Kratos Defense & Security Solutions Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
November 2, 2023

There are 12 speakers on the call.

Operator

Good day, and welcome to the Kratos Defense and 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. You will then hear an automated message advising your hand is raised. Please be advised that today's conference is being recorded.

Operator

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

Speaker 1

Thank you. Good afternoon, everyone. Thank you for joining us for the Kratos Defense and 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 The Safe Harbor paragraph is included at the end of today's press release.

Speaker 1

This paragraph emphasizes the major uncertainties and risks inherent in the forward looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, Potential market opportunities, operational outlook and financial guidance during today's call. Today's call will also include a discussion of non GAAP Financial measures as that term is defined in Regulation G. Non GAAP financial measures should not be considered in isolation from or 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.

Speaker 1

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

Speaker 2

Thank you, Marie, and good afternoon. We've recently received additional interest in Kratos from existing and potential new stakeholders. 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 relevant products and software. A 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 Back to our customers.

Speaker 2

Kratos utilizes existing leading edge technology, not yet to be developed leading 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 is 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 Q3 year to date results, Kratos' 2023 transition year of making targeted internal investments in 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.

Speaker 2

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 TTNC, turbines, propulsion, engines, hypersonics and certain other system areas. As we complete 2023, we expect to achieve our forecast 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' 4th quarter financial results in February to provide our detailed 2024 financial guidance to you as we should have additional clarity on both the fiscal 2024 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 2023 base case organic revenue growth and increased EBITDA margins With Q1 2024 similar to prior years being the weakest due to the currently ongoing CRA.

Speaker 2

Kratos' recent program awards and our record backlog and opportunity pipeline, which are driving our demand for qualified personnel, It's 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 point At the right time to address certain of the most mission and time critical national security and commercial market requirements. We currently have 400 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, 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.

Speaker 2

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 uncrewed 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 PAC P program as Kratos was able to announce today. As reported, the Marine Corps partnered with the Office of the Under Secretary of Defense or OSD 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 continue to progress under the Rapid Defense Experimentation Reserve or RADAR program, including as related with the USMC. 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.

Speaker 2

We have now executed Phase 1 of an expected 5 year funded contract initiative with a 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 Q4 a Valkyrie related contract in the tens of 1,000,000 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.

Speaker 2

We have also recently entered discussions with the customer regarding Kratos' Athena tactical drone 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 fuel thousands of attritable autonomous drone systems over the next few years. Similar to the reported completely separate Air Force CCA program, Word 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 Airwolf, Mako, Valkyrie, Thanatos, Athena and others.

Speaker 2

Assuming the fiscal 2024 budget is approved as we expect and the fiscal 2025 NDAA and FIDUP Typically released by the Pentagon in calendar Q1 are also as we expect. Late next year, we 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. FATOS' Ghostworks has also recently been focused on a large new prime program opportunity, which includes the rapid design and build 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.

Speaker 2

We recently acquired Sierra Technical for approximately $25,000,000 in Kratos stock if all earn outs are achieved. Sierra is a long time partner of Kratos and this was a 1 on 1 negotiated stock exchange merger With STS' Husband and Wife Founders, Sierra recently received an approximate $77,000,000 single award contract For 2 Stealth Jet Drone 5th Generation Aerial Target or 5 Gaat Aircraft with an initial period of performance of approximately 3 years and then expected production thereafter. For both competitive and security considerations, I am not going to comment any further on Sierra related to future growth expectations other than to say that Kratos has big plans for the 5 gas Stealth drone and also an additional opportunity Sierra is working on that is highly confidential along with Kratos' Ghostworks. Our primary focus is to successfully execute the 5 gat program and be first to market with the 5th 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.

Speaker 2

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 planes. The Kratos Shield flights are occurring at the Oklahoma Burns Flat facility, which I completely endorse, 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 3 separate Valkyrie variants, A, B and C underway and a 4th variant we are currently considering based on recent 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.

