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spk11: across every cost point, including as related to materials and wages, is also a challenge which has gotten worse since our last report to you and which is impacting our Q3 margins on existing firm fixed-price contracts and on priced options as we cannot pass the increased costs on to our customers. We expect our margins to increase in Q4 as certain new contracts we have recently received have contemplated inflation and increased costs in them and as the mix of our revenue improves, including in our space and satellite business with open space software as we realize increased leverage also on our fixed cost base and revenues increases. Hiring, obtaining, and retaining personnel, including those with security clearances, is also an operational challenge, and we are having to increase compensation to both retain and obtain qualified personnel which is also adversely impacting our near-term profit margins. Our forecasted execution plan and revenue growth includes the assumption that we will be able to increase our workforce to meet the production and delivery requirements of the contract awards that we're executing on and that are included in our backlog. However, irrespective of these challenges, we believe that Kratos' strategy of providing affordable technology for national security is spot on. and that we have the right products at the right price at the right time to meet the U.S. and its allies' national security priorities. Our plan remains to focus internally on organic growth and our 10% 2023 over 2022 base case growth rate and to successfully execute on our potentially transformational tactical drone, space, and satellite opportunities. Deanna?
spk00: Thank you, Eric. Good afternoon. As we have included a detailed summary of the second quarter financial performance and financial guidance in the press release we published earlier today, I will focus on the highlights in my remarks today. Kratos reported second quarter 22 revenues of $224.2 million above our estimated range of $205 to $215 million, driven primarily by growth in our space, satellite, and cyber and turbine technology businesses and due in part to the contribution from the recently closed SRE acquisition. Excluding the impact of the contribution from the CTT, COSMIC AES, and SRE acquisitions which contributed $21.5 million and excluding the impact of the reduction in our training solutions business of $8.6 million, revenues grew organically 3.2% as compared to the second quarter of 21. Q2-22 revenues continued to be impacted by continued and increased COVID-related supply chain and other delays, including obtaining and retaining qualified personnel, resulting in approximately 14.5 million in revenues being deferred into future periods, with approximately 2.9 million of associated operating income, including increased inflationary costs. Our Q2-22 consolidated operating loss was 1.9 million, compared to operating income of $3.3 million in the second quarter of 21 with Q222 including a litigation settlement charge of $5.5 million. Net loss was $4.7 million for the second quarter of 22 and a GAAP loss of $0.04 per share compared to net income of $1.1 million in the second quarter of 21 and GAAP EPS of $0.01 per share. Included in second quarter 22 net loss is the $5.5 million litigation settlement charge discussed previously. We generated adjusted EBITDA of $17.7 million for the second quarter, exceeding the higher end of our expected range of $11 million to $14 million, due primarily to a favorable mix in our space, satellite, and cyber and turbine technologies businesses. Our unmanned systems segment reported revenues of $56.4 million in the second quarter of 22 compared to $60.3 million in the second quarter of 21. KGS reported revenues of $167.8 million in the second quarter of 22 compared to $144.8 million in the second quarter of 21, including contribution of $25.1 million from the recently acquired COSMIC AES, SRE, and CTT acquisitions. offset partially by the training solutions business of 8.6 million, which included the loss of an international training services contract, which contributed revenue of 4.5 million in the second quarter of 21. Despite the continued unfavorable impact resulting from supply chain COVID and related delays and disruptions, which impacted current quarter revenues unfavorably by approximately 13.9 million on a pro forma basis, excluding the impact of the training solutions business, KGS revenues grew organically 7.7% in the second quarter of 22. Second quarter 22 operating income and adjusted EBITDA for unmanned systems included a heavier mix of more development-based revenues, which are typically lower in margin due to less leverage on fixed overhead manufacturing, SG&A, and development infrastructure. Our unmanned systems business experienced an increase of 900,000 in SG&A, primarily related to increased headcount, and 1.3 million of R&D in the second quarter of 22 as compared to the second quarter of 21. KGS operating income and adjusted EBITDA included a more favorable revenue mix including software and license-based revenues. Q2 22 cash flow from operations was a use of 21.6 million with the use including an increase in receivables of approximately 27.1 million primarily related to future milestone and other contractual payments from customers, and an increase in our inventory balances of approximately $10.5 million during the quarter, primarily in our unmanned systems, C5ISR, satellite, and microwave electronic businesses, in anticipation of the ramps in production in the second half of the year, and in part to secure additional safety stock and advance buys in larger lot sizes to gain pricing benefits where possible. and to mitigate the impact of