Kratos Defense & Security Solutions, Inc.
Q4 2014 Earnings Call Transcript

Published: 13 Mar 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Fourth Quarter 2014 Earnings 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. As a reminder, today's call is being recorded. I would now like to introduce your host for today's conference, Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary. Ma'am you may begin.

[Deborah Sue Butera:]

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions fourth quarter 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 to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos' corporate website at www.kratosdefense.com. It is also available on the SEC's website. Additionally, I'd like to remind our listeners that this conference call is open to the media and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the company's website later today. During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance, and the potential impact of sequestration, Federal Government shutdown and the constraints on the Federal budget constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including those found in the Risk Factors section of our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including our Annual Report on Form 10-K and any of our other SEC filings for a more complete description of these risks. All forward-looking statements are qualified in their entirety by this cautionary statement, and we undertake no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date hereof. This conference call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Certain of the information discussed for the quarter ended December 28, 2014 included adjusted EBITDA and the associated margin rates, adjusted EPS from continuing operations, excluding restructuring and acquisition-related items and other; amortization of purchased intangibles; stock compensation expense; costs related to pending contract change orders and contract modification adjustment; non-cash impairment charges and cost on completed contracts using a cash tax rate and using a statutory tax rate of 40% are considered non-GAAP financial measures. Kratos believes this information is useful to investors because it provides a basis for measuring the company's available capital resources, the actual and forecasted operating performance of the company's business, and the company's cash flow, excluding extraordinary items and non-cash items that would normally be included in the most directly comparable measures calculated and presented in accordance with generally accepted accounting principles. The company's management uses these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating the company's actual and forecasted operating performance, capital resources, and cash flow. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP and non-GAAP financial measures as reported by the company may not be comparable to similarly titled amounts reported by other companies. As appropriate, the most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the company's website. In today's call, Mr. DeMarco will discuss our financial and operational results for the fourth quarter of 2014. He will then turn the call over to Ms. Lund to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business, and then we will open the call up to your questions. With that said, it is my pleasure to turn the call over to Mr. DeMarco

[Eric M. DeMarco:]

