Kratos Defense & Security Solutions, Inc.
Q2 2019 Earnings Call Transcript

Published: 1 Aug 2019

[Operator:]

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Second Quarter 2019 Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call maybe recorded.I would now like to introduce your host for today’s conference Ms. Marie Mendoza, Senior Vice President and General Counsel. Ms. Mendoza, you may begin.

[Marie Mendoza:]

Thank you. Good afternoon everyone. Thank you for joining us for the Kratos Defense & Security Solutions second quarter 2019 conference call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer.Before we begin the substance of today's call, I'd like everyone to please take note of the safe harbor paragraph that is included at the end of today's press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today's call.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.

[Eric DeMarco:]

Thank you, Marie. Good afternoon. Both our industry and Kratos recently received some very good news with Congress agreeing to a two year budget and debt ceiling agreement, which includes a 2020 and 2021 defense spending of $738 billion and $741 billion respectively. Both increases over the 2019 defense budget of approximately $718 billion. This congressional budget agreement, which we understand has White House support, will hopefully be finalized into law by the end of this calendar year after an expected limited continuing resolution, allowing time for the appropriators to reconcile the bills.This budget agreement once signed in the law positions several large Kratos programs including on our drone business. To begin development, begin initial production or realized increased production, we believe positioning the company for sustained significant future organic growth. Additionally, as a result of the increasing geopolitical threat environment, we could see even higher defense budgets in the future as indicated by the five-year Future Years Defense Program/Plan or FYDP, which was recently released in March of this year.Directly related to increasing defense budgets, the recapitalization of strategic weapon systems to address peer and near-peer threat is accelerating globally and Kratos’ primary business areas of unmanned systems, missile defense, hypersonics, space, microwave electronics and training systems are well positioned to address the U.S. and our allies mission critical national security priorities and requirements. We believe that Kratos has proven ability to rapidly develop, demonstrate and field technology leading systems at an affordable cost is a unique and important competitive differentiator for our company in the eyes of our customers.The DoD wants leading technology and affordable systems right now, not in 10 or 20 years, which we believe is providing nontraditional defense system providers like Kratos with multiple large new opportunities, which is reflected in our growth rate and the continued expansion of our bid and proposal pipeline. In June, the Air Force stated that it is focused on working with smaller companies like Kratos with Kratos specifically being named, which we believe is related to our unique and differentiated capabilities.In the second quarter, the Kratos AFRL XQ-58A Valkyrie unmanned combat aerial system successfully completed the second of five scheduled demonstration flights with all test points in the second flight being achieved. Kratos is partnered with the Air Force research lab to develop Valkyrie to the Low Cost Attritable Strike Demonstrator program, or LCASD, the Air Force’s effort to feel the loyal wingman type drone that can accompany a fighter jet or other combat aircraft in manned/unmanned teams.The Air Force has stated that it is currently looking at incorporating the XQ-58A Valkyrie with manned fighters including specifically the F-35 and the F-15EX as force multiplier augmenters in a manned/unmanned teaming role and there have been public discussions regarding teaming three Kratos Valkyries with an F-35 or an F-15EX. The Air Force has recently announced that the upcoming F-35 Block 4 upgrade and technical three refresh program will include the command, control and communications capability for unmanned/manned teaming with drone systems and it was specifically mentioned that this would include Kratos’ Valkyrie.The Air Force is also planning on adding sensors and weapons to Valkyrie and is looking to insert artificial intelligence in the XQ-58A via the recently announced Skyborg program. As a result, we are now in discussions with a number of companies regarding integrating their weapon systems with the Valkyrie with this being coordinated directly with Kratos’ customers. It was recently reported that the Assistant Secretary of the Air Force for acquisition technology and logistics stated that he hopes to acquire an initial 20 to 30 Valkyries in the near future for further experimentation related to these initiatives and concepts of operations.The Assistant Secretary also reportedly stated that he is looking for the Valkyrie to have a spiraling of development and to become a program of record as soon as fiscal year 2021 which begins next calendar year. It was also just recently reported that the Air Force is looking at Kratos’ Valkyrie and Skyborg to be one of the services new vanguard programs, a concept that was introduced in the 2030 science and technology strategy. The focus of the vanguard program strategy is to transition technology faster from development to the field and to the war fighter. As I believe you can see since the second successful Valkyrie flight momentum for the XQ-58A is building including with potential new customers.One of these potential new customers recently expressed interest in acquiring up to an initial 10 Valkyries in either the fourth quarter of this year or the first half of 2020. This would be an addition to the 20 to 30 Valkyries to potentially be initially acquired by the Air Force customer. Congressional momentum and interest is also increasing with the House of Representatives Committee requesting up to a $50 million funding increase for the Valkyrie in the 2020 defense budget and a Senate committee requesting $100 million Valkyrie funding increase in the 2020 defense budget.These requested Congressional funding increases for the Valkyrie. The ultimate amount of which will be determined via the normal Congressional budgetary reconciliation process are in addition to the in excess of $100 million in funding for the LCASD Valkyrie program we understand is already included in the 2020 defense budget. Accordingly, we believe that we are on track to achieve initial orders of at least 20 to 30 Valkyries by the end of this year or early next year with the expectation of significantly increased future orders in 2020-2021 and for our future program of record.Based on these recent events, information and meetings we have had with the customers over the past few weeks, we have now placed the order for a number of Valkyrie engines under an initial flexible 24 engine unit purchasing framework agreement. The customer related competitive and other considerations, we are limited in what we will say here other than we have now made the initial engine orders, which are a critical long lead item for the Valkyrie that we expect to receive the engines from this initial order beginning in the second half of next year in order to match up with the current Valkyrie manufacturing and production flow expectations and that we plan to order additional engines by the end of this year.This is all consistent with our recent announcement that we will be manufacturing and producing the Valkyrie in our new Oklahoma City facility where we are currently making a significant capital investment in preparation for this production. On the Gremlins program, we have begun delivery of the Gremlin tactical drone UAVs to our prime partner Dynetics for the upcoming initial system demonstration flights. The initial Gremlins system and demonstration flights are scheduled for Q3, Q4 of this year. And once the Gremlin