supply chain disruptions. In addition, operating cash flow also includes the continued planned investments in engineering costs in our rocket system and turbine technologies businesses for new products and investments, including the design and development of an affordable hypersonic vehicle and a complementary propulsion system . For the first six months of 22, our operating cash flow uses included $15 million of increases in receivables and increases of $25.8 million in inventories across all of our product-based businesses, including unmanned systems, space and satellite, microwave products, and C5ISR. In addition, we have made approximately $5.6 million in investments in non-recurring engineering costs for these new rocket products during the first six months of 22. Our contract mix for the quarter was 72% of revenues generated from fixed price contracts, 23% from cost plus fixed fee contracts, and 5% from time immaterial contracts. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 70%, including revenues generated from contracts with the DOD, non-DOD federal government agencies, and FMS contracts. In Q2 of 22, we generated 12% of revenues from commercial customers and 18% from foreign customers. Now moving to financial guidance. Our third quarter 22 financial guidance we provided today includes our current forecasted business mix and our assumptions related to the expected continued impact of employee absenteeism, challenges related to obtaining and retaining qualified personnel, supply chain disruptions, inflation, and related expected costs and price increases and other COVID-19 related items that have, are currently, and expected to continue to impact the industry and Kratos. Throughout the first half of the year, Kratos experienced a significant increase in the intensity and effects of COVID-19 and the related impact to our employees, absenteeism, consultants, vendors, suppliers, customers, et cetera, which impact included loss of weeks of manufacturing and production functions in our unmanned system C5ISR and microwave products businesses. We've assumed that these COVID-19 and supply chain-related impacts to our business, including increased inflationary costs, which significantly impacted our first half 22 operations, will continue to impact the third quarter, with an estimated impact of approximately $10 to $14 million in third quarter revenues and $3 to $5 million of our adjusted EBITDA. We are having some success with certain customers on building in cost and inflation escalators on new bids and new upcoming price options, and we expect to begin seeing certain benefit of these efforts in the fourth quarter of this year. However, since our contract is predominantly fixed price with certain of the contracts under longer period of performance terms, it will take some time to transition the contracts to those with increased pricing. As a result of each of these pricing and inflation factors that we are contractually obligated to absorb and the continued delay of our ability to produce and deliver certain products with the most significant impact to our third quarter forecast, which we had originally expected to significantly improve, we are adjusting our fiscal 22 adjusted EBITDA to 80 to 85 million with the most significant impact to the forecasted third quarter margins with improvements expected in the fourth quarter based upon the projected ramp in new large programs, which includes more recent costs, leverage realized on the SG&A and overhead infrastructure, and a more favorable revenue mix, including more software-based revenues, driven largely by the three new open space programs that Eric mentioned earlier. We are forecasting increased revenues in the third and fourth quarters of this year, with the trajectory increasing in the fourth quarter. We are also adjusting our revenue guidance up to 890 to 930 million to reflect the expected contribution from the SRE acquisition, along with forecasted organic growth driven by our bookings and backlog, offset partially by continued revenue delays caused by supply chain disruptions. The growth expected in the fourth quarter of 22 is largely driven by the forecasted execution and delivery schedules of five new programs, four of which have already been awarded, the three satellite program awards, GBSD, and an expected Valkyrie award from a new customer. In order to maintain our fiscal 22 estimated use from free cash flow estimate of 30 to 40 million, we have adjusted our FY22 capital expenditure plan to mitigate, where possible, the additional uses of working capital that we have expended this year to bolster our inventory levels and advance inventory purchases. Eric?
spk11: Excellent. Thank you, Deanna. We'll turn it back over to the moderator for any questions.
spk04: Thank you. Yes, we now transition to our question and answer session. As a reminder to all of our listeners, to ask a question, you'll need to press star 1-1, that's star and the numbers 1-1 on your telephone, and wait for your name to be announced. Please stand by while we compile the Q&A roster. Our first question comes from the line of Michael Charmoly of Truist Securities. Your line is now open, Michael.
spk07: Hey, good evening, guys. Thanks for taking the questions. Eric, just on the guidance, I guess, two questions. For the current year, you've got this bigger fourth quarter. How are you contemplating or thinking about a continuing resolution? And then even just in the – it seems pretty early to be talking about 23, given the range of unknowns and supply chain. Are you thinking it takes – you know, some time for supply chain to normal out and just, you know, I guess you're, you're calling that 10% of base case, but just, just maybe more thoughts on why throwing out that number now.
