Kratos Defense & Security Solutions Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2023

There are 11 speakers on the call.

Operator

Welcome to the Kratos Events and Security Solutions Second 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. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Marie Mendoza, Senior Vice President, General Counsel.

Operator

Please go ahead.

Speaker 1

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense and Security Solutions Second 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 Before we begin the substance of today's call, I'd like everyone to please take note of the Safe Harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today's call.

Speaker 1

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.

Speaker 2

Thank you, Marie. Good afternoon. Q2 came in better than forecasted, which provides us additional confidence in achieving our full year 2023 financial objectives, including increased second half profitability as our fixed price and other contract mix continues to improve. We are on plan for 2023 to be a transition year for Kratos, including reduced internally funded investments and increased year over year financial performance. Kratos' largest business, Space and Satellite Communications, which includes our first to market software based open space virtualized C2, TT and C and ground system products momentum continued, including additional new customer awards and several new opportunities we are now pursuing.

Speaker 2

The large number of satellites being launched into LEO, MEO and GEO orbits is providing a macro level catalyst for our satellite business in both the commercial and national security areas. Our open space platform is a representative example of Kratos' strategy of identifying a potential opportunity area, working with the customer, Kratos making the internally funded investment to be first to market with relevant system software and technology. Kratos' internal funding also enables us to own and protect the proprietary intellectual property we develop, which is an important element in protecting our market leadership position. Kratos' open space architecture enables us To address both the commercial and the national security areas, providing us a larger overall total addressable market opportunity and the associated scale, cost leverage and increased potential margins that come with it. We are also invested in and self funded Kratos' owned and operated Global Space Domain Awareness or SDA network.

Speaker 2

Our SDA network monitors the behavior of space based radio frequency or RF signals to identify critical information about satellites and objects In orbit, including their position, maneuvering, health, proximity to other satellites and more fixed and steerable RF sensors and antennas, which are capable of detecting and tracking space vehicles and providing real time data to our customers. It's been recently reported that the U. S. Space Command is currently tracking and monitoring more than 28,000 space objects, of which only approximately 3,500 are acknowledged active satellites with this growing volume of satellites and space objects contributing to Kratos and Space Domain Awareness Market Opportunity. Kratos owned and operated one of a kind global SDA system is a We are differentiating technology based capability of our company and it's one of Kratos' most valuable assets.

Speaker 2

Also providing opportunity for Kratos is that a significant number of new satellites being launched are high throughput, software reconfigurable, Spot beam enabled and more, each of which requires a dynamic on the fly reprogrammable ground infrastructure and capability Like Kratos' open space. Additionally, the customers' increased focus on not being vendor locked to the traditional satellite providers for their ground infrastructure is also providing opportunity for Kratos. The large growing and changing global space and satellite market is providing opportunity for every Kratos division, including individually and working together on programs, which has been a key aspect of Kratos' overall space focused strategic plan. We expect Kratos' Space and Satellite business to be one of our company's fastest growers with forecast future year over year increased revenue, Profit Margins and Cash Flow. Kratos' Engine and Propulsion businesses are also in well funded growing priority areas With macro catalysts including increased demand for hypersonic systems, missiles, drones, powered and loitering munitions, Increased range and power requirements, supersonic and space and satellite related propulsion and launch systems.

Speaker 2

Kratos' Turbine Technologies is a recognized leading technology disruptor in the propulsion field and we are under contract with certain of the most important highest priority well funded and visible systems platforms and programs and initiatives including both in National Security and commercially. Since our last report to you, KTT has reached customer agreement on a potentially very large propulsion system program, which if successful is expected to be an important overall contributor to our company, including a significant financial ramp beginning in 2024 for Kratos. Also since our last report, A KTT space customer, which we are under contract with, successfully received the new Manned Lunar System Program award, which also could be a significant future contributor to Kratos. Related to drone engines, a HASC subcommittee recently requested the Air Force to submit a report on the schedule and plans for funding, development, testing and establishment of high volume manufacturing of Attritable Engine Technologies for CCAs. Kratos' engine businesses are expected to be certain of our fastest future growers and increased margin contributors.

Speaker 2

Kratos' rocket systems in our rocket motor, ballistic missile target, hypersonic and other system business Is also well positioned from a macro catalyst for priority and funding standpoint, including as related to the recapitalization of strategic weapon systems, The hypersonic ecosystem and strategic deterrent systems. Representative of our leadership position since our last report, Kratos' Rocket Systems business successfully launched a new hypersonic payload for a certain customer. Additionally, Kratos' Rocket Systems business successfully conducted the 1st static fire test of the Kratos Zeus 1 solid rocket motor at Aerojet Rocketdyne's Camden, Arkansas facility. Kratos' Zeus family of Rocket Motors is in Direct response to the market need and demand for new affordable solid rocket motors of a particular size, class and nature For launch vehicle stages, hypersonic, ballistic missile target, research and other systems and vehicles And also for Kratos' Erenes and our Dark Fury hypersonic flyers. With the successful test of Kratos' Zeus 1 And the upcoming Zeus II test, we are planning for Kratos' Aranes and Dark Fury hypersonic vehicle flights next year.

