Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) Q3 2023 Earnings Call Transcript

Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) Q3 2023 Earnings Call Transcript November 2, 2023

Kratos Defense & Security Solutions, Inc. beats earnings expectations. Reported EPS is $0.12, expectations were $0.08.

Operator: Good day, and welcome to the Kratos Defense & Security Solutions Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers presentation there will be a question-and-answer session. [Operator Instructions]. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Marie Mendoza, Senior VP and General Counsel. Please go ahead.

Marie Mendoza: Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense & Security Solutions third quarter 2023 conference call. With me today is Eric DeMarco, Kratos’ President and Chief Executive Officer; and Deanna Lund, Kratos’ Executive Vice President and Chief Financial Officer. Before we begin the substance of today’s call, I’d like everyone to please take note of the Safe Harbor paragraph that is included at the end of today’s press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook, and financial guidance during today’s call.

An IT security expert looking intently at a wall of servers.

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 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: Thank you, Marie, and good afternoon. We’ve recently received additional interest in Kratos from existing and potential new stakeholders. And as a result, I’ll begin my remarks with a summary of our strategy. Kratos is a technology company in the national security, commercial and global markets, and we make targeted internally funded investments to be first to market with the relevant products and software. The benefit of Kratos being both defense and commercial market focused is that we lever our technology, our resources facilities, production quantities providing Kratos a competitive advantage, including cost and also a unique rapid technology development and delivery aspect to our customers. Kratos utilizes existing leading edge technology, not yet to be developed bleeding-edge technology, which approach accelerates our development and fielding time while reducing our risk, schedule and cost elements.

Kratos’ dual commercial and security market focus is most represented by our space satellite software and turbine technologies areas, representing approximately 50% of Kratos’ revenue today. Also consistent with making targeted internal investments in our first to market strategy at Kratos affordability as a technology, and better is the enemy of good enough ready-to-go today, which is becoming even more important in the existing budgetary and threat environment. As reflected in our third quarter and year-to-date results, Kratos’ 2023 transition year of making targeted internal investments and high growth market opportunity areas, while also generating increased revenue profit and cash flow is on-track. With this trajectory expected to continue in the future as an increased number of our programs and initiatives enter or see increased production or deployment.

The Kratos team in every business unit are successfully executing our strategy and business plan in the light of day as a public company, competitively bidding on and receiving large contract and program awards and programs of record, generating revenue and cash flow while simultaneously managing significantly internal funded investments to further grow the business. This approach has positioned the company for sustained future year-over-year organic growth with increased margins along with potential transformational opportunities, including in tactical drones, software-based satellites C2 and TT&C, turbine propulsion, engines, hypersonics and certain other system areas. As we complete 2023, we expect to achieve our forecast and we currently expect Kratos’ base case 2024 revenue and EBITDA profitability to continue to increase.

Kratos’ base case forecast does not include any assumed tactical drone production contracts, which we will only forecast once assured. With the United States government the defense industry and Kratos currently operating under a continuing resolution authorization, similar to previous years, we will wait until we report Kratos’ fourth quarter financial results in February to provide our detailed 2024 financial guidance to you, as we should have additional clarity on both the fiscal ‘24 budget and the ‘25 budget request outlooks at that time. However, unless something significantly adverse occurs funding wise at a high level, we are currently expecting at least 10% 2024 over ‘23 base case organic revenue growth and increased EBITDA margins with Q1 ’24 similar to prior years being the weakest due to the currently ongoing CRA.

Kratos’ recent program awards and our record backlog and opportunity pipeline which are driving our demand for qualified personnel, is a primary reason for our expected future organic growth trajectory confidence. Simply stated, Kratos has the right technology, software, systems, products and solutions at the right price points, at the right time to address certain of the most mission and time critical national security and commercial market requirements. We currently have [400] (ph) open billable requisitions across our company on a base of approximately 3,800 employees which is also indicative of the strength of our business and the demand for our offerings. The obtaining and retaining of qualified workers including those willing and able to receive a national security clearance remains a primary operational challenge in including the continuing increased cost of these individuals which is impacting our margins.