demonstrations are successfully completed, we expect increased momentum and customer and congressional interest for the Gremlin drone similar to what we have experienced with the Valkyrie after its successful demonstration flights.We have recently met with our Dynetics partner and the government customers and we have increased confidence and the ultimate success of the Gremlins program and UAS platform, which Kratos produces. Based on the current demonstration flight schedule, we expect an initial Gremlin order in the first half of 2020 with ultimate timing being driven by the customer and becoming clearer after nominal flight demonstrations. Program Thanatos remains on track. We are currently investing in and building out the required secure program facility and expect it to be complete by the end of this year.We expect Thanatos to give a meaningful financial contribution to Kratos beginning in 2020. On Thanatos assuming successful execution over the approximate 30 months development phase, we now believe the program has the potential to ultimately be as important and significant to Kratos as we currently believe Valkyrie to be. On program F, which is government funded, where Kratos is the prime and our air vehicle is flying today, we remain on track for additional customer sponsored test flights late this year or in the first half of next year where we expect to demonstrate certain mission payload capabilities.Customer interest in program F remains high with one customer now indicating that they currently plan to place an initial order for 100 program F systems once all demonstration flights are successfully completed. We have also delivered to another potential program F customer, a preliminary ROM, or rough order of magnitude estimate, for 1,000 systems to be delivered over an approximate three year period once demonstration flights are complete. We remain highly confident that program F will achieve production status and be fielded in large quantities once the demonstration flights are successfully complete as a result of customer need the mission requirements and the threats we're addressing here.On Spartan, we have now received initial contract funding from our prime partner where Kratos is responsible for the air vehicle and we expect additional clarity on this program path by the end of the year. So on Sparton, we’re under contract. Program ATHENA, which is classified, is also now under contract with system development set to begin later on this year or early next year. Kratos' Ethon ISR/UAS, which is flying today, is under a funded development contract with a government agency, with this program currently expected to be a meaningful financial contributor to Kratos beginning in the second half of 2020 after successfully completing the development program.Program Apollo is now expected to be funded within the next 90 days and we expect to begin significantly executing on this program in 2020. On Kratos' DIU Mako UAS program, we have now received additional funding with this program objective set now expected to be consolidated with Apollo. Accordingly, we will report on this initiative on a combined basis in the future with Apollo. In our last report to you, we had indicated that we expected to potentially have a new Mako customer under contract by the end of this year.This situation has now developed whereby this customer may be interested in Kratos Valkyries instead of the Mako as a result of the successful Valkyrie demonstration flights. We will keep you apprised as this opportunity continues to evolve. As you know, Kratos and AeroVironment recently announced that we have teamed up to demonstrate integrated high performance tactical UAS and tactical missile system capabilities. Simply stated, a Kratos drone will deploy an AeroVironment tactical drone weapon system. We have customer interest in this initiative, which interest has now expanded to two additional potential customers as a result of the community becoming aware of this Kratos AeroVironment initiative and of the potential capabilities of this very affordable and mission capable system.We are currently planning on demonstrating the system either late this year or early next year both well within one year from when we announced this initiative, which also was very favorable to the customer community. On projects A and Z, we recently met with a potential customer and we are now working towards the second half 2020 potential initial contract award. We have now submitted our response to the Skyborg program, RFI. We have met with the customer and we are highly confident that Kratos will ultimately have a significant role in the Skyborg program with our platforms with Kratos Valkyrie and our BQM drones specifically mentioned by the Air Force in the Skyborg program announcement.There was a new classified opportunity that we have been discussing with the government agency called project Omega. We believe that this opportunity has now progressed and that Kratos could potentially receive an initial contract award in Q1, Q2 next year. As I previously mentioned, Kratos has proven ability to rapidly develop, demonstrate and field operationally relevant low cost affordable systems is a key competitive differentiator for our company and one that is highly valued by the customer community.Directly related to Kratos’ positioning, Kratos’ family of high performance jet-powered tactical unmanned aerial drone systems are currently flying today. They are not models. They are not concepts or PowerPoint presentations. As a result, we believe that Kratos has a significant lead in this area and that this is a clear differentiator compared to any of our potential competitors. We are aggressively pressing and taking advantage of our market leading position. We continue to expect significant organic growth from our target drone business with multiple long-term programs under production contracts.These programs include the U.S. Air Force, Navy, Army and other agencies and from a very large multi-year international award we received in 2018 with most of our target drone programs being either sole or single sourced. Under this international award, Kratos’ high performance jet target drone systems recently headlined a war games exercise with the Swedish FMV and a missile firing exercise with the German navy. During this live fire exercise on the open water outside of Härnösand, Sweden, 19 Kratos target drone flights were utilized in both high and low altitude patterns, allowing the German navy to run attack scenarios to test multiple weapon systems. This is just a recent example of Kratos’ target drones exercising state-of-the-art radar, missile and weapon systems capabilities for test, system and crew training and overall operational readiness.Our SSAT BQM-177 program with United States Navy continues to ramp up and in the second quarter Kratos received sole source low rate initial production year three of $25.4 million contract award. A total of 105 BQM-177 target drones are expected to be produced under LRIP 1, 2 and 3. We just recently met with our SSAT Navy customer and the current expectation is for a full rate production contract award to be issued to Kratos in the first half of 2020 and as a result for significant increased production ramping in Kratos’ fiscal 2021.On our U.S. Air Force AFSAT BQM-167 program, in the second quarter Kratos received a $31.8 million sole source contract for production year 15 of the 167 target drone. The production lot year 15, the total number of target drones for lots one through 15 is 482. The ultimate value of Kratos from these target drone contracts are expected to be significantly higher than the published target drone award amounts as a result of related drone payloads, decoys, flares, chaff, spares and other ancillaries required by the systems being awarded under separate contracts.Once in full rate production, these target drone programs have historically been decades long in both production and operations. It was recently reported that both of the United States fifth generation fighters

