood those. I was about to say that there’s a global pandemic, right? So it’s an unprecedented situation. But we’re also watching other defense companies largely reiterate views or take guidance down very slightly. I guess I’m just wondering where the things you excluded or things that were significantly factored are as offsets? And are those still available to you in the back half of the year? Or are we now looking at sort of — I mean I think Seth makes a good point that it’s a pretty back-end loaded profile based on the second quarter guidance. Do you still have these things that are excluded and factor that could be added later in the year? Are we sort of clinging to the new range here?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [67]

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The C5ISR contract $50 million that we won, that was protested. If we’re successful there, that could be added. If we receive contracts — contract or contracts related to Valkyrie or other tactical drones, those could be — those would be added. There are, I’m going to say, a handful of other brand new opportunities that are expected to be awarded in Q3 — Q2 or Q3. If we’re fortunate enough to win some of those, those could be additive because those are not in our forecast either.

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Noah Poponak, Goldman Sachs Group Inc., Research Division – Equity Analyst [68]

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Okay. How many months of delay do you have in the next upcoming test flights for Valkyrie and Gremlins from the disruption related to coronavirus?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [69]

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So the ones that are publicly out there, the ABMS flight with Valkyrie and some of our other drones was previously scheduled for May. As I mentioned this week, either yesterday or the day before, the Air Force announced that they’re shooting for August, no later than September. Our Airwolf flights which were scheduled for Q2, are now scheduled for Q3. The one with AeroVironment, which was scheduled for Q2, is now scheduled for Q3.

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Noah Poponak, Goldman Sachs Group Inc., Research Division – Equity Analyst [70]

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Got it. And then, Eric, you had discussed previously how part and parcel to the $100 million plus up in funding that the Valkyrie saw that came with a requirement for AFRL to submit a plan for that to Congress by, I believe, it was March 31. Can you speak to whether or not that happened? And if everything related to that time line is still in place?

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [71]

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It absolutely happened. It was submitted — I don’t know if it was submitted by March 31. I don’t know the date to be very candid with you, but I know it has been submitted because I have been told it had been submitted. It has been — I have been told it has been accepted. And I have been told that those are some of the reasons why I believe in the near future the Air Force may be putting some information out.

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Operator [72]

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And this concludes our Q&A session. I would like to hand the call back over to Eric DeMarco for any closing remarks.

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Eric M. DeMarco, Kratos Defense & Security Solutions, Inc. – CEO, President & Director [73]

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Great. Thank you all for joining us. And we will chat with you when we report Q2 later on this year. Thank you.

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Operator [74]

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Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.

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