Thank you, Deborah. Good afternoon. Kratos had a solid fourth quarter. We generated $23 million in adjusted EBITDA and over $25 million in operating cash flow, with the cash generation being after making our bi-annual interest payment on our notes in November. In the fourth quarter, we received a large number of new contract awards, and our Q4 bookings were particularly strong at $320 million, with many of these contract awards being received later in Q4 than we had originally anticipated. Kratos' fourth quarter book-to-bill ratio was 1.4 to 1, our company's highest book-to-bill ratio in the past three years. Our backlog increased up to $1.1 billion at December 31, 2014, our backlog's highest level in 2014. And our funded backlog increased by approximately $130 million, up to over $660 million. The increased bookings in 2014 and specifically in the second half of the year also contributed to our Government Solutions segment which represents nearly 70% of our business, and where we perform our DoD and other U.S. agency work generating sequential quarter-over-quarter revenue growth for every quarter throughout 2014. Our increased bookings in backlog provides us greater visibility in the coming year's financial forecast with many of these recent contract awards being multi-quarter or multi-year efforts which we will begin delivering on in Q2 and throughout the second half of 2015. In the fourth quarter, our qualified bid pipeline increased to approximately $7.4 billion even after taking into consideration the $320 million in Q4 bookings, providing further confidence in visibility into the future. Related to our increased bid and proposal opportunities, with the FY 2015 DoD budget authorization and the recent FY 2016 budget request, we are seeing pockets of projected solid or increased DoD spending and prioritization, and we are focused on these areas where we have products, solutions, and capabilities. These include in the Unmanned Systems, Satellite Communications, Directed Energy, Electromagnetic Rail Gun, Electronic Warfare, Missile System, Radar and ISR areas. Operationally in Q4, important program contributors for Kratos included AFSAT, Patriot, EA-18G, P-8 Poseidon, Trident II, SEWIP, Aegis, HATS, LCS, the Electromagnetic Rail Gun, WGS, SBIRs, AEHF, the NYMTA, the SFMTA, Chinook, BLACK HAWK, and certain other Satellite Communication programs. In Q4, we completed deliveries on production Lot 10 of our sole source AFSAT Unmanned Aerial Target Drone System program, and we have now successfully received the previously delayed $73 million new AFSAT contract award, production Lots 11-13m which we will begin delivering on in Q2, Q3 of this year. As a result of the late receipt of the AFSAT award, we will have an aircraft delivery break in Q1 of 2015, with deliveries beginning thereafter on production Lot 11. The AFSAT delivery break will result in lower Q1 revenue and EBITDA with revenue and EBITDA starting to increase in Q2, Q3 as Lot 11 aircraft deliveries begin, which I will discuss further later on in the prepared remarks. Importantly, the recent AFSAT award also includes negotiated sole source production options 12 and 13, providing us clarity with this program, one of our company's largest over the next three years. In Q4, we continued to make excellent progress on an approximate $30 million Patriot order we received last year which we expect to begin deliveries beginning in Q2 and continuing throughout 2015. In the fourth quarter, we also successfully and substantially completed work and deliveries on our initial major HATS program orders with additional significant orders expected from our U.S. Government and certain other customers. Programmatically, since our last report, Kratos supported the successful United Launch Alliance Delta II Mission, which delivered the Soil Moisture Active Passive or SMAP satellite to near-circular orbit. SMAP is one of the four first-tier missions recommended by the National Research Council's Committee on Earth Science and Applications from Space. Additionally, Kratos products, solutions and equipment also recently supported the Aural Spatial Structures Probe Mission, which was successfully launched on a NASA Oriole IV sounding rocket. And in Q4, Kratos' products and solutions supported a certain BMD Target Mission in the Pacific. And also importantly, and representative of the strategic National Security Programs Kratos supports, just a few weeks ago, three Kratos BMD Targets supported a critically important MDA test off the East Coast of the United States which we will be able to more formally announce next week. Over the past several months, since our fiscal year end, we have continued to aggressively execute on the discretionary cost reduction plan across the country, reducing our head count by an additional 100 personnel. The majority of these cost reduction actions included a significant reduction in our Public Safety & Security Division, where, in Q4, we modified our business strategy, and we are now focused less on revenue growth with an emphasis on higher profit margin work, liquidity and cash flow. This business strategy change resulted in lower PSS revenue in Q4 and will result in lower Kratos and PSS revenues going forward, beginning in Q1, though with expected higher EBITDA margins, cash flow and overall liquidity beginning in Q2 as the full effect of these recent cost-cutting actions and focus on higher margin programs begins to be realized. We made the PSS business strategy change in part as a result of the improving prospects for Kratos' Defense and international business, which we expect to continue going forward, and in particular beginning in the second quarter of this year as we commence deliveries and work on many of our recently received new contracts and program awards. Strategically in Q4, we continued to make progress with our UCAS initiative. We completed the first of our three UCAS aircraft, and we solidified our demonstration flight schedule dates with our government sponsor which remains on track for the fourth quarter of this year. In December, Kratos UCAS participated in certain war games and simulation and we recently received positive feedback from the customer on our UCAS' performance. Successful participation in this war game is another important step in our Unmanned Combat Aerial Systems strategy and initiative as we build towards the demonstration flight scheduled for later this year and future production of the aircraft. We also recently reached agreement with our UCAS government sponsor, which includes a one-time $3.5 million Kratos investment along with certain government provided systems equipment, access use of government facilities and government personnel and services. Importantly, this agreement was structured so Kratos will retain 100% ownership of the intellectual property, technology and data rights to Kratos' Unmanned Combat aircraft. This IP ownership was a critical strategic objective for Kratos as owning the IP will protect Kratos' future production rights of the UCAS platform. As you know, Kratos owns significant intellectual property and data rights on all of our Unmanned Aerial platforms which for example is the reason Kratos is sole source on the AFSAT program. In 2015, we will separately identify and exclude from our continuing results this one-time $3.5 million non-recurring IP-related investment and we will keep you informed of our UCAS initiative progress. Also in the Unmanned Systems area, since our last report, we successfully completed another contractually required milestone flight under our SSAT program, achieving seven of eight major of our primary flight criteria, with additional flights scheduled for this year and into 2016. We remain on schedule for SSAT to go into LRIP in the second half of 2016 which is an important element of Kratos' expected return to year-over-year organic growth beginning next year. We have also been recently informed that a separate Kratos UAS program is now being accelerated or pulled forward with LRIP of this program now planned to also begin next year. Additionally, we recently had a number of successful flights with our 178 Firejet Unmanned aircraft for a U.S. Government customer which has now ordered 20 of these systems, which we begin delivering later this year. And since Q3, we successfully executed an Unmanned Drone System demonstration flight for a new international customer opportunity and we believe that we will be successful with an order with this new customer in the second half of 2015. As of today, we have received orders and are under contract on all of the major Unmanned Aerial System program and contract opportunities we have previously discussed with you except one international program which we now expect to receive in the next few weeks. In Q4, we also continued to execute on an approximate $40 million Unmanned Ground and Seaborne System contract we were awarded last year, which will continue throughout 2015. And we have recently initiated the capture process on two additional new and large Unmanned Aerial platform opportunities