Speaker 2

Kratos' Zeus, Airanese and Dark Puri systems are additional examples of Kratos' strategy of proactively working with the user and customer community, Making the internal investment to move fast and be first to market, far ahead of the traditional government funded competitors With affordable relevant product systems and technology to rapidly address the customer needs. As you know it, Kratos' affordability is a technology, and we believe that Kratos' Zeus, Erenes, Dark Fury and other Kratos systems are significantly less costly than any existing or planned future relevant systems. Missile Defense, hypersonics, Testing targets and other vehicles are also certain of the highest priority well funded areas in both the 2024 NDAA and the related fight up. Kratos' industry leading target drone business is also being driven by the recapitalization of strategic weapon systems, including radars, missiles, directed energy, counter drone and other systems, all of which need to be tested and trained against threat representative targets. Kratos is the sole source or primary high performance jet target drone provider to the United States Air Force, Navy, Army, other agencies and numerous international customers.

Speaker 2

Reflective of Pratos' industry leading target drone position, since our last report to you, we have received a $95,000,000 single award contract We are also now awaiting a new target drone system related contract award That we have been informed, we have been successful on with our teammate and our partner. In the tactical drone area, We recently announced that Kratos and Shield AI have teamed up to rapidly integrate Shield's artificial intelligence into Kratos' Valkyrie. The Kratos Shield collaboration is another representative example of Kratos' unique disruptive technology focused business model, which also includes working with venture backed private and commercial entities like Shield to move faster than traditional government contractors and be first to market with relevant systems. We work with a number of smaller technology and software focused companies Like Shield, Peregrine Defense and others, which provide Kratos with access to unique disruptive capabilities. Also in the artificial intelligence area, yesterday, the United States Air Force announced a successful 3 hour sortie Demonstrating the first ever flight of artificial intelligence agents or algorithms controlling Kratos' Valkyrie.

Speaker 2

This mission proved out a multilayer framework on an AIML flown aircraft, Kratos' Valkyrie, and demonstrated the AIML agent The flight On the Eglin test and training complex was the culmination of the previous 2 years of partnership that began with the SkyBoard Vanguard program. AI will be a critical element to future war fighting. It is evolving at an incredible pace And Kratos, the Valkyrie and certain of our other tactical jet drones and other Kratos systems are leaders in relative artificial intelligence enabling areas. The Air Force announcement of AI successfully piloting Kratos' Valkyrie is another publicly available representative milestone of the progress that Kratos' tactical drones continue to make with the customer community. Kratos' Valkyrie progress under the Marines Collaborative Killer Program similarly also continues to progress.

Speaker 2

Since our last report, We have now reached agreement with a new national security related customer for payload and mission system integration into Kratos' Valkyrie. We have recently received the contract. This is a new initiative that is highly confidential and if Kratos and our partner are successful, This program could be a significant contributor for Kratos beginning next year. We have now also reached agreement with an additional new national And we expect to have contract documents definitized with the contracts office by the end of the government fiscal year 2023. We also now expect to receive an additional Valkyrie related customer contract award by the end of this year.

Speaker 2

And Based on the marked 2024 NDAA, we are now hopeful to receive a separate additional largest to date Valkyrie related customer program award next year. We have government customer funded flights with Kratos' We'll jet drones over the next several months, and I encourage you to visit the recently released Air Force Research Lab Future of artificial intelligence dominated air combat video to see Kratos' Valkyrie in flight in action. All of the Valkyries in the AFRL video are actual real drones. They're not computer generated animation, rendition, cartoons or simulations that certain of our competitors like to propagate. We also have flights scheduled for later this year and next with a new customer that is potentially looking for a future purchase of Kratos Valkyries in 2024.

Speaker 2

The Valkyrie production run continues with the most recent data indicated continuing Valkyrie unit cost reductions as we progress through the build and down the learning curve. I am confident based on the customer and competitive information that we have That Kratos' cost points for high performance jet drone aircraft are significantly lower than anything existing, Plans for in PowerPoints that the competition may have. Directly related to cost, A HASC subcommittee has marked the 2024 NDAA specifically stating that there will be 3 categories of drones And not to exceed flyaway cost points. These include expendable at 3,000,000 Attritable, which is my favorite, at $10,000,000 and exquisite at $25,000,000 If this NDA mark is finalized in the 2024 budget, which it is expected to be, then these drone classifications and cost points will become law. As a reminder, Approximate Kratos tactical drone cost points are currently Airwolf or tactical fire jet at $500,000 or less Mako at $2,000,000 or less Valkyrie at $6,500,000 or less, which each of these drones cost which is a $10,000,000 Kratos' Ghostworks continues to work on the new system And we are scheduling a capstone event for this system for either later this year or early next.