Speaker 2

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 Wyvern test last week. In the space and satellite area, almost every aspect of a satellite ground station 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 beam enabled and other advanced system payloads and laser optical and other capabilities. Kratos' first to market open space 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' Open Space platform is the 1st commercially available fully virtualized Satellite Ground System to achieve MEF 3.0 Carrier Ethernet Certification.

Speaker 2

The MES Carrier Ethernet or CE standard is the same industry standard adopted by global terrestrial and mobile network carriers, Meaning Kratos' open space 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 open space system. The total addressable market opportunity for Kratos' open space 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 For engines, motors and propulsion systems, the time to get successfully designed into the vehicles, munitions and Systems is now with working engines, not unproven start up technology and photo renditions and Kratos is taking advantage of our first to market positioning.

Speaker 2

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 by Kratos' engines. We will also have the same vertical integration with Kratos' Zeus Rocket Motors and our Aranes and Dark Fury Aerial Flyers. Kratos Turbine ShadowWorks development team Has also been working on a separate new class of turbofans, Kratos code named 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.

Speaker 2

The demand for Kratos' turbine products, Technology and Solutions is strong across the portfolio, including in the turbofan, space propulsion, hypersonic and other classified areas. Cajun Arciato works as the 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's 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, where Kratos' Zeus, Aranese, Dark Fury, ARAB 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.

Speaker 2

Levin, The vigilant vibrant exercise is a recent example of 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 Aeronys 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 Sentinel, Patriot, THAAD, Enduring Freedom or IPCIC, Integrated Air and Missile Defense Battle Command or IBCS Short Range Air Defense or SHORAD and many others. Kratos' C5ISR team's 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 The National Security Software Systems and Product Business and Kratos' provide a significant barrier to entry to new or start up potential entrants.

Speaker 2

There are also a number of cross Kratos division programs, including where our C5ISR team and our space, defense, rocket and hypersonic businesses together or 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?

Speaker 3

Thank you, Eric. Good afternoon. As we've included a detailed summary of the Q3 financial performance as well as the Q4 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 Q3 were 274 $6,000,000 up from $28,600,000 in the Q3 of 2022, reflecting a 20.1 percent organic increase.

Speaker 3

Revenues came in above our forecasted range of $240,000,000 to $260,000,000 with organic growth in our Space and Satellite, Turbine Technologies, Microwave Products, CPIBISR, Training Solutions and Unmanned Systems Businesses. Our KGS and Unmanned Systems segments grew organically 22% 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 17 $700,000 from the 2nd quarter. Consolidated days sales outstanding continued to improve From 120 days in the 2nd quarter to 117 days in the 3rd quarter, with the increase in receivable balance in the 3rd quarter of $8,000,000 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 $3,700,000 Inventories for the quarter, representing a reduced pace from the first half of twenty twenty three with the total use of working capital for the 9 months $23,700,000 related to increased inventory levels.

Speaker 3

Free cash flow used from operations was $14,300,000 after funding Capital expenditures of $14,200,000 Our contract mix for the Q3 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 U. S. Government during the quarter were approximately 68%, which include Revenues generated from contracts with the DoD, Non DoD Federal Government Agencies and SMS contracts and 12% of revenues generated from commercial customers and 20% from foreign customers. Moving on to financial guidance.

Speaker 3

Our Q4 and updated full year 2023 financial guidance we provided today includes our current forecasted business mix and current delivery schedules and or assumptions related to the expected impact of our continued operating challenge related to obtaining and retaining qualified Technical personnel and the related increased costs 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, including increased personnel costs associated with hiring new qualified technical personnel that are currently and 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 twenty twenty three, 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 $16,000,000 to $17,000,000 shifting into 2024. Eric?

Speaker 2

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

Operator

Thank you. At this time, we'll conduct the question and answer session. One moment for our first question. Our first question comes from Seth Seifman with JPMorgan. Your line is open.

Speaker 4

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 Q4 and what's implied with regard to sales and EBITDA margin Versus Q3, what accounts for the step down there in what's usually pretty Seasonally strong quarter.