[Deanna Hom Lund:]

Thank you, Eric. Good afternoon. Our fourth quarter revenues of $221.5 million came in below our expected range due to delays in contract awards and shipments of Unmanned Targets to an international customer that are now expected to commence in Q2, which Eric mentioned earlier. Shipments have hardened mobile tactical facilities in our Modular Systems business which are now expected to occur in Q2. In addition, shortfalls in our Public Safety business resulting from the large national account delay in the deployment of new systems and to a lesser degree due to the change in focus to higher margins and forgoing lower – larger lower margin opportunities. In the fourth quarter, we have begun to report two separate segments within our KGS businesses; one which includes the historical KGS businesses of our Electronic Products, Satellite Communications, Missile Defense Rocket Support and Modular Systems businesses; and a new separate segment representing our Unmanned Systems business. We have begun to separately report our Unmanned Systems business as a separate segment due to the expected growth potential in the next several years for this business driven in part by the expected 2016 commencement of low rate initial production of our SSAT program, moving to full rate production thereafter, the expected acceleration of low rate initial production into 2016 on another Unmanned System program we're under contract on, and expect it to continue to progress with our UCAS initiative and other opportunities we are pursuing. On a sequential basis, revenues increased for our KGS segment from $151.4 million to $159.3 million for Q4 over Q3. The fourth quarter sequential increase of $7.9 million or 5.2% in our KGS segment was offset partially by a sequential quarter decrease of $1.8 million in our US segment from $22.9 million to $21.1 million, and a sequential decrease of $1.7 million in our PSS segment from $42.8 million to $41.1 million. The US segment decrease was primarily due to the completion of AFSAT production Lot 10 deliveries in Q4, which Eric mentioned earlier, and we are now under contract for production Lots 11-13 which we will begin deliveries on Lot 11 later on in 2015. As mentioned earlier, PSS revenue was down in Q4 in part as we began the transition to focusing on the higher profit margin opportunities. As a large amount of PSS quarterly revenues are smaller programs that are booked and executed in a given quarter, which can present challenges in forecasting revenues, especially when larger contract awards, which typically provide more visibility due to the associated backlog, are delayed. On a year-over-year basis, Kratos' revenues decreased 6% or $14.2 million from $235.7 million in the fourth quarter of 2013, with a year-over-year decrease in our PSS business of $14.5 million from $55.6 million to $41.1 million, primarily due to the delay of system deployments by a large national account mentioned earlier, as well as delays in other expected larger awards, a year-over-year decrease in our Unmanned Systems segment of $7.6 million from $28.7 million to $21.1 million, partially offset by an increase in our KGS segment of $7.9 million from $151.4 million to $159.3 million. The year-over-year comparison for our KGS segment includes the following. Our Legacy Services business continued to decline due to competitive pricing pressures and commoditization, which decreased $5.7 million (sic) [$5.9 million] (24

[Eric M. DeMarco:]

Great. Thank you, Deanna. Operator, we'll now open it up for questions.

[Operator:]

Thank you. Our first question comes from Mike Crawford with B. Riley & Co. Your line is open.

[Mike Crawford:]

Thank you. Thanks for giving all the color on the Unmanned Systems and breaking it out of Government Solutions. Can you talk a little bit about what margin you might expect from that business as you enter full rate production on things like SSAT and Lot 10, 11, 12 – or – I'm sorry, Lot 11, 12, 13 of AFSAT as well as UCAS and whether that margin change is depending much on actual mix?

[Eric M. DeMarco:]

Okay. First piece, on the new program on SSAT, under contract right now, we have two production options. They're both LRIP options. On those LRIP options, the margin we expect to be similar to maybe slightly above what KGS is, and then after we get to LRIP and we get into full rate production and we're down a learning curve, we would expect them to increase from there. What was the second part, Mike?