spk11: Right. On the, on the first one, Michael, we, our fourth quarter is substantially all in 2022 or prior year money. So there's very little that's on the 23 in there, very little. Okay. Okay. On the putting out a number relative to next year, as Deanna kind of sort of went through, you know, big, big drivers we have are Sentinel, which is under contract, and we've got the work plan laid out through at least 23. the big space awards that we've won. Our target drone production schedules, primarily with the Air Force and the Navy, they're pretty much laid down out for the next 18 months. So we believe we have pretty good visibility and we understand the pricing and cost elements in those. And as I went through, certain of those are new. And so there have been inflationary factors built into them. So we feel pretty comfortable. The primary risk we have right now is hiring the people operationally, Mike. That is absolutely the primary risk. It's not winning new business. We're winning a lot of business, and we're going to win a lot more in the next few months than we know. But hiring these people, particularly with security clearances, and not just engineers, manufacturing people that have security clearances on some of these programs we've won. That's where we've got to stay focused to achieve the top line.
spk07: Got it. Okay, perfect. Thanks. I'll jump back in the queue. Okay.
spk04: Okay, yes, our next question comes from Mike Crawford from B. Riley Securities. Go ahead, Mike, your line is open.
spk09: Thank you. Eric, with Skyboard looking near a lock, become a program, a record in the next budget, what does that specifically mean for Valkyrie? And the answer to that is, what about these other myriad platforms that you've been developing over the years, ranging from Sanitos on down. Thanks.
spk11: Right. Right now, Mike, the primary focus of the customer set is on three platforms, and I believe it's because they're mature and they've all been flying for a number of years. It's Valkyrie, Mako, and Airwolf. That is where we are having the most significant activity with customers. And in particular, the past couple of months, I believe, as I said in the prepared remarks, it's, it's in part, maybe a big part being driven by what's going on in the Russian Ukraine war. Um, I saw this just this morning that the Russians alone now have lost over 800 drones, including lots and lots of jet drones. and as are established as the DOD, as I went through, is retiring the Global Hawks for survivability reasons, retiring JSTARS. You've seen the discussion around the Reaper, which is excellent in asymmetric warfare, as we just saw recently, but survivability is not so much. My opinion is the customer focus on Valkyrie right now, Mako, and Airwolf is because they're flying, they've proven, they've They've exercised things, they've deployed things, and that's where the focus is now. That's where the money is.
spk09: Okay. And of course those are, you know, a treatable, expectable and disposable platform. So it's good to have the whole mix there. And I guess maybe air wolf being runway independent, is that what gives it a leg up over say gremlins?
spk11: Um, yes. And, um, my opinion. The Airwolf is much more survivable, even though it's expendable, than the Gremlins was designed to be. The Airwolf is an incredible high-performance aircraft. It has very interesting characteristics on it, as far as identifying it's even there, versus the Gremlins was not designed for that mission. And that's why I believe survivability to get to the mission area to exercise its mission. Um, it has a leg up on the gremlins.
spk09: And then what about this, uh, down select on the onboard sensing station or your demo Gorgon, uh, project.
spk11: Yep. So that's, uh, we're in, we're in phase one as is the other party and the, uh, The down select or the move to phase two is scheduled for Q4. I think it's October or November. And so we're heads down and we're focused on that. As I did mention, Mike, in the prepared remarks, though, Mike, the nearer term opportunity for meaningful revenue and profit margin increases for our company right now is in Valkyrie, Mako, and Airwolf. And we've all been patient. We've waited a long time. We're doing everything we can to pull some of these in now that the geopolitical position has changed. That's where our focus is primarily.
spk09: Just the last question on unmanned systems. So with the growth and the targets and then these opportunities, Is your Oklahoma facility like highly underutilized now or that's one place you need to staff up or exactly how are you going to go about this operationally?
spk11: Yep. So that is absolutely an area where we are staffing up and we are staffing up. We need to staff up. We're looking at executing the next option to expand the facility once again. We're going to probably make that decision by the end of this year, similar to we're going to make the decision I don't think it's going to be any later than the end of this year that we're going to begin the next lot. I'll call it lot number twos of the Valkyries. That all ties together. And that's where we're going to get leverage on the margins going forward, of course, as we continue to fill up that facility. And, Mike, it's primarily Valkyries and Air Wolves right now and one other program that we just haven't talked about.