Speaker 2

Right. 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 1 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.

Speaker 2

That's number 1. Number 2, I mentioned there are a number of new opportunities that we are pursuing where we are incurring very significant bid and proposal, Non recurring 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're also positioning ourselves to go after and win some of these new opportunities.

Speaker 4

Great, great. Thanks. And then maybe when we think about where things are ending up for the year on open space 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.

Speaker 2

Yes, absolutely. Open space, as 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 And as I mentioned, even in the remarks around 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.

Speaker 2

We've got a tiger by the tail. And we're going to hit an inflection point. It's either going to be in late 'twenty my opinion late 'twenty four or 'twenty five. 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.

Speaker 2

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 leader is focused.

Speaker 2

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 2 later than I hoped, all is going to be fine.

Speaker 4

Okay. Very good. Thanks very much.

Speaker 2

Yes.

Operator

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

Speaker 5

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 twenty twenty one, 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?

Speaker 2

We are starting to. We're starting to. But Michael, the costs of labor Continue to be significant, especially in the specialty areas. Think Turbomachinery Engineers, Software engineers and system engineers. And as I mentioned, we have about 400 open reqs On a 3,800 person base, and we're a product company.

Speaker 2

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.

Speaker 2

But it's not going to be for the next few quarters because of the reasons I said. Okay. Got it.

Speaker 5

And then the color on 24% and the 10% growth, can you give us maybe Your underlying assumptions, I know it's hard, but 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 I think you said you didn't really include didn't include any tactical drones in there.

Speaker 2

Yes. So If we 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 no and it's not really the no new contract awards. It's the no new it's No new increases in existing production because we have a number of programs that we're in production on that are ramping.

Speaker 2

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 asked, our C5 ISR business, We are in production on a number of programs and we are entering production on programs like IBCS And SHORE RAD, Sentinel EMD 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 IFPIC 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.

Speaker 2

Our engine business, our turbine business, Michael is doing phenomenally well. That is where a Significant number of those open RECs are and those are programs in space propulsion, Turbofans and turbojets and hypersonic systems and also the big B-fifty 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 Iron Dome. We are on aero.

Speaker 2

You've been reading about these in the paper. We're on the radar. We're on the bird. So our microwave business Is going to continue to be up and to the right significantly. Our Rocket System business, Okay.

Speaker 2

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, our partners, the Primes, like Lockheed Martin, They're another outstanding partner and it was their system that was involved in vigilant Wyvern on the weekend test. They have to be exercised Against target drones and ballistic missile targets.

Speaker 2

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.

Speaker 5

Got it. Got it. Just one other one. The downward revision to cash It sounded like just the working capital to 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.

Speaker 5

What sort of the thought around cash flow?

Speaker 3

Yes. I don't want to comment about next year at this point, Michael, but The milestones, they were about $16,000,000 to $17,000,000 on a small number of projects, They obviously were fairly significant in our training solutions and our modular systems business. We expect to collect those in 2024.

Speaker 5

Okay. Okay.

Speaker 2

Mike, let me give you a little more color on that. I want to We're standing up an engine production line. We're going to be standing that up. It will be done by the middle of next year As we're anticipating going into production on at least one engine. So we're standing that line up.

Speaker 2

We've stood up a new line in the tactical drone area for something. That will be stood up by the end of Q1, middle of Q2. These are for programs that are funded. So we are spending some money to get we've won these programs. We've won development.

Speaker 2

Now they're going into production. We're standing these up and that's going to take some capital as well.

Speaker 6

Got it.

Speaker 3

As well as The second lot of the Valkyrie production that we announced that we started earlier this year. So that will be ongoing throughout 2024 as well. Got it.

Speaker 5

All right. Thanks, guys. I'll jump in the queue. Okay.

Operator

One moment for our next question. Our next question comes from Mike Crawford with B. Riley Securities, your line is open.