[Deanna Lund:]

Thank you, Eric. Good afternoon. Kratos’s second quarter 2019 revenues at $187.9 million exceeded our expectations of $175 million to $185 million and increased $36.7 million or 24.3% year-over-year. Excluding the impact of the recently acquired FTT entity, which contributed $17.2 million in revenues. Kratos revenues grew organically 12.9% in the second quarter.Our adjusted EBITDA came in at $19.2 million above our expectation of $16 million to $18 million, primarily driven by a favorable mix of revenues and execution. Kratos’s adjusted EPS of $0.08 per share also exceeded our forecast of $0.05 to $0.07 per share for the quarter.In the second quarter, KGS generated revenues of $145.4 million, up 25.8% from $115.6 million for Q2 2018. Adjusted EBITDA of $15.7 million or 10.8% of revenues, up from $8.4 million in Q2 of 2018 and operating income of $10.7 million, up from $5 million in Q2 2018 which included a $2.8 million of expenses related to a legal settlement.Excluding the impact of the FTT acquisition, KGS revenues grew organically 10.9% year-over-year. Operating income and adjusted EBITDA were impacted by a favorable mix of revenues and leverage on fixed manufacturing, overhead and administrative expenses. Revenues in our unmanned system segment increased 19.4% from $35.6 million in the second quarter of 2018 to $42.5 million and adjusted EBITDA decreased from $3.7 million to $3.5 million in the second quarter of 2019.Our Q2 operating income was $9 million, up from the second quarter of 2018 operating income of $2.6 million. Our adjusted EBITDA for the second quarter is from consolidated continuing operations including net income attributable to non-controlling interest and excludes non-cash stock based compensation costs of $2.8 million, separates related costs of $300,000 and transaction related costs of $600,000.On a GAAP basis net income for the second quarter was $3.9 million, which includes income from discontinued operations of $3 million, resulting from a $3.6 million gain related to the release of an indemnification liability following the lapse of the statute of limitations associated with the potential tax liability that was recorded in 2015 as part of the sale of the company's electronic products division. Net income also includes a tax provision of $2.5 million.Moving on to the balance sheet and liquidity. Our cash balance was $176.2 million at June 30th, at quarter-end we had zero amounts outstanding on our bank-line of credit and $5.7 million of letters of credits outstanding. Debt outstanding was $294.6 million at quarter end and net debt was $118.4 million. Our LTM adjusted EBITDA was $71.4 million with a net leverage ratio of 1.7 to 1.Cash flow generated from continuing operations for the second quarter was $4 million and capital expenditures were $5.8 million including approximately $3.6 million related to the unmanned systems division, primarily reflecting the build-out of the company's new manufacturing facility in Oklahoma.Our DSS or day sales outstanding decreased from 136 to 115 days, due to the contractual milestone payments and long-term delivery contracts in our training solution, modular systems and unmanned systems businesses. The reduction in DSL was one of the primary drivers for the operating cash flow generation for the quarter.Our contract mix for the quarter was 83% generated from fixed price contracts, 12% from cost plus contracts and 5% from time and material contracts. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 71% including revenues generated from contracts with the DoD, non-DoD federal government agencies at FMS or Foreign Military Sales contracts, which were approximately 8%. We generated 11% from commercial customers and 18% from foreign customers. Our book-to-bill ratio for the quarter was 1 to 1 and for the last 12 months was 1.1 to 1. Our bookings were $188 million for the quarter.Today we are providing third quarter revenue guidance if $175 million to $185 million, adjusted EBITDA guidance of $16 million to $18 million, and adjusted EPS guidance of $0.05 to $0.07 per share, and our adjusting the high end of our full-year revenue guidance to $720 million to $740 million and reaffirming our full-year guidance for adjusted EBITDA of $71 million to $77 million.We are also reaffirming our full-year 2019 cash flow from operations guidance of $40 million to $50 million. Capital expenditures of $28 million to $30 million and free cash flow guidance have $10 million to $20 million plus the expected final cash receipt of the routine working capital of the companies divested PSS business of approximately $4 million to $6 million. Approximately $1.4 million of these amounts have been collected through June 30th.We expect capital expenditures to be at elevated levels for 2019 with continued expected significant outlays in Q3 as we make the necessary investments for manufacturing and test equipment for our new Oklahoma facility and a new secured facility of approximately $6 million to $8 million and approximately $4 million to $6 million related to aerial target drones the company plans to manufacture in preparation of fulfilling expected customer requirements. We expect our estimated cash taxes to be approximately $2.5 million to $3.5 million for FY 2019 reflecting the impact of the over $300 million in net operating losses that we have, Eric?

[Eric DeMarco:]

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

[Operator:]

Thank you. [Operator Instructions] Our first question comes from Mike Crawford with B. Riley FBR. You may proceed with your question.

[Mike Crawford:]

Thank you. Just first, quickly the equipment for the new secured facility, that is not in Oklahoma or in the CEI operations in the Sacramento area. Is that somewhere else?

[Eric DeMarco:]

It is…

[Mike Crawford:]

It's somewhere else.

[Eric DeMarco:]

It's not – yes, somewhere else, Mike.