spk09: Okay, thanks. And then final question, switching gears, just relating to open space. Okay. there you you uh you have the the software or virtual uh you know commercial platform but there are others that have their own proprietary platforms that may be interoperable and do you see those as um alternatives for the customers you're going after are those just customers that are kind of that you're locked out from um maybe assisting
spk11: Yeah, if you could see me, I'm smiling, because that's the exact dynamic we're going after. What you just mentioned is the legacy traditional model that's vendor-locked, that the operators, like the U.S. Air Force and Intelsat, they can't stand it, because they're vendor-locked into dedicated ground equipment for those satellites, where open space is open, and it's open architecture, and it's software, And as I think I talked about on the last call, these new operators, these new constellations that have software-defined satellites that are mega-capable, this is greenfield for us, and that is our primary target opportunity market. We are not looking to displace anybody on an existing 20-year constellation. We're going after the new stuff, and there's a lot of them national security-wise. and commercially.
spk09: All right. Thank you, Eric.
spk11: Yep.
spk04: Okay. Next up, we have Ken Herbert from RBC Capital Markets. Ken, your line is live.
spk03: Yeah. Hi. Good afternoon, Eric and Deanna. Hi, Ken.
spk11: Hi, Ken.
spk03: Hey, Eric, I just wanted to first start off with the with the wins on the open space, the three large programs and the contracts you called out. What is it considering the size of the opportunity there? What can you quantify what you expect to be sort of the revenue impact in the back half of this year as they ramp or I guess more importantly, maybe in 2023 in particular? And how do they factor into the the expected double digit growth next year?
spk00: Ken, this is Deanna. So obviously we're not giving any guidance on 23 at this point, but the ramp in the second half, we would expect a portion of that in the third quarter and then a more significant ramp in the fourth quarter. And remember, a lot of these are license-based, so it'll be a much more favorable mix from a margin perspective.
spk11: And, Ken, your question kind of dovetails into Mr. Trimali's question on why we're given our initial thoughts on growth rate between 22 and 23. With these contract wins and those are bolted in, obviously they give us pretty good visibility into our space and satellite business, our company's largest in 23, which is a layer of comfort of what we're looking at next year.
spk03: Okay. Okay. No, that's helpful. And I guess considering the risks around – not only this year, but next year when you look at hiring, what operationally, Eric, what are you doing differently maybe now to try and accelerate that to the extent to which you can? I know you're in obviously different parts of the country, but what levers do you have to pull besides just salary perhaps as you look at addressing that issue? Because it's an issue obviously across the industry, and so it seems to be phenomenally competitive for talent right now. So how How can you maybe accelerate that or differentiate yourself there?
spk11: Yep. And so it's different in certain of our different business areas. So let me tell you what I mean. In our unmanned area, we're finding it much easier to bring people in because they like the work and it's exciting. And they get to work on a new airplane every couple or every three years. They're not like stuck on the B-2 bomber for 30 years. Okay? So there's that group and we're having – Better success in that area. We're also having better success in the hypersonic area because that's exciting. That's exciting work. It's interesting stuff. There aren't very many people doing it, et cetera. In our C5ISR business, that's different. We're also having better success in the hypersonic area because that's exciting. That's exciting work. It's interesting stuff. There aren't very many people doing it, et cetera. In our C5ISR business, that's different. That is very challenging where you have these very skilled machinists that work on all types of exotic and unique materials to build weapon systems and platforms and there's an incredible demand for that in the industry right now as the entire industry is ramping up and doing the pivot away from the war on terrorists to protecting against the peer threats. That's very difficult, and that is money, and it's trying to take people from other companies, if we can, through relationships. We have referral programs that we've rolled out. We're doing that. We've got mentorship programs that we've rolled out. And, Deanna, what's the name of the programs with the colleges?
spk00: It's both high school and colleges, internships.
spk11: Internships, where we're training, internship programs. But, Ken, that is a challenging area, very challenging.
spk03: I appreciate that. And just maybe remind us what percent of your overall contract mix is revenue recognized on a percent complete basis, or maybe what could be the risk of incremental delays on those contracts based on your ability to get people in the door?
spk00: Yeah, I don't have the percent complete as far as what the total percentage is, but our fixed price contracts are 72%, and I would say a substantial majority of those are on cost over cost percent complete. There is a portion that's on units delivered, and that's primarily from an international contract perspective. So I would say the vast majority of that 72% is percent complete. Perfect.
spk03: All right. Thanks, Deanna.
spk00: Sure. Thanks.
spk04: Okay. Next up, we have Josh Sullivan from the Benchmark Company. Josh, your line is live. Hey, good evening. Evening, sir.