Speaker 2

It's going to depend on range availability. We announced today Kratos' newest most capable Valkyrie for the United States Marine Corps will be at the Miramar Air here in San Diego along with several other Kratos high performance jet powered drone aircraft. These will be the actual aircraft that will be at the show. We are planning on producing approximately 150 jet drones all in the United States of America this year, including Targets, Valkyrie, Mako, Airwolf and others. And we are now positioned to double production to approximately 300 drones annually in 18 months, assuming we receive contract award and customer funding.

Speaker 2

We are ready to go now and we are clearly and routinely communicating this to the customer community. As I mentioned before, Kratos' affordability is Technology and maybe better, maybe someday in the future at some hoped for hypothetical price, That's the enemy of good enough and ready to field now and today. We believe that Kratos' approach is particularly relevant in the tactical drone area With the value of affordable mass and quantities having a quality all of their own is clear. Kratos' C5ISR and our microwave business are both positioned for a strong second half of twenty twenty three with the demand for space, Satellite, missile, radar and other systems contributing to the demand for Kratos' products and systems. We've received a large number of new program awards over the past several months and we have a record consolidated backlog and an opportunity pipeline at record.

Speaker 2

Accordingly, we are focused on internal execution, organic growth with forecasted future year The primary operational challenge continues to be obtaining, training and retaining qualified employees and the related high labor costs for these specialized personnel, including those that can obtain national security clearances. These and other items were included in our decision to affirm and not to increase our financial forecast With the potential contribution mix shift between KGS and KUS possible due to potential award and execution timing. In closing, Kratos' priorities include supporting the United States National Security, the U. S. Industrial Base, Science, technology, engineering, math or STEM opportunities for the United States and for Kratos' workers Developing dual commercial national security offerings like Kratos' open space, which drives value for all Kratos' customers And value generation for all Kratos' stakeholders, including the DoD, the Taxpayer Congress, our employees and our investors.

Speaker 2

Deanna?

Speaker 3

Thank you, Eric. Good afternoon. As we have included a detailed summary of the Q2 financial performance as well as the Q3 and full year 2023 financial guidance and the press release we published earlier today. I will focus on the highlights in my remarks today. Revenues for the Q2 were $256,900,000 up from $224,200,000 in the Q2 of 'twenty two, reflecting a 14.6% increase.

Speaker 3

Revenues came in above our forecasted range of $230,000,000 to 240,000,000 And most of our KGS businesses with the most notable increases in our Space and Satellite Turbine Technologies, Microwave Products and C5ISR Businesses. Excluding the impact of the SRE acquisition, which contributed 13 point $1,000,000 in revenues in the Q2 of 2023 as compared to $4,100,000 in the Q2 of 2022. Kratos' consolidated revenues grew organically 10.7%, including a 17.1% Organic revenue growth rate in our KGS segment with organic growth across all businesses within KGS. Cash flows generated from operations for the quarter of $23,600,000 included cash collects revenue growth and continued advanced purchases of inventory in an effort to mitigate potential supply chain disruptions and delays. Also included in our working capital uses are continued internal investments of approximately $3,000,000 related to non recurring engineering costs to complete new rocket systems and hypersonic and related products, including for Kratos' Zeus, Aranes and Darkfury Systems and continued development of certain software products supporting our OpenSpace platform.

Speaker 3

Free cash flow generated from operations was $20,700,000 after funding capital expenditures of $11,200,000 and receipt of $8,300,000 of proceeds for Valkyries that were built as capital assets prior to contract award. Our contract mix for the Q2 of 2023 was 67% fixed price, 27% cost plus and 6% time immaterial. Revenues generated from contracts with the U. S. Federal Government during the quarter were approximately 69%, including revenues generated from contracts with the DoD, non DoD federal government agencies and FMS contracts.

Speaker 3

In the Q2 of 2023, we generated 11% of revenues from commercial customers and 20% from foreign customers. We continue to make progress in our hiring and retention of skilled technical labor, including in our C5ISR business with a notable net increase in C5ISR headcount of 37 since the end of last year, including 18 in the 2nd quarter, plus an additional 12 recently clearing the pre hire process. Kratos' overall total increase in consolidated headcount this year is 152 from 3,645 at year end 2022 to 3,797 at the end of the second quarter. Moving on to financial guidance. Our Q3 and affirmed full year 2023 financial guidance We provided today includes our current forecasted business mix and our assumptions related to the expected impact of our continued operating challenge related to obtaining and retaining qualified technical personnel as well as the lingering impact of supply chain disruptions, Inflation and related expected cost and price increases that are currently and expected to continue impacting both the industry and Kratos.

Speaker 3

Our revenue guidance range for the Q3 of 2023 reflects an approximate 5% to 13% organic increase over Based on the current budgetary environment, we are expecting to be in a continuing resolution for the 4th quarter, which is reflected in our affirmation of our full year revenue guidance. Based upon funding, production, delivery and execution schedules, Our Q3 'twenty three revenues are expected to be fairly consistent with the Q2 based upon current production and delivery schedules. We expect margins to expand in the 4th quarter based upon the expected mix of revenues, including new fixed price contracts, which include more recent cost estimates and more software based content. Estimated incremental ramps Production in the second half of twenty twenty three are expected to be driven by a handful of key programs in our Space, Satellite and Training, C5ISR and Unmanned Systems Businesses. Operating cash flows are expected to be stronger in the 4th quarter, driven by the expected expansion in margins and the expected conversion of inventory builds from FY 'twenty two and the first half of twenty twenty three based upon estimated milestone payment schedules.