Recent Kratos business highlights include: The Air Force has now reported that an Artificial Intelligence Combat enabled Valkyrie successfully recently flew at the Eglin Gulf Test and Training Range. As reported, AI algorithms developed and trained by the United States Air Force Research Lab, autonomous air combat operations, with the AI trained through deep reinforcement learning, use neural networks to fly the Valkyrie against simulated opponents, mission systems and weapons. Also recently reported in a separate flight, Kratos’ Valkyrie successfully demonstrated all defined artificial intelligence enabled high performance unproved air vehicle specified relevant functions. Kratos’ Valkyrie with the United States Marine Corps also continues to progress with the Marines recently announcing the successful first flight of Kratos’ Valkyrie under the penetrating affordable autonomous collaborative killer portfolio or PAACK-P program as Kratos was able to announce today.

As reported the Marine Corps partnered with the office of Undersecretary of Defense or OUSD for research and engineering, the Navy Air Systems Command and the Naval Air Warfare Center Aircraft division, with multiple expected additional funded future Valkyrie flights planned under the program. Kratos’ drones, including Valkyrie, also continued to progress under the Rapid Defense Experimentation Reserve or RDER program, including as related with the U.S. MC. The Valkyrie is the only high performance stealthy jet drone in its class flying today, continues to mature in actual flights with funded customers, including with artificial intelligence and other relevant mission systems as the DoD progresses towards the future large scale deployment of high performance jet powered drone UAV systems.

We have now executed Phase I of an expected five year funded contract initiative with the new National Security entity for Kratos’ Valkyrie B version mission capability expansion, which initiative is very confidential. We have also now completed negotiations and expect to receive in the fourth quarter a Valkyrie related contract in the tens of millions of dollars from a separate National Security entity for a Valkyrie version A category. And we have recently received an entirely new tactical system related contract award, which we are unable to discuss further in any detail at this time. Separately, we are in negotiations with the customer related to Kratos’ Thanatos tactical drone system, a version of which is flying today with multiple Thanatos systems expected to be performing funded mission capability demonstration expansion flights with this new customer in the future.

We have also recently under discussions with the customer regarding Kratos’ Athena drones system, also which is now flying and we hope to be under contract next year. Since our last report to you, Deputy Secretary of Defense Kathy Hicks announced the new replicator initiative to field thousands of attributable autonomous drone systems over the few years. Similar to the reported completely separate Air Force CCA program, where it has also been reported that thousands of CCA drones are expected to be fielded, I am also unable to say anything more on either replicator or CCA at this time. However, Kratos is the only company with low cost high performance expendable and attritable jet drones, both in production and flying today, including Air Wolf, Mako, Valkyrie, Thanatos, Athena and others.

Assuming the fiscal 2024 budget is approved as we expect and the fiscal ‘25 NDAA and FITA typically released by the Pentagon in calendar Q1 are also as we expect. Late next year, we hope to receive our largest to-date Kratos tactical drone related contract award, which once again is not included in Kratos’ base case financial forecast. In addition to recent developments with Thanatos and Athena, Kratos’ Ghost Works continues to make progress on a separate new system and assuming the range scheduling holds, we expect to demonstrate this system later this year. Kratos’ Ghost Works has also recently been focused on a large new prime program opportunity, which includes the rapid design and build of an additional separate new system requiring significant Kratos funded NRE, BNP and other costs, which we expect to incur through Q4 and into Q1 of next year.

We recently acquired Sierrea Technical for approximately $25 million in Kratos stock if all earn outs are achieved. Sierrea is a long-time partner of Kratos, and this was a one-on-one negotiated stock exchange merger with STS’ husband and wife founders. Sierrea recently received an approximate $77 million single award contract for two stealth jet drone fifth generation aerial target or 5GAT aircraft with initial period of performance of approximately three years and then expected production thereafter. For both competitive and security considerations, I am not going to comment any further on Sierrea related to future growth expectations, other than to say that Kratos has big plans for the 5GAT stealth drone, and also an additional opportunity Sierrea is working on that is highly confidential along with Kratos’ Ghost Works.

Our primary focus is to successfully execute the 5GAT program and be first to market with a fifth generation aerial target drone system. We are working with Shield AI with Shield’s artificial intelligence pilot integration into several of Kratos’ high performance jet drones, including Valkyrie. The Shield Kratos relationship is exactly consistent with Kratos’ first to market with relevant system strategy, with Kratos flying drones and Shield flying today Hivemind AI pilot. We believe Shield will have a clear market advantage over its primary competitor as Shield has access to Kratos’ family of flying today jet drone systems and its competition of power points, ground models, simulations or propeller points. The Kratos Shield flights are occurring at the Oklahoma Burns Flat Facility, which I completely endorse, that the competition does not know what Kratos and Shield are up to as Shield AI is expected to be advanced through these flights and also at a separate additional range facility.