[Mike Crawford:]

Okay, all right, thank you. And then just, Eric, please on hypersonics, I think it would helpful if you could differentiate it into kind of three different sub-components if you could and discuss maybe the possibilities related to like a KTT type of small engine replacement versus what you might be able to do on the suborbital side with your Oriole rockets or just all together as a whole system?

[Eric DeMarco:]

You've got it. So, in our rocket support services business we have exclusive rights, perpetual in nature for a specific solid rocket booster stack that is very well positioned to do – to put hypersonic vehicles in the right place at the right time at the right speed at a very affordable cost. This can include a hypersonic target. This can include testing hypersonic front end. So we do not do the front end, for example, a glide vehicle, but we can put that glide vehicle in the right place at the right spot at the right time with our stack. So that would be in the solid rocket, so the non-air breathing side. In our – in KTT, this would be on the air breathing side. And I just cannot say a lot there other than we are involved in propulsion systems for air breathing hypersonic systems.

[Mike Crawford:]

Okay. Great, thank you very much.

[Eric DeMarco:]

You got it.

[Operator:]

Thank you. And our next question comes from Seth Seifman with JPMorgan. You may proceed with your question.

[Seth Seifman:]

Thanks very much and good afternoon Eric and Deanna. I wonder if you could talk a little bit more at the Saudi training contract, the recompete that's coming up. Can you tell us when it is? And also, you know, to the extent on the recompete that there is any remaining risk for 2019? And what the risk might be for 2020?

[Eric DeMarco:]

Yup. So 2019 is bolted in.

[Seth Seifman:]

Okay.

[Eric DeMarco:]

So the period performance goes through then it's in solicitation right now. Contract award and you heard me talk about some delays, so this is just most recent. Contract award is expected sometime between now and the end of this year, all right. The contract has – I don't want to get too far ahead here. The nature and the scope of the contract vehicle have changed in the recompete. So the future potential exposure is around $25 million to $30 million a year, but margins are significantly reduced.

[Seth Seifman:]

Okay, okay. And then as a follow up, when you talk about the satellite business and how it's evolving. And I think you spoke a little bit about this last quarter and it sounds like maybe it's moved forward even a little bit more. When you think about that business becoming more software oriented and less hardware oriented, what does that mean about the size of it as we think about maybe next year or something like that, the growth rate of it and the profitability?

[Eric DeMarco:]

Yup. So, think of that business right now and this specific satellite product business is being somewhere between $90 million and $100 million in revenue, this specific piece in its current configuration. Think of margin somewhere around 13%, 14%, 15%, all right. I'm looking at that probably on the revenue side year-over-year going forward, 2% to 5% going up, but the margins increasing significantly because it's shifting away to more being software-based, think like a software defined radio.

[Seth Seifman:]

Okay, okay.

[Eric DeMarco:]

Yup. And that's not only for the margins. The modeling is looking very good for future cash flow as well.

[Seth Seifman:]

Excellent. Okay, well, I'll hop back in the queue for now, but thank you very much.

[Eric DeMarco:]

Hope you do.

[Operator:]

Thank you. And our next question comes from Josh Sullivan with Seaport Global. You may proceed with your question.

[Josh Sullivan:]

Hey, good afternoon, Eric and Deanna.

[Eric DeMarco:]

Hi.

[Deanna Lund:]

Hi, Josh.

[Josh Sullivan:]

On the Valkyrie, the 2020 markups in the House and the Senate, the Valkyrie related programs at $150 million, a little over $200 million. It seems to be above the 25 unit assumptions at $3 million a piece. What is that incremental dollar content composed of?

[Eric DeMarco:]

Yes, so I'm going to talk generally, so I don't get ahead of people integrating weapons systems, integrating ISR systems, okay. The cost of sending teams out as they're flying to develop concepts of operations.

[Josh Sullivan:]

Got it.

[Eric DeMarco:]

So it's getting the planes ready very similar to what's been publicly reported. So, these are operationally capable by 2022-2023 and they're with the forces.

[Josh Sullivan:]

And would those be your systems or your electronic packages?

[Eric DeMarco:]

They most likely would not. We very well may be the system integrator which would then increase the sales price per plane up from the current estimate to a higher number of where the prime system integrator. But if we're not the system integrator then either the government or the prime would do the system integrating. There were two models. We're doing both models right now literally.

[Josh Sullivan:]

And then, I guess, related to that, the capacity at the Oklahoma facility for Valkyries program F et cetera, you mentioned the potential next year to have some pretty significant orders. Do you have the capacity to meet those orders? Or are you going need to reach out or engage any other manufacturing partners at this point?

[Eric DeMarco:]

Yup. This is – so as we talked about last time, we've got 100,000 square feet under contract with two additional approximate 100,000 square foot facilities connected to that facility. Autoclaves are going to be up and going in the next few months. We've developed the factory with absolute cutting edge next generation technology manufacturing processes and process flows. So based – if you recall about six months ago we talked about our base case anticipation and then the pie in the sky are the – the stars align case that we had. We can handle a base case scenario over the first couple of three years with what our current plan is. Under stars align case that we would have to increase the build out there.

[Josh Sullivan:]

Okay, got it. And then just one on program F, I think you mentioned a need for thousand units over three years. Can you just talk about the funding status of that? And then just an idea of what the individual ship set value to Kratos might look like?

[Eric DeMarco:]

Yup. So I'm tying into your previous question. If we're the system integrator and we integrate the system and deliver it excluding one element, which I believe the government would integrate, take approximately 500,000 to 600,000 per system. If we deliver the system and then I'm going to use the word payloads are integrated on to the system, I think 300,000 a system.

[Josh Sullivan:]

Got it.