Speaker 3

Eric?

Speaker 2

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

Operator

Thank you. Our first question comes from Joe Gomes with Noble Capital. Your line is open.

Speaker 4

Hi, good afternoon. This is Joshua Zolfo filling in for Joe Gomes. Just on another call.

Speaker 5

I just wanted to start

Speaker 2

off, congratulations on the quarter, you guys.

Speaker 4

It seems like you hit a nail on the head and even more so with the growth. So I just wanted to start off just actually just kind of going into the growth rate as well. Obviously, you guys thought it's like right around Like 3% or 7% increase over the last quarter and obviously came in over like 15%. So like what was kind of like obviously the big impact behind that large growth?

Speaker 3

Yes. It was organic growth literally in every business unit within KGS across the board. Space satellite training, C5ISR, microwave products, Turbine Technologies and Defense Rocket all across the board.

Speaker 4

Okay, perfect. And so, I just wanted to see, you guys mentioned last quarter that You guys had Enduring Shield was going into kind of LRIP in the back half of 2023. Kind of when Do you guys kind of expect that kind of more towards the 3rd and more towards the 4th?

Speaker 2

Yes. As you know, we're partnered with Dynetics on this and they're the prime. We're building the ground infrastructure for IFPIC and Enduring Freedom. I would speak with them. Things are consistent with where we were previously.

Speaker 2

There have been No changes. We expect to begin sometime in the second half of this year. But I just I don't want to get ahead of the prime. There's nothing wrong here. I just don't want to get I have respect for the chain of command.

Speaker 2

So just circle up with Leidos Dynetics on that for the specific, please.

Speaker 4

Okay. But yes, that'd be fine. And then just lastly, kind of you guys sounded like you guys are really hiring a good People, it seems like well over 100 at least. So has the market been just favorable toward Is that for you guys as well as like it has been retention for those

Operator

employees been extremely positive?

Speaker 2

It's the market for the type of employee we're looking for continues to improve over the past several months. It is still difficult on a cost standpoint. It's very costly, especially for individuals that Want to and will obtain and retain a security clearance. So it's getting better. It's one of the reasons we're feeling better about the business in the second half of this year and 2024, But it's still expensive for people with very specialized capabilities.

Speaker 2

So that's the nature of it right And yes, we have a lot of openings. If we could fill all the openings we have based on our existing backlog And not just the backlog, the programs we have where we're going to get options exercised and it's not in the backlog yet. And we're going to win some big opportunities. As I mentioned, we've been told we've won some and they're going to be coming out soon. We our growth rate organically, which we're Laser focused on could be substantially higher.

Speaker 2

It really could be. But we just can't we can't get the people right now in the industry.

Speaker 4

Okay. And I'll jump back in the queue. But once again, great quarter guys.

Speaker 2

Thank you. Thank you.

Operator

Thank you. One moment for our next question. We have a question from Pete Osterland with Truist Securities. Your line is open.

Speaker 6

Hey, good evening. I'm on for Mike Ciarmoli tonight. Thanks for taking the questions. First of all, I just wanted to ask, given that you maintained Full year outlook after putting up a pretty strong quarter, was there any pull forward in demand versus what you originally expected or any maybe unexpected easing in the Supply chain, just what drove the outperformance versus what you originally expected 2Q to look like?

Speaker 2

Yes, it's not really the supply chain. The supply chain is as expected and it continues to be challenging, All right. Maybe a couple of things move forward a little bit, a couple, but the team is executing very, very well. And as I tried to allude to in my prepared remarks, the fact that Q2 came in better than we had hoped, It gives us higher confidence in the full year because frankly it takes some pressure off of the year. Right now, obviously, you guys if you do the math, At least on the revenue side, Deanna talked, our mix is getting better and better, why margins are going to be up.

Speaker 2

We continue to do $250,000,000 quarters Q3, Q4. We're going to drill our guidance. So there's no ramp. There's no hockey stick. And as Deanna mentioned, as we all know, we're probably going to have We expected that, but what I'm starting to worry about is, is it going to be worse than a continuing resolution?

Speaker 2

Will the government shut down for a period of time? And so we're factoring all those things in where we just don't want to get ahead of ourselves. We have a lot of good things going on here across the We want to deliver on what we say. That's where our heads at.

Speaker 6

Great. That's very helpful. And then, as a follow-up, just as we think about the opportunities internationally for Target drones, have you seen any signs of increased momentum for demand on that front, Either from orders or conversations with potential customers and just how are you thinking about the growth trajectory for that business over the next couple of years?