We continue to come down the learning curve on the 24 Valkyrie serial production run, with currently three separate Valkyrie variants A, B and C underway and a fourth variant we are currently considering based on recent customer interest. We are internal resource planning, balancing and phasing the Valkyrie production pace and Kratos’ capital allocation against other new customer funded tactical drone programs we have recently received and potential opportunities. We have also now submitted a large quantity ROM or rough order of magnitude to a government customer for a significant Kratos tactical drone production run which production planning and preparation we have completed along with our existing in-place critical suppliers. The demand for Kratos’ target drones is strong and we expect to continue for the foreseeable future as the global recapitalization of weapon systems and the need to test and train on these weapon systems increases as recently demonstrated in the vigilant live run test last week.

In the Space and Satellite area, almost every aspect of a satellite ground station can now be converted from hardware and software lowering cost, accelerating technology advancement and deployment time and increasing the ability for an operator to immediately react to changing conditions and requirements, which is the large new and growing addressable market Kratos is pursuing. New satellite space vehicle technology and requirements providing Kratos market opportunity include software defined payloads, high throughput spot being enabled and other advanced system payloads and laser optical and other capabilities. Kratos’ first to market OpenSpace software platform is the only software networking solution specifically designed to address and advance this new software and commercial technology focused paradigm, connecting dynamic space to a dynamic virtualized ground system.

We recently announced that Kratos’ OpenSpace platform is the first commercially available fully virtualized satellite ground system to achieve MEF 3.0 Carrier Ethernet Certification. The MEF Carrier Ethernet or CE standard is same industry standard adopted by global terrestrial and mobile network carriers, meaning Kratos’ OpenSpace makes satellite service networks seamlessly interoperate with terrestrial and cellular transport networks. The CE standard achievement is representative of Kratos satellite team’s successful and methodical execution of our global satellite software-based virtualization strategy led by Kratos’ first to market OpenSpace system. The total addressable market opportunity for Kratos OpenSpace, both commercially and for National Security is expected to remain strong with thousands of additional satellites planned for launch in the future.

Kratos’ Turbine Technologies or KTT and our TDI Engine business, we believe similar to our tactical drone business, is well-positioned for the expected significant growth in drones, cruise missiles powered munitions, high performance loitering munitions and other systems all of which need engines. Kratos’ first to market made in the USA engines are flying today and are designed into several new program systems, including as recently reported with Kratos TDI engines and the Boeing Powered Joint Direct Attack Munition. For engines, motors and propulsion systems, the time to get successfully designed into the vehicle’s munitions and system is now with working engines, not improving startup technology and photo renditions, and Kratos is taking advantage of our first to market positioning.

Since our last report to you, we have received a contract to integrate Kratos’ running engines into certain of Kratos’ jet drones, both target and tactical. Once integration is complete, we believe that Kratos will be one of the only companies in the world vertically integrated building both the jet aircraft and propulsion system significantly reducing cost and supply chain risk, while also increasing system performance for our customers with new technology provided Kratos’ engines. We will also have the same vertical integration with Kratos’ Zeus rocket motors and our Erinyes and our Dark Fury aerial flyers. Kratos Turbine Shadow Works development team has also been working on a separate new class of turbo fans, Kratos code name blade for new larger drones.

And I hope to be able to provide an update on our tangible progress with this initiative in the future as the total addressable market size for this larger engine class is incredibly large as represented by recently published reports. The demand for Kratos’ turbine products technology and solutions is strong across the portfolio, including in the turbo fan, space propulsion, hypersonic and other classified areas. [indiscernible] works as a crown jewel of Kratos and is having an incredible 2023 and we are expecting continued significant future organic revenue EBITDA and profit growth from the business. Kratos microwave electronics business with a record backlog and opportunity pipeline is also performing well including our team successful penetration of the new to Kratos microwave Space and Satellite market.

In addition to Space and Satellite, the global recapitalization of air defense, drone counter UAS, missile radar, powered and loitering munitions and C5ISR systems is providing a large and growing market opportunity for Kratos’ microwave business. Kratos Rocket Systems business or Kratos Zeus, Erinyes, Dark Fury, [ARAB] (ph) and other rocket related systems are produced, also recently had a very successful mission with our government partners at the Vigilant Wyvern exercise with multiple Kratos rocket system ballistic missile targets and multiple Kratos unmanned drone system targets utilized with all Kratos systems being successfully tracked intercepted and destroyed by the USS Carl M. Levin. The Vigilant Wyvern exercise is a recent example a franchise Kratos programs, systems and products from multiple Kratos business units, providing mission critical solutions to our customers for the United States National security.