spk12: Just the lack of mill capacity for Kratos products, and I think you mentioned carbon fiber and aluminum antennas issues as well. What's the visibility on these issues? Are lead times improving? Are they still going out at this point? And then are you having any issues with smaller suppliers facing any financial viability issues?
spk11: Yep. On the aluminum and castings, it has not improved at all for us. And you can imagine both aerospace and defense, the demand that's going on there. So that is not good. On the composite side and certain resins in that area, Josh, it's become challenging. We are reaching out not only to the supply base, to other companies that do composite structures that we have great relationships with, and we're having some luck with some of those that have a significant amount of inventory available. We just hit it with somebody, a company you know very well, last week where we got some. So that's choppy. I don't expect that one to get worse, but it's choppy. Josh, what was the third part of the question?
spk13: Are you having any issues with smaller suppliers facing any financing issues?
spk11: Knock on wood. We have not had any to date, but that is an area where our team routinely is doing the due diligence and the checks, the financial reviews of them routinely. And the corporate team here, we go through that with the divisional teams monthly. So we're trying to stay on top of it. We have not run into any issues to date.
spk12: And then on the $50 million low-cost jet engine development contract, what are some of the timeline issues there or timelines and maybe milestones you're looking for?
spk11: Right. So the timeline, we've already received the initial funding of several millions of dollars, so we're off and running. In my opinion, this effort here by the AFRL, it's directly related to programs like Golden Horde and swarming munitions that need very small, low life, which means low-cost turbojet engines for missiles and powered munitions and things like that. So we're off and running with that. I expect that to ramp up between now and the end of the year, and then that's going to be a significant contributor next year. And I'm not going to be surprised, Josh, if we don't see more of those coming our way as a result of all of the new missile systems, weapon systems, powered munitions, drones that are on the drawing border that are coming online. Let me be specific on that. And I'm just talking generally here. You've seen Lockheed Martin. They've talked about Speed Racer. As you know, we're on that one. They rolled out just a couple weeks ago a whole new family of small aircraft that they're planning on bringing out in the next few years. They announced that a couple weeks ago. That is perfect ground for Kratos Turbine Technologies in our engine business. Northrop Grumman, they announced a couple weeks ago or a month ago that they're working on a jet-powered loitering munition that can get there very quickly. That's another area that's right up the sweet spot of that contract and other efforts we have going. So I see a lot of inertia in this area that ties into the thesis we've been talking about for a while and today. Quantities have a quality all their own and affordable mass. And that's where I think the requirements are heading.
spk12: Thank you for the time.
spk04: Okay. Okay. Next up, we've got Austin Moeller from Canaccord Genuity. Austin, you are live.
spk14: Good afternoon, Eric and Deanna. Good afternoon. Good afternoon, sir. So my first question here, you know, it looks like the Valkyrie is, you know, in the process of ramping here right now. So I assume you guys must feel pretty good about this. You know, you've got Multiple service branches that are looking at or committing to purchase the aircraft now, and the closest competitors, Boeing's VAS is way behind in development relative to the Valkyrie, and General Atomics' Gambit is even further behind them. And then the other proposed UCAS that are sort of in development, a lot of them are flying wings, which is useless in air-to-air combat. If we think about that next production lot, can you sort of talk about directionally how many we should expect quantity-wise compared to the existing lot?
spk11: Yeah. Not yet, but over the next several weeks and couple of months, we have a number of meetings scheduled with these potential customers and certain existing customers to talk exactly about this. Austin, if things go as I currently see them, I'm hopeful, and I put the timeline out there by the end of the year, I'm hopeful by the end of September, October, we're going to have the data points and we're going to have received certain things that are going to give us the confidence to pull the trigger, order the engines and the long leads, and get going on the next lot. And to give you a data point on this, Austin, to kind of frame it for you, and these are by memory, so they may be off, but Austin, they're close. On the engines, we get price breaks on lots. And so like if we order six, we get a price break. If we go to 12, we get a price break. If we go to 18 or 24, we get an even bigger price break, which drives it lower. So it's going to probably be somewhere, and don't use those numbers, but it's going to be Partially driven by the price break we get on the engines, which also gives us a quicker slot to get them. And so those are the dynamics that we're thinking through with the customers and the prospective customers.
spk14: Okay, that's helpful. And then if we think about all the inflation that's going on, Should we still expect the Valkyries, and I know it's lot dependent, but should we expect them sort of around a $5 million price point or closer to $10 million? I know it's still a step function below whatever the next competing drone is going to be priced at.