Speaker 2

Yes. International Target Drone Business is continuing to ramp. It's going to continue to ramp. However, as I think I mentioned on the previous call or 2, the big three target drone Users in the world are the United States Navy, the United States Air Force and the United States Army. Obviously, we have all of them.

Speaker 2

Then there's the U. K. Ministry of Defense. That's our customer too. And then just looking at defense budgets globally, target drone by country drops off precipitously After that.

Speaker 2

So we're going to book and we're going to be able to announce a lot of international target drone wins Over the next several months quarters, but the quantities are nice, but they're not the big needle movers like the U. S. Stuff. They're just not. The award that I mentioned in my prepared remarks that we've been informed we've won And hopefully, it's going to be definitized in the next few weeks.

Speaker 2

That can be a needle mover in 2024 or 2025. And I can't say much more about it, but that's a good one.

Speaker 6

Great. Thanks for taking the question.

Speaker 2

Yes.

Operator

Thank you. We have a question coming from Mike Crawford from B. Riley Securities, your line is open.

Speaker 7

Thank you. Eric, you talked about a new payload and mission integration system customer Potentially for Valkyrie. And I know you have a number of customers within the DoD, maybe Mystery and Defense, but Would you be able to supply Valkyrie, say, to another prime?

Speaker 2

Yes, we would be able to Provide the Valkyrie to another U. S. Prime. There is no prohibition on us doing something like that if the opportunity arose.

Speaker 7

And is that something you would consider to be beneficial given maybe their channels?

Speaker 2

The answer yes, we would definitely consider it. We're going to do what's right for the business and what's right for the shareholder. I model we have multiple models here at Kratos. One of them, it's better to have part of something than all or nothing. And if we could get a big part of something doing something like you're talking about, Instead of taking a high risk and going out alone, we'd weigh those factors and we'd make the decision.

Speaker 2

So the answer is yes.

Speaker 7

Okay. Thank you. And then You talked about a plan and Steve Fenley was actually quoted about this and even further to Double production of drones from the 150 target and tactical aircraft this year So 300 within 18 months. And I know that you have space to do that given the Oklahoma Facility where I think you're on your 2nd Valkyrie production spiral right now, but what will this require from a human capital Standpoint in terms of increased number of employees to execute on that point?

Speaker 2

Right. So Mike Related to that and I did not say this in my remarks, we have acquired an additional autoclave Specifically for Tactical Drones. Our team got an incredible financial deal on it. We've got it and it's going in. On the people side, that is something we're always focusing on.

Speaker 2

Think an additional for what you just framed up and what Steve said and I know what you're talking about. Think another approximate 125 people.

Speaker 7

Okay. Thank you. And then I have one final question. So Your solid rocket motor partner, Aerojet Rocketdyne is now part of L3 Harris. And What if any concessions or assurances do you have We're not half from L3 regarding your ability to continue to get ready access To a merchant supplier of solid rocket motors for some of your vehicles.

Speaker 2

Right. So Obviously, I can't talk about any direct communications that we may or may not have had with anybody you're talking about. However, L3Harris executive leadership immediately upon the close Pledged. This is public. They made a pledge that they're going to invest in the business.

Speaker 2

They're going to be a merchant supplier and someone sent me a letter where they communicated to the Department of Defense That they are not going to play any favorites and they are going to continue to treat us all as equal partners. So that's what my friends at 03 Harris have said publicly To the other part of your question, we of course are very prudent when we're always looking for second sources or backup plans. And that's across the company and across the business and we'll continue to do that including now in the Rocket Motor area.

Speaker 7

Okay. Thank you, Eric. Thanks a lot.

Speaker 2

You're welcome.

Operator

Thank you. We also have a question from Ken Herbert with RBC Capital Markets, your line is open.

Speaker 8

Yes. Hey, Eric. Good afternoon.

Speaker 2

Hey, Ken. Good afternoon.

Speaker 8

Hey, I wanted to start off, congratulations on the AI Valkyrie flight. Coming out of that flight, the Air Force specifically commented that they see direct transferability or applications of This slide in the technology to the CCA program, can you provide any more color on How you see Kratos' involvement in the CCA program playing out, any maybe milestones, incremental milestones we We should be thinking about and specifically how you see the technology sort of risk initially As you look to transfer this into or the Air Force looks to transfer this into CCA amongst other areas in the future?

Speaker 2

Ken, I apologize. I cannot say anything at all about that program. I'm sorry. Okay. I can't do it.

Speaker 8

Okay, fair enough. Can you provide any comments on the test flight and And maybe any of lessons learned in particular or how it completed the flight relative to initial expectations?

Speaker 2

From my perspective, from our perspective, the Valkyrie Absolutely knocked it out of the park over the 3 hour flight. And Our customers continue to applaud the Valkyrie. They applaud the aircraft. Can I mention the video, the Air Force Research Lab video? And you may have had a chance to take a look

Speaker 6

at it. For those of

Speaker 2

you that haven't, I encourage you again to please go take a look at it. It will address and answer a lot of the questions. It's by the government, by the Air Force that Ken is asking that I'm not just not comfortable talking about publicly. Ken, we continue to make incredible progress in the tactical drilling area. As I said about a year ago, I thought everything was going to become more classified and I was going to not be able to talk much anymore and that's where we are, Which is why I'm now wherever I can pointing to or identifying what the government is saying.

