Kratos Defense & Security Solutions, Inc.

Thank you for standing by, and welcome to the Kratos Defense and Security Solutions Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you'll need to press star 1-1 on your telephone. As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Marie Mendoza, Senior Vice President and General Counsel. Please go ahead.

Good afternoon, everyone, and thank you for joining us for the Kratos Defense and Security Solutions Third Quarter 2022 Conference Call. With me today is Eric DiMarco, Kratos' President and Chief Executive Officer, and Deanna Lunn, 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 insurgencies 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.

Thank you, Marie. In the third quarter, Credo successfully executed on what we could control in a continued and increasingly difficult operating environment, generating a 1.1 to 1 book-to-bill ratio, successfully executing a Valkyrie Block 2 flight, and receiving a recent new hypersonic system-related program award, MOC-TB, or Multi-Service Advanced Capability Hypersonic Testbed with our partner Dynetics, both which we were able to announce today. We are currently positioned for additional upcoming milestones and significant contract awards, including another important new hypersonic-related program we hope to announce by the end of this year. and the definitization of an approximate $250 million potential value microwave electronics C2 program award. Additionally, we now expect two new Valkyrie-related tactical drone system contract awards from two separate new customers from multiple aircraft, and we have just recently begun discussions with a potential fourth new customer also from multiple Valkyrie systems. The interest in Kratos' tactical drone systems has recently increased and is gaining momentum, I believe in part due to the ongoing Russia-Ukraine conflict, the heavy use of drones involved, including jet drones, and the reality that quantities do matter, and that Kratos is the only company with affordable, high-performance jet drones flying today, also with active production lines. Since our last report to you, we have also faced challenges. including that we were recently informed that a certain Kratos satellite program related to software products expected to be delivered in 2022 to an existing under-contract government customer have now been delayed to a future period, and we were informed by another under-contract customer that additional funding is now not available for the continuation of a certain non-Valkyrie-related Kratos tactical drone program we have been working on. Both of these were previously forecast as important contributors to our fourth quarter. We also have now determined that as a result of the continuing incredibly tight labor market for qualified machinists, production, and other skilled personnel, including those with security clearances, that we will not achieve by this fiscal year end our previous forecast net increase headcount target required to execute on our backlog and achieve our financial forecast which I discussed on last quarter's call as a key operational and execution imperative. As a result of these issues and considering that the DOD just last week published a letter reiterating that they would not allow companies like Kratos to receive contract price adjustments, requests for equitable adjustments or increases in funding for inflation and related cost growth on our existing contracts, We have reflected the financial impacts of each of these related and other items in today's third quarter financial report and our updated fiscal 2022 forecast, which Deanna will discuss in her remarks. So we've been taking action to address these matters, including we have hired and continue to hire a large number of qualified personnel, which is a top priority across the entire company. additionally over the past several months in our new bids proposals and contracts we are increasing labor and other costs and escalators which are making us more competitive in not only obtaining but also in retaining qualified and trained workers and we have adjusted the organization in certain areas to adjust customer related delays funding and other issues we have taken these actions now in order to position Kratos to continue to compete for and win large new program opportunities, of which there are many, and execute a significant growth trajectory in expanding margins in 2023 and beyond. We remain confident in our mission of being the disruptive technology company in the national security market area, evidenced by our continued success, including having a 1.2 to 1 LTM book-to-bill ratio, as I mentioned, a 1.1 to 1 Q3 book-to-bill, with multiple large new programs both received and ramping, like Mock TB, and having a record combined backlog and opportunity pipeline. Accordingly, we continue to forecast base case full year 2023 over 2022, 10% revenue growth and increased margins, with potential accelerated growth opportunities in the tactical drone, space, satellite, rocket, and hypersonic system areas. Importantly, we have recently begun to see some improvement in the labor market, including technology and other companies now executing layoffs, and Kratos recently having a very successful job in recruiting fare with multiple qualified hires related to a key Kratos manufacturing location. So we believe that we may have seen the bottom here with things starting to turn around in the labor market. Operationally and directly related to Kratos' first-to-market affordable leading technology system and product-based strategy, Kratos remains an industry leader in virtually all of our business areas. We are the industry leader in providing affordable rocket, hypersonic, and other systems to national security customers, including as recently demonstrated by the successful intercept of a Kratos ballistic missile target in the Pacific Dragon 22 exercise. Kratos's proprietary new and first to market Zeus and Aeronis affordable launch and hypersonic systems continue to progress with initial flights with our customers planned for next year, which we anticipate will provide us with new program opportunities in addition to our current family of flight systems and vehicles. We