Speaker 6

Thank you. And thanks for providing some color on some of these other Drones under development in addition to Valkyrie like Thanatos and Athena. Another one that you won Couple of years ago, AFRL award for the off boarding Sunshi Station, the OBSS contract, So which is the I think the derivative drone out of that is your demo gorgon. Is that one that's still featuring in your plans?

Speaker 2

We are not involved with OBSS at this point, Mike.

Speaker 6

Okay. And you also mentioned the 3 year $77,000,000 5 GAAP I imagine that there's no reason you wouldn't To execute on the same playbook you've used with targets in the past and develop the 5th generation Actual tactical drone out of the 5 gas, is that a process that's already starting or something you're going to decide on next year?

Speaker 2

I'm sorry, Mike. No, I can't comment on that. I'm sorry.

Speaker 6

Okay. That's fine. Just maybe switching gears to OpenSpace. So you're first to market with this virtual Networking solution that goes way beyond just tracking and telemetry and control. Are there any bottlenecks that you see with your solution, be it data radio or something else When you're trying to connect all these disparate networks?

Speaker 2

I don't I do not believe so. The team that the President of that that fills pulled together and created, They're incredible. These are some of the, if not the greatest technologists, Not only in the company, but in the entire industry. And the speed that they have developed OpenSpace to address existing hardware elements on the ground to virtualize them to interface with space, The speed of which they have mastered the technology of the RF or analog signal coming down, converting it to IP, so now it's virtualized and There is an issue Mike relative to what you asked.

Speaker 6

Okay. Thanks, Eric. And then Maybe just, you know what, I'm going to leave it there. Thank you.

Speaker 2

Okay. Thank you.

Operator

One moment for our next question. Our next question comes from Ken Herbert with RBC Capital Markets. Your line is open.

Speaker 7

Hey, good afternoon, Eric and Deanna. Nice results this quarter.

Speaker 2

Good afternoon, sir.

Speaker 7

Hey, Eric, maybe just to start off, I wanted to see if you could level set us on maybe the revenue run rate For the Turbine Technologies business and how much of growth in 2024 can that perhaps contribute? And then maybe more importantly, You've had some nice wins there recently, but can you talk about the pipeline in that business in particular because it sounds like there's it's expanding pretty rapidly?

Speaker 2

Right. So level setting that business, Think of it going from approximately $70,000,000 or $75,000,000 to over $100,000,000 In 24. So that's the type of trajectory that it's on. Programmatically, The big programs are in no particular order, but these are the big ones, are with our partner Rolls Royce on the B-fifty two reengine. I'm not allowed to say the name, but we're involved with companies that are doing lunar landing And maybe beyond the moon, those types of engines, those companies.

Speaker 2

We're involved with agencies for engines for drones and KTT's engines certain of KTT's engines right now are being integrated into drones. All of this I can't talk about other than what I just said. We have the program with Boom. So we're designing a supersonic engine for Boom Supersonic. That's a big one.

Speaker 2

And then we have a number of programs with the Air Force and or the Air Force Research Lab We are working on TurboJetson turbo fans for drones and cruise missiles and loitering munitions. And we are we have a very specialized aspect of that business that's MRO for helicopter engines that is doing phenomenally. If you're designed in on legacy systems right now, There are very few new starts in certain areas, which means the legacy systems have to survive and keep flying for years years. If you're in some of those niches on certain helicopters that we are, that business is very powerful because there are no replacements coming.

Speaker 5

Okay, very helpful. And if

Speaker 7

I could, just one follow-up On sort of the slower pace of EBITDA growth into next year and obviously the margin pressure you talked about From staffing and specifically the specialized people you need, it seems like this has obviously been going on for quite a while as the industry is Going through some pretty substantial growth, how much are you looking at maybe other geographic locations or maybe sort of significantly Changing maybe the where you're recruiting or other maybe approaches to that because it seems like that's clearly Holding you back a little bit, it has for quite a while in terms of some of the opportunities.