Speaker 2

They're not endorsing, but what they're saying To try to keep the investors as up to date as possible. So we're with the U. S. Marine Corps, we're doing great. I know it's out there.

Speaker 2

I saw a public thing out there now. We're involved with the Office of the Secretary of Defense. That's moving forward, obviously, with the Air Force in multiple areas. We feel the government moves on their own timeline. We will not get ahead of ourselves.

Speaker 2

We have a whole family of airplanes flying today. And I mentioned the cost points. I mentioned new stuff. We're ahead of everybody. And our plan is to stay ahead of everybody.

Speaker 2

A very important person said to me in the past couple of weeks, you need to have strategic patience. For those of you who know me, you know that's very difficult, But I'm having to have strategic patience and we will win.

Speaker 8

Okay, perfect. Appreciate that. And if I could maybe just one for Deanna. In the Q2, it looks like working capital, specifically accounts receivable, was a really nice source of cash. The guidance implies Nice inflection in the second half of the year in terms of cash generation.

Speaker 8

Are there was there anything sort of one time in In the quarter, you'd call out around working capital. It was a nice tailwind. And how do we think about maybe the upside for the full year expectations from a cash standpoint?

Speaker 3

Sure. There were some favorable milestones in the 2nd quarter that did accelerate some receipts that we had originally anticipated in the Q3. So that was favorable in the second quarter. In my prepared remarks, I highlighted Q4 where we expect to working capital to be Beneficial as well in the Q4 as based on scheduled milestone payments as well as Our expected conversion of some of the inventory builds that we've been building throughout 2022 and thus far through 2023.

Speaker 8

Perfect. Thank you very much.

Speaker 2

Thank you. You're welcome.

Operator

Thank you. We have a question coming from Seth Seifman with JPMorgan. Your line is open.

Speaker 9

Thanks very much. Good afternoon. And congratulations again on the latest Valkyrie Flight. At the risk of asking a question about something that's difficult to talk about, Just following up on that, maybe hopefully this is high level enough that is something you talk about. When we think about the path forward With Valkyrie and things that need to be developed in order to see demand really ramp up, I assume that some of it is the artificial intelligence capability being developed kind of outside the company.

Speaker 9

When you think about the pace of that and how that happens and how that development Path relates to the demand profile for Valkyrie. How do those two things kind of link together and where are we in that now?

Speaker 2

Right. So Seth, right now, the Valkyrie as a low cost affordable Minimal viable product is ready to go. It's ready to go for certain missions, which is why on the last few calls, including today, I Continue to call out payloads are being integrated, flights are happening, tactically, operationally relevant flights are happening, etcetera. That minimal viable product and minimal is very substantive. I'm sure it's better than anything that any of our adversaries have.

Speaker 2

It's ready to go and I'm noodling on the artificial intelligence With a very robust and proven augmented autonomy system. If you remember, we first Flew manned unmanned teaming in 2015. And that video you can see a manned Harrier, a manned fighters Sending Makos out, deploying things, coming back, etcetera, etcetera. So we've been evolving A robust augmented autonomy system for a number of years. What the Air Force has announced here, what we're doing with Shield, etcetera, This is much more sophisticated.

Speaker 2

This is the artificial intelligence piece. So with those two data points out there, I believe and this is my opinion, we are ready to go with virtually every one of our tactical drones except the newest one. With augmented autonomy systems, we've deployed payloads, we've deployed weapons, we've deployed tactical drones, etcetera, etcetera, etcetera, etcetera. Things are evolving very, very quickly. And I don't I will not speak for any of our customers, But by the announcement the Air Force put out yesterday, some other things that are going to be coming out soon, artificial intelligence is moving ahead rapidly.

Speaker 2

I'm not sure where the customer will step in and say good enough ready to go, could be tomorrow, could be in a month, could be in a year, I don't know. But that's the evolving game field we're in. Does that help?

Speaker 9

Yes, absolutely. Thanks. And then Obviously, another key milestone we saw in the quarter was the Zeus Static TestFlight. It seems, I guess, can you take us through kind of where things go From here and how you see the hypersonics opportunities playing out. I mean, it seems like if we think back Several years ago in terms of where hypersonics was supposed to be big picture for DoD, it seems like Maybe some of that hasn't panned out and maybe some of that is because costs are high.

Speaker 9

And This is something that's moving in a different direction. But when you think about gaining further acceptance of this And what future milestones are kind of how do you think about that?

Speaker 2

Yes. So as I mentioned, Obviously, I can't get into any details. Since our last call, Kratos had a very successful hypersonic launch of a government customer's Vehicle, very successful. Things At least relevant to Kratos in the hypersonic area are moving very, very quickly and it's happening right now. And I believe it's because of our affordability, our low cost, which we've demonstrated with low cost ballistic missile targets, Which is as we all know ballistic missiles go hypersonic speeds when they reenter, it's the maneuverability which we've done before.