spk11: Yeah, I'm glad you asked that question. So as you know, the Air Force's definition of a trittable, is $20 million on down. That's a fully missionized aircraft. The Marine Corps, as you've probably seen, has been talking a lot about attributables, et cetera. Their all-in missionized price point is substantially less than that, okay? I'm going to throw out $10 million, fully missionized. We... because of our target drone business and the quantities that we produce and as you know our tactical drones we use substantially the same composites avionics electronics flight control etc etc etc we're still getting leverage there and a lot of that's made in america so the price increases there haven't been terrible yet we're seeing them but but they haven't been terrible yet so i am very comfortable that we are going to be, for the aircraft and the full mission systems, and I can't get into much more than what I just said on that, we're going to be well within those price points. And, you know, mission systems can be $3 million, $6 million, $8 million. So we are beautifully positioned because of how low cost, I'll use the word the truck, our truck, our flying truck is. And as you alluded to, In my opinion, any of the other players, even if they ever do get anything flying, they can't practically get anywhere near us on price, on cost. They can't do it. They're not designed to do it.
spk14: Okay, that's very helpful. And then just one last, if I could. I think you mentioned in your remarks or earlier commentary that the Airwolf has a – in a radar cross-section that is considered to be interesting to the customer?
spk11: I said that they're hard to identify, is what I said. That's the term I use, and I'll stick with it. They're hard to see, very maneuverable, very hard to hit. That's what I'll use.
spk14: Okay. Thanks for all the color, Eric. Appreciate it. Okay, thanks.
spk04: Okay, next up is Noah from Goldman Sachs. Noah, your line is open. Hello, everyone. Hello.
spk05: Hi.
spk10: Eric, I guess, you know, the key question is, you know, why is 2023 the year that will prove to have had the visibility, the accurate visibility on growing double digits organically? you know, relative to each of the past few years where, you know, I think you came inside of the original guidance range that was an official guidance range each of those years, but they were all described, you know, one or two years in advance as step function years or game changer years or double-digit organic revenue growth years. How can we feel comfortable that this is different?
spk11: I'm glad you asked that because I can clarify and add some meat to what I said. Our 10% base case growth that we're looking year over year, 23 to 22, does not include any significant production of tactical drones. To clarify, it doesn't include it, and if things occur, That's where I said we could substantially beat it. But our base case does not include it. The base case is driven by our space business, target drones, GBSD, which has come online now, and we got that LOI on that microwave program, that quarter-billion-dollar microwave program. We're going to be under contract by the end of the year. And it includes that. Those are some of the biggies. Okay.
spk10: That's helpful. Within the guidance for this year, if I take the full year and then I take the third quarter top line, it implies a sequential revenue growth rate, 4Q over 3Q, that's significantly higher than you've had any time in the recent past. Can you speak to what drives that?
spk00: Yeah, Noah, this is Deanna. So those five programs that we've highlighted, the three space satellite contracts, GBSD, and the new customer that we're expecting to book on Valkyrie, those five contracts comprise about over a $20 million sequential revenue increase from Q3 to Q4. So that's the lion's share of the growth that we're projecting for the fourth quarter. over the third quarter.
spk10: Okay. That's helpful. And Eric, on Valkyrie, you know, why is a new customer kind of seemingly sliding in front of some of the older customers? And you've highlighted in the past the budget dollars for the category of aircraft that have been in the few hundred million dollar range for a few years. Where is that money? Was that not really ever, just not ever obligated onto contract? How do I square where those numbers were for a little while with the lack of orders and the revenue that you've had on the program?
spk11: I will tell you how I square it. When the new Secretary of the Air Force came in, Mr. Kendall, he announced late last year that he was rolling out two new classified drone programs. And the Secretary used the term that all of the other drone programs, or virtually all of the other drone programs to date, would be feeders into these two new programs. In my opinion, a significant amount of the funding on the other programs were feeders into those two new programs. I believe they sucked the air out of the room. I'm not saying that in any way negatively. But as we saw at Farnborough three weeks ago, the Secretary has now canceled one of those two new drone programs, which was the loyal wingman for the B-21 bomber. And I'm paraphrasing now, saying that it would take too long, it would be too far out, and they would be too expensive. So that might change again now. I don't know. So a lot clearly, Noah, as you're pointing out here, buddy, is a lot is happening in the last six, eight months and really in the last four weeks.
spk10: Why? I mean, if they, you know, given their commentary about the desire to have this product, your ability to have it ready to go, right? Is it just not needed imminently so they'd rather figure out exactly what they want to buy before they start buying larger quantities?