[Eric DeMarco:]

And on the funding question, Josh, I believe as soon as we complete the final demonstration, which is scheduled for Q2 of next year. I believe this will be funded very rapidly because of the requirement and the threat.

[Josh Sullivan:]

Got it. Thank you.

[Eric DeMarco:]

You’re welcome.

[Operator:]

Thank you. And our next question comes from Ken Herbert with Canaccord. You may proceed with your question.

[Ken Herbert:]

Hi, good afternoon, Eric and Deanna.

[Deanna Lund:]

Hi, Ken.

[Ken Herbert:]

Hey, Eric, I just wanted to first ask about the $10 million sort of reduction in the guidance or $20 million at the upper end of the revenue range. Can you just parse out the timing of that relative to some of the mix impact you're seeing? I mean, how should we think about maybe the pieces of that?

[Eric DeMarco:]

Yeah, so, as I said, we had factored – there were three BMD target hypersonic opportunities that we were chasing – we've been chasing from the beginning of the year. And as I said, we had factored timing, we had assumed we would not get all of them, but we had a factored timing. If we get two of them and we get two of them by the first half of the year, we're good. If we get three of them and we get three of them at certain times of the year, we're good or we could even be better off than what we guided to. As I mentioned, one of them we won and – and on this the second one, the large one, I am – it's so frustrating because it's – there were continuing responses with the customer question set. And so, I'm saying between now and the end of the year that will be awarded.It could be awarded imminently. But we're virtually pulling it out and pushing it out to the very end of the year because we're just not – we can't tell what it will be awarded. And the other one, the third one, and this is why we factor things. The third one is most likely move now to 2020 award. So that is the primary reason. Along with that the defunding, we had a solid contract, but we've got customers from time to time defund on the training contract. They defunded the $5 million for the second six months of the year. The profitability that we are seeing in our C5isr business for example on the weapon systems we're working on is phenomenal. The mix is very strong. The software mix in the space business is very, very strong. And we see those trends continuing, which is why we're very comfortable with the EBITDA, the operating income, the EPS and the cash flow. And if we had gotten those – if those other ones that are being awarded where we initially thought we'd really be sitting pretty.

[Ken Herbert:]

Okay, that's very helpful. Thank you. And is there anything contemplated in the fiscal 2019 guidance around Valkyrie in terms of revenues?

[Eric DeMarco:]

Not production.

[Deanna Lund:]

No.

[Eric DeMarco:]

No. We're – not production. We're under the original contract with AFRL and we're going through the flight series, so that that is included in there. And we mentioned late last year, Ken, I think that we had mentioned we had gotten three spirals that are tied directly to the base contract. Those spirals on the development contract are in there, but nothing for production. And so that's an upper – that's an upside if we receive an award.

[Ken Herbert:]

Okay. Okay, that's very helpful. If I could, Deanna, just one final question.

[Deanna Lund:]

Sure.

[Ken Herbert:]

It looks like you've given nice third quarter guidance. If you think about the free cash flow, I know typically you're very strong seasonally. How should we think about that, especially in light of your, I guess, assumption that we have some sort of continuing resolution into the calendar fourth quarter. Do we – is there a risk to things maybe get pushed out of your fiscal fourth quarter? Or how should we think about that?

[Deanna Lund:]

So, for the third quarter, as I had mentioned in my prepared remarks, CapEx is going to continue to be quite elevated and that's going to be our highest CapEx quarter for the year, anywhere probably in the $10 million to $11 million range. So that that will certainly impact our free cash flow. The other piece is going to be the timing of milestones and when we achieve those milestones. Second quarter was very favorable with a number of those milestones being achieved. But as we achieved some of the new ones need to be achieved as well. So the rest of the second half and the timing of the cash flow in Q3 and Q4 is going to depend on the achievement of those milestones. At this point we believe we're going to achieve those milestones that we expected, but that can move sometimes.

[Ken Herbert:]

Okay. So I guess it sounds like even if there is, based on your assumption, some sort of continuing resolution, it doesn't jeopardize the cash flow outlook for the year.

[Deanna Lund:]

It shouldn't. The bigger impact is really from an operational milestone perspective and when we have those milestones.

[Ken Herbert:]

Perfect. Thank you very much.

[Eric DeMarco:]

Sure, thank you.

[Operator:]

Thank you. And our next question comes from Peter Arment with Baird. You may proceed with your question.

[Peter Arment:]

Hey, good afternoon, Eric and Deanna.

[Eric DeMarco:]

Hi, Peter.

[Peter Arment:]

Eric, a question on just R&D and I guess this is more of a response to just what we're seeing in the industry. Get your thoughts on just the step up and requirements in the industry for more internal R&D investments. If I look at your most recent quarter, you're in about 2.5% of sales. Are you feeling, I mean, just given all the opportunities that you have that you're going to have to step that up? Maybe just get some color on that initially.

[Eric DeMarco:]

Sure. And so certain parts of our business require far less R&D than other parts. So, for example, our C5isr business, let's say for this discussion that's about $70 million, just for this discussion. And let's say our training business, another one, there's some R&D in there, but it's less than say our satellite business. Let's say that that's $90 million to $100 million in revenue. We have our traditional legacy services business, which really has no R&D, which is like $50 million to $60 million in revenue. So the major focuses of our R&D are in three spots

[Peter Arment:]

That's very helpful. And just as a follow up, when you look at the government solutions business, it's pretty much split between half services, half products. When you look out just given the opportunities of the growth that you're seeing, is this a segment that's still could easily get into the low double digits for operating margins when you think about the – where defense spending is going? Thanks.