Speaker 2

I think low cost is going to win because the customer community wants to test, fail, test, fail, test to get it right Instead of do a test, wait 3 years to figure out what happened and then test again. You can't do that philosophy if they're real expensive. The test fail, test fail. We're very low cost, Which is one of the reasons why, Seth, I believe we were successful with our partner on winning the mock TB program, The Mach TB test bed program, it's a hypersonic test bed program. I can't get into many details, but I anticipate this starting next year is going to be one of our biggest growth drivers.

Speaker 2

And ZEUS 1 and ZEUS 2, In my opinion, our primary reasons why we won in addition to Airanese. Airanese, Don't quote me on this, but it's orders of magnitude. It's like 1 eighth of the cost of what anybody else has. And we're going to fly 1st. And Dark Fury is coming after it.

Speaker 2

And Dark Fury is incredibly capable. And so we're taking the approach here very similar to what we did with the tactical drones. We took proven existing technology, The target drones and we modified it, adapted it and converted it to tactical. So we're taking our ballistic missile target capabilities, our ballistic missile motors, The OREO, the Terrier 1, the Terrier 2, the ARAV, we're using those. We specifically have designed Aerojet is of course building it for us, but we own it, Zeus 1 and Zeus 2.

Speaker 2

And with the flyers, we're going to be, as far as I know, one of the only companies, I think there might be one other that has the stack and the front ends in the world. And Seth, you reminded me of something on that. Next year, we're going to start putting our engines in certain of our target drones. So we are now starting to vertically integrate in the drone area with our own engine. And the engine is about a third of the cost of the bill of materials.

Speaker 2

We're not going to have to pay the gross margin to somebody. So that's going to we're going to be one of the only companies in the world, if not the only one, that builds the aircraft and the engine. And also related to that, we've stood up we're standing up an organization For casting, milling, machining and 3 d printing, the components for our engines. So we're not going to have to go outside and be held up by supply chain anymore. That's going to be up and rolling next year too.

Speaker 2

So I know that's a long answer, but that kind of ties into the vertical integration question you were asking and that's our vision.

Speaker 9

Great. Thanks very much.

Speaker 2

Thank you.

Operator

Thank you. One moment for our next question. We have a question from Sheila Kahyaoglu with Jefferies. Your line is open.

Speaker 10

Thank you. Good afternoon, Eric and Diana. Eric, first off, happy birthday. So I have a few questions for you.

Speaker 2

Thank

Speaker 10

you. So on the budget, you mentioned a few things you're looking for on the unmanned side. What would be two things we should look for in the fiscal 2024 budget when it comes to Kratos?

Speaker 2

I want to name some things that I think you can see. You want to definitely take a look at Target drone, target drone. So look at PEO-two zero eight, program executive office 208 on the United States Navy on their target drones. And so this is unmanned aerial systems and strike where target drones are. They're also going to be doing some other things in there.

Speaker 2

We are heavily involved Take a look at the target drone line of the United States Air Force. You heard me mention in my prepared remarks A lot is going on in the world and so a lot more target drones are going to be needed. So I would take a look at the target drone areas That you'll be able to see and you'll be I think in the narrative under the program element lines, you'll be able to see narrative that's specifically related to Kratos. I think you'll be able to see Under the United States Marine Corps, I think it will be narrative that will call out Attritable aircraft, attritable unmanned aircraft, expeditionary aircraft, that's one to look for too relative to what we're doing with the United States Marine Corps.

Speaker 10

Thank you for that. And then my second question for you is on KGS, Great quarter, grew 17% organically. You called out basically every business area. And you even mentioned like if you had the lever there, you'd be So obviously the budget is not growing 17%. Are you taking share?

Speaker 10

What are some of the key areas where contributed to that growth?

Speaker 2

Yes. So let me handle the programmatic part and then I'll Dan will handle the numbers. We absolutely are taking share. And there were 2 guys in particular we're taking it from. And that's been our plan where They traditional people and legacy people are very hesitant to do anything innovative and come out with any new products Because they don't want to cannibalize what they have existing.

Speaker 2

They don't want to cannibalize it. So they're disincentivized To come up with virtualized software command and control, telemetry, tracking and control, modems, etcetera for space communications. They're just not incentivized to do it because they cannibalize. Well, it takes a disruption Like software defined satellites, high definition satellites, high throughput satellites, etcetera, That needs a whole new generation of ground equipment to give a guy like us an opportunity. And so We're definitely taking share and we intend on continuing to do that.

Speaker 6

Okay. And maybe one last one, unless Diana is going to comment on

Speaker 10

the numbers. 5 years from now, how do you think about The fighter programs, whether it's F-thirty 5, B-twenty 1, NGAD, CCA, FAX,

Speaker 2

Sheila, right after you went through the different platforms, you went the phone went silent And then you came back on. So if you could crisply again, I'm sorry, just what was the question?