expect Kratos's rocket systems business to be a solid future revenue organic growth driver with increased margins as both the U.S. and our allies increase their exercising and testing of ballistic missile defense, radar, space, satellite, hypersonic, and other systems. Kratos' industry-leading space and satellite business performance, our company's largest, is critical to our forecast organic revenue, profit, and cash flow growth trajectory. and we are currently forecasting approximate 12 to 15% growth for this business in 2023, with significantly expanding margins supported by recent and expected program awards. The thousands of new satellites forecast to be placed into orbit over the coming years, including in LEO, MEO, and GEO, for both national security and commercial missions, are expected to provide a large, rapidly growing market and opportunity set for Kratos and for our proprietary first-to-market open space virtualized suite of C2, TT&C, and other ground system software products. Kratos' C5ISR business is also positioned for future organic growth and expanding margins with key growth drivers including the IFPIC, IBCS, SHORAD, and Sentinel programs. On the Sentinel program, we expect to see a significant ramp in 2023. Kratos' microwave electronics business is similarly positioned for future organic growth, also with expanding margins, with a focus on well-funded mission-critical national security areas, including missile, radar, EW, SEAD, DEAD, and C2 systems, several of which are in production and ramping. Our turbine technologies and engine business had a very strong third quarter, and 2023 also is looking strong. with a focus on drones, missiles, powered munitions, spacecraft, and strategic platforms, including the B-52 re-engine program, which is ramping for Kratos. Kratos' industry-leading target drone business also is very well positioned as the U.S. and our allies recapitalize strategic weapons systems and radars, which need to be tested and their crews trained against the highest performance, most threat representative target drone systems in the world. Those are Kratos targets. Future program drivers in our target drone business include the SSAT program with the U.S. Navy, which achieved full operational capability in Q3 and with full-rate production now expected to continue to ramp. A confidential program that is now expected to transition from low-rate initial production to full-rate production. We have an expected sole source $100 million contract award with the U.S. government agency coming in the next few months. and a number of new expected international contract awards driven in part by the Russian-Ukraine conflict and the expected significant increase in NATO member and U.S. allies' defense budgets. Also in the target drone area, there are currently multiple new programs in solicitation here in the United States that Kratos is pursuing, including NGAT, 5GAT, and T-THREAT, all focused on affordability and innovation to address the increasing global threat profile. As I mentioned, the tactical drone or collaborative combat aircraft CCA opportunity continues to evolve, including the Air Force recently announcing another new classified program initiative, which includes a competitive fly-off in 2024. Multiple recent statements and data points from the Pentagon signal a future with hundreds or thousands of drone systems consisting of several different types with different capabilities and at different cost points. As I mentioned before, Kratos remains the only company with a family of low-cost, expendable, disposable, and attributable drones flying today, also including active manufacturing facilities with each drone that we can publicly talk to you about at price points between approximately $400,000 and $5 million. Being the only company with actual flying aircraft in this drone class, not having PowerPoints or renditions, concepts, or computer models with hoped-for someday delivery dates at guesstimate price points, we believe is a significant advantage for Kratos and to our customers and for the taxpayer. At Kratos, better is the enemy of good enough and also to low cost. As we reported today, Block 2 Kratos Valkyrie production aircraft recently demonstrated extended capabilities by flying longer, higher, at a heavier mission weight and at a longer range than ever before, with the flight achieving a key milestone of the AFRL Autonomous Collaborative Enabling Technologies portfolio. Simply stated, Kratos tactical drones continue to mature and progress. We remain on track to complete the initial Valkyrie 12 production lot next year, And we are in process of deciding on a subsequent Valkyrie serial production run, including as things are definitized with our three new customer opportunities over the next few months. Kratos's Ghostworks had a recent successful test of a new system at the Burns Flat Range Complex, with additional tests of this new system planned over the coming months, and which system we currently hope to be able to unveil publicly next year. We are confident that this new Kratos Ghostworks system will significantly expand both our existing platform capability lead and affordability positioning to our customers and competitively. We believe the macro and geopolitical backdrop for the national security industry is strong and is expected to remain so, including importantly for innovative and disruptive technology and growth companies like Kratos. I also believe that we are at the beginning of a long-term, multi-year recapitalization of strategic weapons systems globally, where quantities, affordable mass, speed, and survivability, as is being demonstrated in the Russian-Ukraine conflict, will matter and where clearly Kratos is uniquely positioned. We are not planning on making any acquisitions. We have successfully competitively bid on and received a number of large new program awards, as I mentioned before. and we expect to receive several more in the coming months it has definitely been challenging the last couple of years with covid supply chain inflation the labor market and other things these issues will pass and kratos is teeing it up and we are ready to go do it with that i'll turn it over to diana thank you eric good afternoon