Speaker 2

Yes. So on the first part of your question, I want to make sure I clarified that I was clear. In our base case, assuming we get a budget in a reasonable amount of time And we do 10% year over year growth. We're going to expect our EBITDA margins to increase at a greater rate than that. So we're expecting significant EBITDA margin growth.

Speaker 2

I'm saying it's being held back By the cost inputs, including labor.

Speaker 5

Got it.

Speaker 2

Okay. So I want to make sure I'm very clear, okay? We are absolutely we are studying everything that you mentioned, different geographics, Educational areas, technical schools, Mike, this is a supply demand problem. There is Ken, excuse me. Ken, there's no the supply Of qualified people or people that want to get qualified, people that want to get a security clearance, Ken, it's not there.

Speaker 2

And there is a recapitalization of strategic weapon systems occurring for the obvious reasons. And in addition to that, we have new Base companies that are hiring these people because they want to go to Mars or Venus, there's just an incredible demand and there's not enough of them And they're being bid up, which is why we are and now I'm going back to a question Mr. Charmali asked. Ken, I'm really glad you asked this. We are putting a significant amount of money in robotic machinery, 3 d printing, automation.

Speaker 2

We're standing up a center of excellence to produce very, very unique Elements for our engines. We're making significant capital investments to address that we can't get the people, so we're going to automate the heck out of it. I would say we are on the leading edge in the industry, including the big guys on a relative basis, of course, of robotics, 3 d printing, automated manufacturing, we're doing all those things and it's another reason why our CapEx Our other stuff is going to remain up because we're trying to offset the labor issue we have.

Speaker 7

Great, Eric. Appreciate the color and good luck there.

Speaker 2

Yes. Thank you.

Operator

One moment for our next question. Our next question comes from Peter Arment with Baird. Your line is open.

Speaker 8

Yes. Thanks. Good afternoon, Eric and Deanna. Hey, Eric. Good afternoon.

Speaker 8

Where are you in the development of engines for your own drones? Have you I know you had talked about that was one of the areas that you had focused on way back when. But what can you say on that?

Speaker 2

Well, let me so we have now received a contract from a U. S. Government agency, And we are integrating running Kratos engines into certain of our tactical drones and our target drones. We're doing it right now. We're going to be doing that throughout 2024 and hopefully this time next year or shortly thereafter.

Speaker 2

We will be, I believe, the only company in the world totally vertically integrated airframe, Electronics, etcetera and engine with flying aircraft. So we I'm glad Pete, I'm glad you asked. We've made the team has made significant progress. We're under contract. We're integrating Kratos Engines into Kratos Aircraft.

Speaker 8

Yes, that's helpful. That's very nice. And then on just in general on Valkyrie and maybe we'll just focus on Valkyrie.

Speaker 7

Ed, do we do you still anticipate that this is just going

Speaker 8

to be another year of a lot of test flights? I mean, you still continue to be kind of in this lead position, but Just like the Marine program, PAC program, I mean that's a new development and obviously they're going to continue to test flight. How do you see this kind of playing out?

Speaker 2

I learned my lesson in 2019 and 2020. Even when the customers came out publicly and they said we're going to start ordering Valkyries or other Kratos planes in quantity and because of either change in personality at the government or change I'm going to Pete, I'm going to be very cautious. I don't know. But On the optimistic side of the point you made, we are flying with multiple customers right We're the only one flying. We're the only one with aircraft.

Speaker 2

We're doing all types of mission systems, including with artificial intelligence. I believe that this will happen. I mean Replicator, I think, is just another indication. This is going to happen. And we're going to be there when it happens and we're going to participate.

Speaker 2

And I'm sorry, I'm just going to be cautious, brother, on this one.

Speaker 8

Yes. No worries. I figured I'd ask. But on the target side, what Should this business be ramping up further just given all the sort of national security implications that we're seeing on missile defense and other activities? Do you expect that it should be a bigger business in your account?