[Eric DeMarco:]

Absolutely. It's going to happen and let me tell you why it's going to happen, okay. Number one, our microwave business, these are my words now. There's a bow wave of good stuff coming in the next year or two. I mean that’s the [indiscernible] program, that's just the beginning. I've read reports. They're looking at 5,000 to 6,000 missiles and again our content is 50,000 a missile. The Gripen fighter, they're in blocks chipset 1 of the100 of them - our content is 250,000 per. We are about to receive very soon a very large order for an upgrade on an F-15 system, on an F-16 system. Then on our satellite business, the shift that's occurring, it's reducing revenue a little bit. The margins are going up. I mean this is moving towards being a software business. And then Peter, the biggie that could be not a trend like I'm talking about, but a step function. If we're successful on this opportunity we're pursuing in the BMD hypersonic area, that's going to be a step function increase in production sales, product sales and margins.

[Peter Arment:]

Appreciate the color, Eric. Thank you.

[Eric DeMarco:]

Got it.

[Operator:]

Thank you. Our next question comes from Noah Poponak with Goldman Sachs. You may proceed with your question.

[Noah Poponak:]

Good afternoon. Good evening.

[Eric DeMarco:]

Good evening.

[Noah Poponak:]

Eric, which tactical programs have pulled to the left to contribute to the end of 2019 that you’d previously didn't think would do so?

[Eric DeMarco:]

Pulled to the left of 2019…

[Noah Poponak:]

No, pulled to the left of what you thought three to six months ago and now contribute to the end of 2019 when you previously didn't think they would.

[Eric DeMarco:]

Oh that contribute to the end of 2019, it really hasn't yet. I mean if we get a Valkyrie god willing a Valkyrie ordered by September 30, the answer to your question would be there is one right there.

[Noah Poponak:]

It sounded like in your prepared remarks like maybe F or ATHENA had. Am I reading that incorrectly?

[Eric DeMarco:]

Those are still – and so they are in development. So, let me be very clear. Program F isn’t the airplane. The vehicle is flying. It is in the test flight phase. And those were assumed – those development revenues were assumed in our guidance.

[Noah Poponak:]

Okay. So it's not like you're – it's not like they're going through development faster and you're getting more development revenues on those programs than you thought you would.

[Eric DeMarco:]

No, no, no.

[Noah Poponak:]

Okay.

[Eric DeMarco:]

Not now, but on the converse to that like Spartan or ATHENA, those are going to be more additive to 2020 than I originally thought because those have been pulled to the left into their occurrence than I thought. I thought they were going to be – I thought we'd get funding in 2020.

[Noah Poponak:]

Right. So those are moving faster. So I'm hearing you correctly that those are moving faster, but they're not contributing to 2019.

[Eric DeMarco:]

Right. That is correct.

[Noah Poponak:]

Okay. Yeah, because I mean where I was kind of going with that is, you know, in your prepared remarks, listing through all of the major opportunities and I totally understand that these are beyond 2019 major movers. It sounded like even if it's the development revenues of things that are still in development that some things were moving to the left a bit. You beat the 1Q revenue guidance. You beat the 2Q revenue guidance where you guide the quarters specifically. You've been telling us you're embedding budget conservatism into the fourth quarter. The budget now looks better than anybody thought it was going to be for the – with this two year deal. And so, I'm just surprised you haven't had enough incremental upper surprises to offset the one thing that slid to not have to lower the guidance.

[Eric DeMarco:]

Well, it's – on the one thing that's slipped. I might – no, I might not have been clear. There are two opportunities in the BMD target and hypersonic area, both of which we expected to be awarded in the first half of the year. In my assumption, I assumed we would win one of those other two.

[Noah Poponak:]

Okay.

[Eric DeMarco:]

Okay, both of those have been pushed out, one of them to the third one. It looks like it's going to be the first quarter of 2020. The other one has been pushed into the second half. As I mentioned, I think, to Ken, it could be imminently awarded, but I'm saying by the end of the year, because now I'm gun shy. I'm just gun shy.

[Noah Poponak:]

Can you just guide those for us?

[Eric DeMarco:]

Okay, so the big one. It could be – it's – again a single award. It could be an incremental $50 million to $75 million a year in revenue beginning next year.

[Noah Poponak:]

Okay.

[Eric DeMarco:]

It could be more than that depending on op-tempo of missions. The third one that has been pushed to 2020 that can be an incremental $25 million to $50 million a year. These are new specifically related to op-tempo of missions.

[Noah Poponak:]

So – and what you lost from the plan, which was the factored versions of that?

[Eric DeMarco:]

Yes.

[Noah Poponak:]

Is what you lost from the factored versions of that more than the $10 million to $20 million depending on how you define it at the high end or the new midpoint of what came out of the revenue guidance such that there were actually some offsets?

[Eric DeMarco:]

And there's one other definitive piece, the de-scoping of that Saudi training contract took $5 million that I had bolt – I had that in hard because you don't expect to get de-scoped. I had that $5 million hard in the second half of the year. That funding is gone. So there's that piece.

[Noah Poponak:]

Okay.

[Eric DeMarco:]

And there's another – this is softer. Approximately $5 million of satellite revenue, $5 million to $7 million that has converted from hardware to software, which were the margins are great. That is also out. And so that that bundle, let's say that that is $20 million. I have offset that $20 million by 2020.

[Noah Poponak:]

Okay, got it.

[Eric DeMarco:]

You know what I mean?

[Noah Poponak:]

Knocked out. Last year there was the DIU program in that split and then there were two services programs that moved around a little bit on you. Are those all now…

[Eric DeMarco:]

Yup…

[Noah Poponak:]

Totally…

[Eric DeMarco:]

Yes, DIU is under contract. The services contract, the services ones, they're under contract. They are absolutely ramping up. The number of bullets are ramping up. They are still not where I thought they would be, okay.