Speaker 6

Sorry about that. No, just 5

Speaker 10

years from now, how you About like the biggest fighter program contribution to Kratos. I know you couldn't answer Ken's question, so I'm asking it slightly differently. Yes.

Speaker 2

I'm going to be very aloof on that and I'm going to answer it this way. We are seeing in the Ukraine that quantities matter, especially when it comes to drones. 100, if not thousands of drones are going to be used. Now people are saying, oh, those are propeller planes. And yes, I get that because it's a land war.

Speaker 2

But in the Pacific, Take a look at the recent RAND report that came out last week. And the RAND report specifically laid out That to deter and defend Taiwan against somebody, the best way to do it is to Use 100, if not 1000 of high performance jet drones to give the bad guy a hell of a targeting problem. They have to respect them all They're an incredible threat. So you flip the cost curve on them where they have to fire something more expensive at you than the drone. I also encourage people, 3 Star General Hinote just retired 3 weeks ago.

Speaker 2

Go take a look at his most recent interviews regarding what he sees The drones are going to be needed in the next 3 to 5 years for the Pacific. And so with that as the backdrop, Sheila, I believe that The most important from an aircraft standpoint for Kratos is going to be our tactical jet drones, Specifically in the expendable and the attritable areas and we intend to be one of the leaders there.

Speaker 6

Great. Thank you.

Speaker 2

Yes.

Operator

Thank you. And it looks like our last question comes from John Franz Engelbrecht with Baird. Your line is open.

Speaker 5

Good afternoon, Eric, Zana and Marie. Congrats on a good quarter. I'm on for Peter today.

Speaker 8

Just wanted to

Speaker 5

talk good afternoon. So You mentioned in the release your bid and proposal pipeline of $10,000,000,000 Can you just talk more about the potential for new space awards and Maybe a little bit of information about the adoption of OpenSpace, how that's going with customers?

Speaker 2

Right. If you could see me, I'm first time I'm smiling. Our OpenSpace team is incredible. The technical team, the sales team, the business development team, it's truly incredible. And we have put a tool in their toolbox or an Arrow in their quiver with this first to market software, command and control, TT and C modem system, etcetera, That is the exact right answer at the exact right time for the type of satellites that are going up today.

Speaker 2

We are we have my opinion, we are 3 or 4 years ahead of the competition for some of the reasons I said before. We have extreme high expectations that are being proven out for our satellite and space business. It's our biggest business and it's going to be our I believe it's going to be our fastest growing with incredible margin expansion that we're Starting to see it's going to really take off next year than in 2025 as the software license model under OpenSpace kicks in. And the vendor lock comment that I made in my prepared remarks, the satellite operators Do not want to be vendor locked to the guys that are building the satellites anymore where they're tied into the ground equipment forever.

Speaker 6

They don't

Speaker 2

want that. And so we are the independent merchant supplier of the ground equipment that can interface with the LEOs, MEOs and GEOs. And it's we might have a tiger by the tail here. And I encourage you all, if you haven't, go to Intelsat's website. They've actually put a video on their website of what Kratos' open space is, what it's doing for them, how it's differentiating for them.

Speaker 2

And that will give you an idea of why you hear a giddy up in my step relevant to this. So we're feeling very good And a big part of that pipeline, an important part of that pipeline is space and satellite communications with open space content.

Speaker 5

Perfect. Thank you. Thanks for the detail. And if I could just have a quick follow-up. So there's been some questions about Valkyrie and the ability to scale production, but if we could just return to your comments on the doubling of production and I know We have to assume funding comes in if you want to move from 150 to 300 jet rounds, but can you just touch sort of on Airwolf, Mako And Valkyrie, the lead times that you would experience to Ram production, the difference between that?

Speaker 2

Yes. It's on the Valkyrie right now, it's 12 to 15 months And it's because of the engine. And I'm working on fixing that. And I'm not going to get into too many details on that. But that's the big lead time on the Valkyrie.

Speaker 2

The engine is the long lead time on all of them, but the longest one is the Valkyrie. The other one, I'm going to say, are within 6 months. But that is the long pole in the tent. It's the engine, Which obviously ties right into Kratos' engine strategy and why we have engine businesses and why I'm so optimistic about how good our engine businesses are going to do over the next few years because there is an we were fighting terrorists for 20 or 25 years And range and power, when I say power, it's not thrust, it's electrical power to work all the systems on the drones and the powered munitions wasn't important. Now range is important, power is important, new engines are important and those engines are going to go in the drones.

Speaker 2

That's the plan.

Speaker 5

Perfect. Thank you. I appreciate it. I'll jump back in the queue. Thank

Operator

you. And I'm showing no other questions at this time. I'd like to turn the call back to Eric DeMarco for closing comments.

Speaker 2

Great. Thank you everyone for Joining us, if you have any follow ups other than what we went through, please don't hesitate to shoot Dan or I a note and we'll plan on chatting with you when we report Q3.

Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.

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Earnings Conference Call
Kratos Defense & Security Solutions Q2 2023
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