Speaker 2

Yes. You will see 2024 Will be a significant increase in our unmanned systems revenue, primarily from target drones At multiple customers that are ramping up their utilization and also Pete In our rocket business, ballistic missile targets and other rocket propelled targets, you're going to see a significant increase there. We have the orders In 2024, which again ties into my optimism that we're going to generate the growth we have, our Targets business And obviously, it's because of what's going on geopolitically in the world.

Speaker 7

Makes sense. Thanks for the comments.

Speaker 2

Yes, sir.

Operator

One moment for our next question. Our next question comes from Josh Sullivan with The Benchmark Company. Your line is open.

Speaker 5

Hey, good evening.

Speaker 2

Good evening, sir.

Speaker 5

Hi. Just as far as the Sierra acquisition, how much of the $77,000,000 5 GAC Contract is yet to be consumed as the deal closes here.

Speaker 2

Is yet to be incurred, Yes.

Speaker 5

Yes. Yes, exactly.

Speaker 2

Yes. The vast majority. They received the contract approximately 2 months, 60 days prior to us acquiring them. As I mentioned and as I think you know, we've been partners with Sierra And the family that owns it for a long time. And so the significant majority of that program, We will execute with the Sierra team.

Speaker 6

Got it. And then just as

Speaker 5

far as the new Thanatos Your Athena customer that you mentioned in the opening remarks, are you able to say if that customer is a government service branch or another defense contractor?

Speaker 2

I am not able to say. I am sorry. Got it.

Speaker 5

All right. Thank you for the time.

Speaker 2

All right.

Operator

One moment for our next question. Our next question comes from Joe Gomes with NOBLE Capital. Your line is open.

Speaker 9

Congrats on the quarter and thanks for taking my questions.

Speaker 2

Hey, Joe. Good afternoon.

Speaker 9

Good afternoon. So Eric, you just in the previous question, you were talking about geopolitically. And I was just wondering, on the Great quarter. You just posted, the events that were in Ukraine, is that helping boost The revenues for you guys, have you seen anything material coming from there?

Speaker 2

I can't comment on what we're doing over there. I'm sorry.

Speaker 9

No worries. And then If we put aside the continuing resolution and the labor issues for a moment, What else do you see as kind of the biggest challenges to achieving the growth you're hoping for in 2024?

Speaker 2

Putting aside tactical drones, so just talking our base case And putting aside people, which is number 1, 2 and 3, our operational challenge right now, It's we have to build a lot of stuff. Our space team has to do a lot of software delivery of open space. It's just a lot. We are ramping across the company. And with ramp comes risk and challenge.

Speaker 2

And so just the ramping, we have to get those engine factories set up. We've got to do that. We've got to do it seamlessly, efficiently. We've got to make sure we do it in conjunction with the applicable program office. So just those types of operational execution types of things are the biggest drivers.

Speaker 2

And then I'll say this one, I don't see it being an issue, but I want to mention it. Specifically in our Space business, that's an international business. And they've got some very big well known customers across the globe that are existing customers that we have some large and midsized If those get delayed 2 or 3 months here, 2 or 3 months there, That could move some things out of next year into 2025. That could be a risk too, totally outside of our control, but that kind of stuff happens internationally.

Speaker 9

Right. And one last one for me. On Sierra acquisition, I think they're based at an Airport in California there. And I was wondering, is there opportunities Do some of the same things there as you do in Oklahoma, is that could be a potential additional benefit to that acquisition?

Speaker 2

Joe, that's a great question. The facility is in Atropine and it is actually on the runway. It's on the air base with the hangars. Absolutely, unequivocally, That was a strategic element of our plan here.

Speaker 9

Great. Thanks, Eric. Appreciate it.

Speaker 2

All right. Thank you.

Operator

One moment for our next question. Our next question comes from Pete Skibitski with Alembic Global, your line is open.