spk11: So my opinion, that last part of your statement is what has been going on for the last year or two. They truly wanted to assess and figure out exactly what they wanted, which makes total sense. I totally get it. Things that have changed.
spk10: Do they now know exactly what they want?
spk11: I don't know. I will refer the group here to public statements. There was an incredible interview with a Navy Admiral last week where he specifically talked about the Valkyrie and what that is going to be used for. He talked about it. The The four-star general of Pacific Air Force recently did an interview, and he said, I'm paraphrasing, the only way we can deter China is if I have hundreds or thousands of low-cost affordable jet drones. This is just recently. So I don't know if they've decided, but I know what their narrative is, and I know what has been specifically going on with our company, and we're doing everything we can to respond to them.
spk10: Okay. I appreciate all that. Thanks for taking the questions. Okay.
spk04: Okay, next question comes from Sheila Kayaglu from Jefferies LLC. Sheila, your line is open.
spk08: Thanks so much. Good afternoon, guys. Just on Noah's line of questioning, if we could think about it, Eric, you mentioned the customer potentially coming in in Q4. How do we think about Valkyrie options into 2022? Is it still contributing 100 million? Does it go to 150 and 23? What are the range of options for Valkyrie?
spk11: Yeah. So I'm going to be, as I talked about in the last call and the one before that, I'm going to be very, very conservative. I'm going to assume we continue to execute on RDT&E and S&T money and S&T funds. I'm going to assume that we continue to do demonstration flights of different capabilities, carrying different payloads and different mission packages. And I'm going to assume that we continue to sell or lease a handful or two a year. That's one scenario. You know, the upside scenario. And the data points that support that this could happen are the cancellations of all these other programs. You know, the Mosquito has been canceled. And take a look at some of our competitors have said recently. So the upside scenario is what's going on in the Ukraine. I've talked about the losses of the drones, what we're seeing going on over in the Taiwan Strait as we speak, that a decision is made. to field affordable mass with the capability that we have today that we know is flying and so we uh we we we next year or the year after we we get some significant production runs that's that's how i see it but but i'm focused on the conservative ones okay that sounds good and then um on your 10 baseline for next year potentially
spk08: You know, what are the top three growth drivers of that? One, I would guess, is GBSD. Maybe can you talk about what your top three are?
spk11: Yeah. GBSD. Go ahead, Deanna.
spk00: Yeah, GBSD, the continued ramp of the space programs.
spk11: And there are a couple, three of them.
spk00: Yeah, there's three of those and some of the production in our target drone business as well.
spk08: Okay. And then last question from me. I think you mentioned supporting Rolls-Royce and their B-52 re-engineering. What's your role on the contract, and how do we think of timing of revenue there?
spk11: Yeah. I don't believe that Rolls-Royce has disclosed what we're doing. So let me talk in general about what we do in that area. We are one of the industry leaders, if not the industry leader, in building the ground rigs for jet engines for test and evaluation purposes, all types of testing, all types of evaluation. That is one of our expertise areas. We are an expertise area in the exotic materials that are used in all types of engines. That is another area. area where we are one of the industry leaders. And so those would be the types of areas that a company like Rolls would come to us on. And then on the second part of your question, as you know, we just received that initial contract. It is growing. It's expanding. I can't get into numbers, but it's a big program for us. It's a big program. and it's expected to begin ramping in Q4, and then it'll ramp in Q1, I think, and then it's going to flatten out a little bit because some of the big work we're doing, including materials, is Q4, Q1. Okay, great.
spk08: Thank you so much.
spk11: Yep.
spk04: Okay, next question comes from Peter Arment from Baird. Peter, your line is open.
spk05: Thanks so much. Good afternoon, Eric and Deanna.
spk04: Good afternoon, Eric.
spk05: Hey, on the space business, Deanna mentioned, you know, that a lot of it's in licensing, and so that's obviously less of the top-line story, better on the margin. What do we think about as the margin opportunity when we're looking at space, you know, compared to what you report today?
spk11: Yeah. So it will be different probably for government versus commercial. because there are certain limitations on the government side that there aren't on commercial. But our mid- and long-term view is mid-teens, profit margins for our space business. And the reason I'm saying that is because we're going to more of a software model. So there's significant R&D and continued development on next versions. And I talked about that in my... in my prepared remarks. In addition to that, let me just throw this piece in there. As you know, we build, manufacture, and deliver very sophisticated antennas. Those antennas can have a lower margin than the software side. And the antennas business is very lumpy, depending on the stage of the ground deployment for the base station we're building. And so those can be mid-single digits, not even high single digits, mid-single digits, because it's a hardware type thing and it's really not all that unique. And so one quarter in the space business could be very, very high, but another quarter could be lower because we delivered significant antennas in that one. So think of blended mid-teens.