[Noah Poponak:]

Okay, they’re moving.

[Eric DeMarco:]

But they can – absolutely, they’re moving, yes.

[Noah Poponak:]

Okay. Your comment on a new separate customer looking at Valkyrie, I think you said, it’s sounded like you said could buy it in the fourth quarter or is that purely order or is that potentially revenue producing in the fourth quarter?

[Eric DeMarco:]

Okay. So, that's actually an excellent question. So as you know, there are three Valkyries

[Noah Poponak:]

And then, Deanna on the margins, the guidance implies lower margins in the back half versus the first half. Can you just walk us through why that happens?

[Deanna Lund:]

And that's on the mix of what the expectations are on software content versus left software content in the second half.

[Noah Poponak:]

You guys have talked in the past about having this cyber business with software like margins. Did you have that in the first half and it doesn't happen in the second half? Or have you not had that at all and you're not assuming it at all? And it could happen or where – what’s the status of that…

[Deanna Lund:]

We had some in the first time.

[Eric DeMarco:]

Noah, no, I remember our discussion – I remembered, Noah, this discussion with you. We typically don't put in our internal plan for these software sales.

[Noah Poponak:]

Right.

[Eric DeMarco:]

Because they're very hard to predict when the – these are very unique systems. And historically – and this is why in the second half of the year for the past two or three years, our margins we've just – we've just killed it around that federal fiscal year of September 30 either because my opinion, the government, the customer, they want to spend the funds they have are obligated before the next fiscal year. We get significant software sales in Q3 and Q4.

[Noah Poponak:]

Okay. That's going to happen this year.

[Deanna Lund:]

Sure.

[Eric DeMarco:]

Absolutely could historically – at – absolutely could.

[Noah Poponak:]

And it's not in the outlook.

[Eric DeMarco:]

Correct. There's some, but just – but we'd very – we're very conservative on that, which we've demonstrated in prior years.

[Noah Poponak:]

Can you size what you had from that in the first half?

[Eric DeMarco:]

I don't know.

[Noah Poponak:]

That’s okay.

[Deanna Lund:]

No, I don't have that…

[Eric DeMarco:]

Yes, I don't know.

[Noah Poponak:]

Okay. Thanks so much for answering my questions. I appreciate it.

[Eric DeMarco:]

Okay, thank you.

[Operator:]

Thank you. And our next question comes from Joe Gomes with NOBLE Capital. You may proceed with your question.

[Joe Gomes:]

Good afternoon.

[Eric DeMarco:]

Hi, Joe.

[Deanna Lund:]

Good afternoon.

[Joe Gomes:]

You talked a little bit about the exercise with the Swedish FMV and Germany. Has that led to any more or increased interest in your products for them?

[Eric DeMarco:]

Absolutely. We are working on a similar, if not significantly larger exercise next year now. Absolutely, good question. Yep.

[Joe Gomes:]

Okay. And then a couple of quarters ago and that Boeing Australia made their announcement. And I know if you had heard anything or seen anything more on where theirs, ours is – that potentially could be viewed as a competitive to your guys on manned.

[Eric DeMarco:]

So I understand they gave a briefing on that in Washington just yesterday. As you know Joe, it's a concept right now. It’s a model. It rolled out a model.

[Joe Gomes:]

Right.

[Eric DeMarco:]

I'm going to – let me answer at this way. I am extremely comfortable and confident that being one way independent, being able – being less than 30 feet long. There’s just 38 having or our published un-refueled range published is at least 3,000 miles and our price at quantity without payloads of approximately 3 million. I am not worried about that that airplane one bit.

[Joe Gomes:]

Okay, that's great. Thanks.

[Eric DeMarco:]

You got it.

[Operator:]

Thank you. And our next question comes from Michael Ciarmoli with SunTrust. You may proceed with your question.

[Michael Ciarmoli:]

Hey, good evening guys. Thanks for taking the questions. Eric, can we just talk about – I think you said you placed the order for 20 engines and long lead time, you're getting those. I think you said we'd be getting them in the second half. So how should we be thinking about the trajectory of free cash flow as you guys are presumably starting to ramp up production and you're going to have various aircraft and work-in process. Just – how should we think about that? Just given that you've started to order some materials here.

[Eric DeMarco:]

Right. And Michael, I was probably not clear, so I'm glad you asked the clarifying question. We have a – think of it as a single award IDIQ contract we gave to the engine manufacturer that single award IDIQ contract is for 24 engines. We have placed an order for the first 5 to 10 on that single award IDIQ.

[Michael Ciarmoli:]

Okay.

[Eric DeMarco:]

We expect based on our interactions with our customers, et cetera, et cetera, to place another order before this year is out. And then we expect to place another order in either Q1 or Q2 of next year and it's possible Deanna and I on a call could say to you if things happen, we've placed them all in one shot.

[Michael Ciarmoli:]

Okay.

[Eric DeMarco:]

Okay. We have – and I don't want to – okay, we have negotiated. Our customer here has worked with us on very favorable payment terms that we believe will align with receipts we will receive as they're being built.

[Michael Ciarmoli:]

Got it.

[Eric DeMarco:]

Okay. And I know you appreciate why I'm being delicate there.

[Michael Ciarmoli:]

Sure. What about – I mean you gave us sort of the laundry list of the programs, the updates, what – where they stood. It seems like a lot is going to happen in first half 2020 second half 2020. You just – I think to know Noah's question, you just said the BDMs could add $100 million to $125 million alone. Can you give us a sense as you kind of knock down some of these orders, secure them? What is this exact pipeline look like from an order standpoint? Again, just with the varying programs that you've mentioned, the size of them, everything decisions expected to be made late this year, early next year. Can you size the pipeline?