[Mike Crawford:]

So, that's interesting on SSAT. And then what about if you are successful in your demonstration on Unmanned Combat System?

[Eric M. DeMarco:]

We would hopefully expect those to be somewhat higher than that on those.

[Mike Crawford:]

And just, let say, we're down the path at some point in the future without getting into a specific year, but let's say that business is running somewhere closer to, say, $200 million in revenue, is that something that could be high teen margin business or would it be less than that you think?

[Eric M. DeMarco:]

It can be mid-teens to high teens at that revenue rate.

[Mike Crawford:]

Okay, great. And then you mentioned the Lockheed and Northrop protest of Raytheon's 3DELRR win. So, you're a Raytheon partner, are you partnered with the others as well?

[Eric M. DeMarco:]

I'll answer that question, generally, Mike, because of the NDAs we're under. On most of the large procurements, our strategy, as we've talked about before, is we, our strategic partners with – strong partners with all of the OEMs, except BAE. We do not have a very strong position with BAE. So our strategy is to have content or to be in a position – be positioned to have content with each team. And more often than not, the content position with one can be higher than the other. And that's typically our strategy. So, if Raytheon is involved in a large program where Northrop is involved in a large program, we – or Boeing, we typically expect to participate in that because we have participated on their past programs and we have strategic relationships with them.

[Mike Crawford:]

Okay. Thank you. Just one final question; on your strategic process, you seem confident in being able to discuss some progress in the second quarter on that. Is that, do you think, limited to non-core businesses, such as maybe training, Modular Systems, PSS, or could it also include something more – that you would define as more core?

[Eric M. DeMarco:]

Because of where we're at in this process right now, Mike, I really cannot say any more than I said in the prepared remarks.

[Mike Crawford:]

Okay. Thank you very much.

[Eric M. DeMarco:]

Okay.

[Operator:]

Thank you. Our next question comes from Mark Jordan with Noble Financial Group. Your line is open.

[Mark Conrad Jordan:]

Hello? Hello?

[Eric M. DeMarco:]

Hi, Mark.

[Mark Conrad Jordan:]

Hello? Can you hear me?

[Eric M. DeMarco:]

Somewhat. It's very staticky, sir.

[Mark Conrad Jordan:]

I'm sorry. Could you talk a little bit about the UCAS market with regards to what other players in the marketplace may or may not be doing? I mean, this is a major opportunity. Some people have tremendous vested interest in things like Predator (36

[Eric M. DeMarco:]

I'll tell you what I know. What I know is that four of the biggest players; Boeing, Northrop, Lockheed and GA, are all focused on the UCLASS opportunity, which is going to be coming out in RFP very, very soon now. And so, on the UCLASS opportunity, that's where they have been focused. There have been some RFIs that have come out primarily from DARPA, including very recently, on some other types of next-generation Unmanned Combat aircraft that we are pursuing, and I understand that certain of they are pursuing. So, we obviously expect this to ultimately be very, very competitive, which is why it was so critical for us to maintain our intellectual property position on our aircraft for the niche area that we are going for. And the niche area that we are going for, and when I say a niche, that sounds small, but for us, it's very, very big as we're a small company. Our understanding right now was we are the primary player there today, Mark.

[Mark Conrad Jordan:]

Okay. Of the $7.4 billion pipeline, what of that will – has been submitted or will be submitted within by mid-year of 2015 and how much of that do you expect to be awarded by the end of the current year?

[Eric M. DeMarco:]

Right. Roughly, Mark, approximately $1.6 billion of that has already been submitted. It has been submitted already. I would imagine probably another $1.5 billion or so will be submitted between now and the end of the year, and then the balance of it waterfalls in 2016 and into 2017.

[Mark Conrad Jordan:]

Do you have any guesstimate as to what amount of that $3.1 billion that you will have submitted to the government by the end of the year will actually be adjudicated?

[Eric M. DeMarco:]

Mark, when I don't know something, I'll tell you. I don't know that off the top of my head. I do not know.

[Mark Conrad Jordan:]

Okay. The Rail Gun, I thought I saw or read somewhere that there's now talk that that initiative may actually be deployed on a DDG-1000. And the evolution of that from a – not a laboratory but from its development phase to actually being put to street (39

[Eric M. DeMarco:]

Yes. What is happening there is very positive for us. We are involved in the Electromagnetic Rail Gun in several different areas under several different programs. So this is – this over time, as this continues to move forward, will become a significant program for us at various divisions throughout the company.