spk05: Okay, that's helpful. And then just regarding your space business, just, you know, it's your largest business. You know, how long do you expect it to be your largest business? Ultimately, what I'm asking is when do you think unmanned can kind of overtake it?
spk11: In my conservative view, unmanned will not overtake space for the next several years because our space business, Peter, it's ripping. And we may have a tiger by the tail here. We are first to market with the total software-based virtualized ground system. We're two or three years ahead of everybody else. The first three big programs we went for, we won. As I said in my remarks, we're lined up to win some more. And I've gone through on previous calls on why this is such a big differentiator. So in the base case, the space business will continue to be the lead horse. In the upside case, the drone business in a couple, three years could pass it.
spk05: That's helpful. And just related to your drones, just Any updates on fentanyl? We don't hear as much about that recently, so maybe if you could just give us your thoughts there. Thanks.
spk11: Yep. So let me – Peter, I have to answer it this way. Most, if not all, of the previous drone programs have become feeder programs into other programs that are all classified.
spk02: Okay. I get it. Appreciate it, Eric. Yep.
spk04: Okay, and next up is Pete Skibitsky from Alembic Global. Pete, your line is open.
spk01: Hey, good afternoon, guys. Good afternoon. So, guys, pretty solid revenue in the quarter. I want to make sure I understood, Deanna, your comments about the reduction in the operating income guidance. Obviously, you had the $5.5 million charge in the quarter. Is the whole rest of the balance all due to inflation, or were there any other, I don't know, negative EAC adjustments at all that impacted that guidance?
spk00: All due to inflation.
spk11: And primarily in Q3, because... You know, we're substantially firm fixed-price contracts, and we can't pass it on in the existing contracts and the existing price options. So we just eat it.
spk01: And in terms of the recovery, you know, recovering that inflation through the contracts, obviously you have, you know, a positive mix in the fourth quarter, but is it reasonable to assume that first half of 23 you'd still be kind of in process? of repricing your contracts or hopefully about a back half of 23 is when you kind of make up all the inflation that we're seeing this year?
spk11: Yes. Yes, sir. Okay. It's a process as the existing contracts or options, which are typically one or two years priced, transition off and the new negotiated ones or the new wins come in.
spk01: Right. Okay. Okay. And then on the charge, the $5.5 million charge on the training program, does that impact kind of the go-forward revenue from that customer? I think it sounds like maybe international targets, any color you can provide there?
spk00: Yeah, so we have not had any other work with that customer since the original contract of 2011, so it should not impact any future revenue streams.
spk01: Okay, so you haven't generated revenue there for a while on that one? That's correct. I see. Okay, okay. Okay, last one for me, Eric. On OpenSpace, you're winning new contracts, but I feel like I've been hearing about development for a long time, so I just want to make sure I understood this. Is kind of the core development of OpenSpace completed, or is there, you know, do you kind of have to do some bespoke R&D every time you get a new customer? Is that how it works? Can you help me kind of understand the business model there?
spk11: Yeah. So think of it like an operating system, okay? So like on your Apple iPhone, the iOS system. So the operating system for space ground infrastructure is substantially complete, if not complete for the existing customers. R&D now, think of the apps on the operating system. And so the apps, in the space area, think of like modems. They're all hardware right now. All the different types of communication modems that are not just related to satellites that are on drones or aircraft or ships, we're turning them into software. And you can just think about what, instead of having a rack of all types of different modems or communication systems on a drone, now you have just code. Okay? Okay? So the R&D is for, in my example here, is for the apps. And think of it on the operating system. Each customer is probably a little different. So there's some R&D, I'm making this number up, 10% or 15% to modify that operating system for that specific customer. But it's substantially done, as you can see with the program wins.
spk01: Yeah. Okay, that's really helpful. Thanks, guys.
spk11: Yeah.
spk04: Okay. At this time, I'd like to turn it back to Eric DeMarco for closing comments.
spk11: Great. Thank you all for joining us this afternoon and truly for the interest and the questions. We'll circle up with you at the end of Q3. Okay.
spk04: Thank you for your participation in today's conference. This concludes the program and you may disconnect.
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