I encourage you to watch the videos of Vigilant Wyvern when you can, where you can see your company’s products in action. Importantly, the Kratos rocket system team recently met with the L3 Aerojet team, and I can assure you that L3 is 100% mission and customer focused, including as related to Kratos Zeus systems and Kratos recently ordered numerous Zeus rocket motors from L3 related to upcoming Kratos Erinyes and other missions. Kratos’ C5ISR product, hardware and systems business is expected to be one of our strongest future organic growth generators, for the next several years, with important contracts and programs of record including [Seatnil] (ph) Patriot, THAAD, Enduring Freedom or [if picked] (ph), integrated air and missile defense battle command or IBCS, short range air defense, or SureRAD and many others.

Kratos’ C5ISR teams professionalism, our facilities, classified assets, past performance qualifications, etcetera, and their mission focus and execution has positioned Kratos C5ISR as the go to relevant hardware product and system provider in the industry. Past performance qualifications are incredibly important in the National Security Software Systems and Product business and Kratos’ provide a significant barrier to entry to new or startup potential entrants. There are also a number of cross Kratos division programs, including where our C5ISR team and our space, defense, rocket, and hypersonic businesses together are providing a complete integrated system solution to the customer. We’re focused internally on organic growth and on increased profit margins with no significant acquisitions planned.

We are balancing our increased future EBITDA profit objectives against a significant number of new program opportunities that we are and expect to pursue, many of which are right in Kratos’ wheelhouse that have recently presented themselves. Now is the time to win these and get designed in for these new significant opportunities. Deanna?

Deanna Hom Lund: Thank you, Eric. Good afternoon. As we’ve included a detailed summary of the third quarter financial performance as well as the fourth quarter and full year 2023 financial guidance. In the press release we published earlier today, I will focus on the highlights in my remarks today. Revenues for the third quarter were $274.6 million up from $228.6 million in the third quarter of 2022, reflecting a 20.1% percent organic increase. Revenues came in above our forecasted range of $240 million to $260 million with organic growth in our space and satellite, turbine technologies, microwave products, C5ISR, training solutions, and unmanned systems businesses. Our KGS and Unmanned Systems segments grew organically 22% and 13.4%, respectively.

Cash flows used from operations for the quarter of $100,000 included working capital requirements associated with funding the sequential revenue growth of $73.7 million from the second quarter. Consolidated days sales outstanding continued to improve from 120 days in the second quarter to 117 days in third quarter, with the increase in receivable balance in the third quarter of $14.8 million driven by the sequential increase in revenues. In addition, advanced purchases of inventory to mitigate potential supply chain disruptions and delays continued as well as increased production to fulfill scheduled future deliveries, resulting in an increase of $3.7 million in inventories for the quarter, representing a reduced pace from the first half of 2023 with the total use of working capital for the nine months of $23.7 million related to increased inventory levels.

Free cash flow used from operations was $14.3 million after cutting capital expenditures of $14.2 million. Our contract mix for the third quarter of 2023 was 72% from fixed price contracts, 22% from cost plus fixed fee contracts and 6% generated from time and material contracts. Revenues generated from contracts with the US government during this quarter were approximately 68%, which include revenues generated from contracts with the DOD, non-DOD, Federal Government Agencies, and FMS contracts, and 12% of revenues generated from commercial customers and 20% from foreign customers. Moving on to financial guidance. Our fourth quarter and updated full year 2023 financial guidance we provided today includes our current forecasted business mix and current delivery scheduled and our assumptions related to the expected impact of our continued operating challenge related to obtaining and retaining qualified technical personnel and the related increased cost for these employees and across our labor base as well as the continued impact of supply chain disruptions inflation and related expected cost and price increases, included increased personnel costs associated with hiring new qualified technical personnel that are currently in expected to continue impacting both the industry and Kratos.

Our revised full year 2023 cash flow guidance reflects the ongoing impact of working capital requirements to fund revenue growth, including the continued increase in inventory balances which was previously expected to begin reducing and converting to cash in the second half of 2023, as well as the shift of certain milestones on a handful of projects, primarily in our Training Solutions and C5ISR businesses, which has impacted expected cash receipts of approximately $16 million to $17 million shifting into 2024. Eric.