Speaker 10

Hey, good afternoon, guys. Eric, can you help me understand the nuances to the extent you're able to on Replicator a little bit more because You mentioned in your remarks Replicator being distinct from Air Force CCA, but I thought Replicator wasn't really Funded program of record, I thought it was more so kind of a, I don't know, a concept or kind of an umbrella program. What's the right way to think about that?

Speaker 2

Right. Replicator is not a program of record. Replicator is an Initiative, that is what Secretary Hicks calls and Hsu, Heidi Hsu, an initiative. It is part of the Office of the Secretary of Defense. It is going to be managed By the Defense Innovation Unit out of Silicon Valley.

Speaker 2

And who is in charge of it, I believe is the Vice Chair of the Joint Chiefs of Staff. That is the ultimate decision maker. I believe that is what has been reported. I believe that Air Force officials have very clearly stated Replicator is completely separate from their CCA program. I believe that's been reported.

Speaker 2

These are 2 Complete initiatives and the I believe it's been publicly reported also that the people involved with Replicator have said They've identified the funding. I know something about this. That's why I'm choosing my words very carefully. They've identified the funding and How they want to deploy thousands of these in the next few years? That's how I would frame it up.

Speaker 2

They've talked about the RADAR funds. I mentioned the RADAR funds, the RDER funds. You should take a look at That's a tidbit that is out there on this. And there are some other ones where you can connect the dots, and I think you can see where the money is coming

Speaker 10

Okay. But I guess most importantly, it's not a program of record, but there's money behind it, which I guess is what matters.

Speaker 2

That is what OSD is saying, absolutely.

Speaker 10

Okay. Okay. Last one for me, just on this power JDAM, I guess your press release was the first time I heard about that. But are we kind of early days in development Of power JDAM and maybe it will be a few years before a production would start. Is that the right way to think about that?

Speaker 2

You can see if you could see me, buddy, I'm smiling ear to ear. I cannot get ahead of our Boeing partner. I cannot. However, we're standing up a production factory, as I mentioned, to do some things, And I'll leave it at that.

Speaker 5

Okay. Fair enough. Thanks so much. Okeydokey.

Operator

One moment for our next question. Our next question comes from Sheila Kahyaoglu with Jefferies. Your line is open.

Speaker 11

Good afternoon, guys. Thank you. I know it was somewhat asked, but I wanted to get into more detail. Eric, can you talk about The tactical drone program showing some of the biggest promise here Valkyrie, Mako and Airwolf. Can you just talk about potential Scenarios for 24 on those 3 programs.

Speaker 2

Yes. The potential scenarios I'm comfortable talking about Sheila as We will continue to work with our customers in test and evaluation And mission development, flights and scenarios. And that is what we Modeled in for 2023 and it worked out and that is what we're going to model in our base case 2024 That we will continue to sell drones, 2 here, 3 there, 4th here for test and evaluation RDT and E and S and T. But no, we will not assume any production until it happens.

Speaker 11

Cool. And then, Thanatos, you had an image in the press release on that one and Athena, I think you brought back, you haven't talked about those 2, I think, since August 2022. So maybe just what brought those back into the fold and just near term milestones there?

Speaker 2

Yes. Good question. Customer interest. That Sheila, That's what it is. It's customer interest and customer funding.

Speaker 2

And as I said, we're In contract negotiationsdiscussions, I'm confident these will turn into contract awards mid next year or so, Confident and then we're going to go fly underfunded contracts.

Speaker 3

Awesome.

Speaker 2

It's a your question is indicative of there's a lot going on and it's accelerating In the low cost and attributable drone area and I believe it's because of what's going on in the world.

Speaker 11

That's great. Thank you, Eric.

Speaker 2

Yes.

Operator

Thank you. That concludes the question and answer session. At this time, I would like to turn it back to Eric DeMarco for closing remarks.

Speaker 2

We appreciate you all joining us this afternoon and your interest and support in the company. And we'll be chatting with you after we close out the year. Thanks.

Operator

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

Powered by Quartr
Earnings Conference Call
Kratos Defense & Security Solutions Q3 2023
00:00 / 00:00