[Eric DeMarco:]

So our published pipeline is $7.6 billion. I can assure you that that number we look at very closely. So that is a very conservative number based on what our divisions are chasing. In that $7.6 billion, Mike, there is zero for Valkyrie production that we're publishing. We're waiting for the first order and better clarity. I'm just giving you an example of the conservatism on this. That $7.6 billion, there are no IDIQs. There were no MACs. There's nothing like that. These are very discreet programs where you can find a program element number in the budget line items, and as you can see over the past few quarters, I don't know how many, it's been increasing. It’s very helpful – it’s probably as healthy right now as it's been since 2011 – Budget Control Act 2011-2012.

[Michael Ciarmoli:]

But can you give us a magnitude if we think about all these decisions, Gremlins, Thanatos, F, Spartan, AETHON, Mako A and Z. Can you size those?

[Eric DeMarco:]

Okay, so between now and say the end of next year, let's go with – let's go with Valkyrie. Based on current information, I think it's going to be 20 to 40, and the 40 is on top of the 10 that the air force mentioned – at the top of the 30 the air force mentioned just to other customer, okay. There are other things happening, but that's where I would put that.On F that’s not in the – there’s a piece. It's not a very big piece in the pipeline. That would be –I would put the 1,000 units in at – let's be conservative but let's say that we are not the system integrator that 300,000 or 400,000 a point over three years.On Gremlins, I'm talking about in the next 18 months. On Gremlins if the test schedule holds and I think in the second half of next year, we could see an initial order for 100 or 200. So you had a million each and although, I know the numbers 700,000, that's in the BCA, but I believe initially because I know we are on the learning curve with be near $1 million.Thanatos will be in development – would be under development contract as I've told you, that's a few tens of millions of dollars for us over the development period. So Thanatos would not be beyond that in there or within Thanatos is the next one that's coming along. And so those would not be ready for production until the out year starting in 2021-2022.

[Michael Ciarmoli:]

Got it. Okay. And then just can – can you tell us last one, status of Oklahoma. I mean, you think you talked about the line of sight there to potentially 40 Valkyrie units, I mean, is there any production happening right now? Is it still sort of outfitting the facility or what's actually happening in Oklahoma?

[Eric DeMarco:]

Absolutely. So it's been producing since the beginning of the year. A government customer, last week was out there I think they signed off and accepted – I'm going to say approximately five drones. It was four to six, so I'm being told six, he signed off on six drones last week that we were manufactured there. It is ramping rapidly and that's where we're going to build Valkyrie and that's where we're going to build F, and that's what we're going to build Gremlins.

[Michael Ciarmoli:]

Got it. All right, perfect. Thanks a lot guys.

[Eric DeMarco:]

Yes.

[Deanna Lund:]

Thank you.

[Operator:]

Thank you. And our next question comes from Sheila Kahyaoglu with Jefferies. You may proceed with your question.

[Sheila Kahyaoglu:]

Hi, Eric. Hi Deanna.

[Deanna Lund:]

Hi Sheila.

[Sheila Kahyaoglu:]

Fairly comprehensive line of questioning. So I'll be quick, just two questions. Maybe on Valkyrie as we look through the fiscal 2020 budget coming together. How do you think about risks to it? And what's your ultimate upside Erik with regards to that budget on Valkyrie?

[Eric DeMarco:]

Yes. So my understanding and I went through this, we have a consultant that helps us go through all the program outlined. On the current – in the current existing budget request in the 750 and I know that the house – it came out at 738 because the house started at 733. My understanding is there was about $119 million in there, okay. I don't believe that that's going to take a haircut unless let's take – let's say that takes a haircut and it gets haircut to $100 million, all right. But on top of that, the house and their $733 billion request had a $50 million plus up in there for Valkyrie.In the center and the $750 billion request had a $100 million plus have been there for Valkyrie, right. I believe based on – I was just in Washington earlier this week meeting both congressionally and with customers. I believe truly we're going to see that 100 is very close to it, but let's be conservative and let's say it 75. So between the budget request and plus it’s that we've all read about that have been publicly available, I'm thinking about $175 million. And then I think the question that Josh asked developed very relevant. How much of that is that? Well its plain relative to weapons integration, systems integration and tested operations, I don't know that yet.

[Sheila Kahyaoglu:]

That makes sense, okay. And then as we think about the bridge to 2020 revenues, I haven't been able to keep up with all your programs. I don't know how you do like – how do we think about what sets up in development funding next year? It doesn't seem like anything steps into production.

[Eric DeMarco:]

It doesn't Sheila. Say that again. It doesn't seems like lot…

[Sheila Kahyaoglu:]

Does anything increase in terms of production? Like for instance, program math it seems like next step is by test so, you wouldn't get a production contract for 2020?

[Eric DeMarco:]

Yes, so the hard increases for production next year that are just – that are very hard. The Navy SF program.

[Sheila Kahyaoglu:]

Yes.

[Eric DeMarco:]

We've got LRIP3. [Indiscernible] We're going to get full rate production in the first half. That has gone a step up so significantly. We have a confidential program. That is heading into full rate production next year. That is going to step up significantly.Thanatos. Thanatos will begin – Thanatos will begin at the beginning of this year – at the beginning of next year. That's brand new, that will be additive. We have a drone program with the United States army that is forecasted. Production is supposed to increase beginning next year as well. So we have some hard programs under contract that are funded that we can clearly see significant step ups in 2019 to 2020.

[Sheila Kahyaoglu:]

Thank you. Thanks for clarifying.

[Eric DeMarco:]

You got it, okay.

[Operator:]

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Eric DeMarco for any final remarks.

[Eric DeMarco:]

Thank you all for joining us this afternoon. We look forward to updating you at the end of Q3. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a wonderful day.