Eric M. DeMarco: Great. Thank you, Deanna. We’ll turn it over to the moderator now for questions.

See also 25 Safest Exotic Places to Travel in the World and 13 Best Real Estate and Realty Stocks To Buy According To Hedge Funds.

Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Seth Seifman with JPMorgan. Your line is open.

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

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

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

Eric M. DeMarco: Yes, absolutely. OpenSpaces, I said, continues to make progress. It is not making as fast a progress as I’ll speak about me personally as I had hoped. But my expectations, as you know, on the CEO, are very, very high. But the business is killing it, literally killing it. And as I mentioned, even in the remarks or in the release, we’re in source selection on a very large opportunity right now. And there are a number of very large opportunities that we’re pursuing that we believe we’re going to win because we’re the only one that has the virtualized software element. So we believe we’ve got a tiger by the tail here, Seth. We got a tiger by the tail. And we’re going to hit an inflection point. It’s either going to be in late — my opinion, late 2024 or 2025 and that inflection point is when we cross the lines of development against production and deployment and sales.

And the production, deployment and sales aspect of that curve are rapidly going up. And when they cross that development cost and maintenance cost number that we have to maintain, then we’re going to see significant margin expansion. And that’s what’s coming. So the business is doing it’s doing phenomenally well. I mean, they’re first to market with new technology. The leaders, he’s focused. The whole team is focused and they’re doing it. And thank God at Kratos, we have we’ve got a number of other things that are coming up that are hitting all cylinders. And so if it’s a little if it’s a quarter or two later, then I hope, all is going to be fine.

Seth Seifman: Okay, very good. Thanks very much.

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

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

Eric M. DeMarco: We are starting to but, Michael, the costs of labor, continue to be significant, especially in the specialty areas. I think turbomachinery engineers. software engineers and system engineers. And as I mentioned, we have about 400 open recs on a 3800 person base, we’re product company. So that tells you the amount of revenue we’ve got sitting there ready to convert and those are expensive people. So good news, we’re growing. And at some point, the growth irrespective of what the cost increases are, the growth is going to overcome it. We’re really going to have a step function in margin increases. But it’s not going to be for the next few quarters because of the reasons I said.

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

Eric M. DeMarco: Yes. So obviously, if we have a the industry has a full year CRA, we’re not going to — we will not hit 10%. It’s not going to happen. It’s a note and it’s not really the no new contract awards. It’s the no new increases in existing production because we have a number of programs that we’re in production on that are ramping, all right. Assuming we get something by the end of the year, January, February, I feel pretty good. We can hit the 10% with some of the big drivers trajectionally as you as you asked our C5ISR business. We are in production on a number of programs and we are entering production on programs like [IBCS and SureRAD, Sentinel ESG phase is ramping. That’s going to significantly ramp this year and we’re following our great partner, Northrop Grumman.

They’re probably one of the best partners we have on that. Enduring Shield or EFPIC with our partner Dynetics we’re expecting significant activity with that program. I think it was publicly reported that the units that we’re building are all going to be delivered next year. Our engine business, our turbine business, Michael is doing phenomenally well. That is where a significant number of those open reqs are. And those are programs in space propulsion, turbo fans and turbo Jets and hypersonic systems. And also the big B52 re engine program. So our engine business is definitely going to have it up and to the right trajectory next year. Our Microwave Electronics business. As you know, it’s in Israel and God bless and help them all the whole country.

But that business is ripping as you can imagine. We are on we are on Iron Dome we are on arrow. You’ve been reading about these in the paper. We’re on the radar. We’re on the birds. So our microwave business is going to continue to be up and to the right, significantly. Our rocket system business okay, ballistic missile targets and hypersonic system testing. Those are incredibly well funded and the launch manifest is very robust for us next year. And we’re going to see an uptick in the drone in our drone business next year, primarily driven by target drones. All of the weapon systems that the primes are selling right now are partners, the primes like Lockheed Martin. They’re another upstand partner and it was their system that was involved in vigilant Wiverns on the weekend test.

They have to be exercised against target drones and ballistic missile targets. So that’s driving our target drone business. So literally across the board, we’re expecting and have the programs for significant growth and margin expansion. We are being very cautious in tactical drones. We are not going to assume anything until it happens, but I hope you can see by my commentary. God willing, we’re almost there.

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

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