[Mark Conrad Jordan:]

All right. Final question from me, the services revenues declined 6% sequentially, down at $91 million in the fourth quarter. Given your comments, should we assume that that services line for the full year will be closer to kind of annualizing that fourth quarter run rate than what you had for the full year?

[Deanna Hom Lund:]

Yes. So, Mark, this is Deanna. The way we actually dissect it is looking at – so what we report from on our earnings release with services is not necessarily our traditional services revenue because services that are wrapped with products are also included in that number. So, what we look at more carefully is the actual traditional Legacy Services revenue which is at about a $13.5 million run rate per quarter. So, it's running just under $60 million currently. That's down from last year's annual run rate of about $85 million. We did see sequentially from Q3 to Q4 that that $13.5 million was about the same as it was in the third quarter. So, we don't expect that to continue to decline at the rate that it has on a year-over-year basis, especially just given what we've seen in the most recent two quarters.

[Mark Conrad Jordan:]

Okay. Thank you. One last question; you did note that the strategic review is ongoing. Do you have a sense that of a timeframe at which it will – things will happen or it will be completed and I think will happen?

[Eric M. DeMarco:]

Yes, sir. You may not have heard it, Mark, in our prepared remarks. We believe that before the end of the second quarter, we will be able to report on progress made.

[Mark Conrad Jordan:]

Okay. Thank you very much.

[Eric M. DeMarco:]

Yes, sir.

[Operator:]

Thank you. Our next question comes from Eric Sal with SunTrust (42

[Unknown Speaker:]

Hey. Good afternoon. I see that you guys have changed the manner in which you're estimating guidance. Should we see the current guidance as more conservative and achievable as we've seen in the past?

[Eric M. DeMarco:]

We definitely, Eric (42

[Unknown Speaker:]

Okay. Good. And then given the lower Q1 guidance in EBITDA, should we – and slightly or close to slightly down over 2014, should we expect year-over-year growth in the back half?

[Eric M. DeMarco:]

Oh, yes, sir. Yes, absolutely. A good portion of that, as I mentioned in the remarks, is under contract, and that's when the deliveries begin and start to ramp up.

[Unknown Speaker:]

And they can't be protested?

[Eric M. DeMarco:]

We've won them.

[Unknown Speaker:]

Okay.

[Eric M. DeMarco:]

They cannot be protested.

[Unknown Speaker:]

Okay. And that's offset by we're going to keep R&D higher?

[Eric M. DeMarco:]

As Deanna mentioned, we're going to keep R&D higher, and we're going to keep some other investment areas higher, particularly in the Unmanned area.

[Unknown Speaker:]

And then what are the key drivers/press releases that could cause you to meet or beat it? And kind of laden in your answer assumptions on the budget, the size of the cost savings and then the potential for some of these protests to come back.

[Eric M. DeMarco:]

Right. So, I think the biggest question mark out there is October 1 of this year, Federal fiscal 2016 begins. And as we all know, there's a very large disconnect between the Pentagon and the President's request and what the Budget Control Act says and what sequestration, the law, says. And so, we'll just have to see where all that plays out and what that does or does not mean come October 1. That is probably the largest question mark that is out there.

[Unknown Speaker:]

Would that impact 2015 or 2016?

[Eric M. DeMarco:]

It depends. So, it's obviously in our fiscal 2015, and let's say for – I don't expect this, but let's say, for example, that there's not an agreement and the government shuts down again, but there's not an agreement and there's an extended continuing resolution. That should not impact us materially in 2015. But if it were to go into Q1, it would impact us in 2016, which is very similar to what happened to us in 2014.

[Unknown Speaker:]

Okay. And, Deanna, you guys said that despite flat to slightly down revenue and EBITDA, that free cash flow is going to be up in 2014 (sic) [2015] (44

[Deanna Hom Lund:]

So, our 2014 free cash flow is actually a use of $7.7 million. So, the comments that we made that we expect free cash flow to be greater in 2015, it is driven somewhat by the interest savings, as well as expectations from a working capital perspective.

[Unknown Speaker:]

And that 101 AR days, can we assume that you guys stick to that for the year, I mean just as you see it right now?

[Deanna Hom Lund:]

So, we're actually at 102 days, and what I had mentioned in my prepared remarks is that because we are so product-centric now and delivery-based and shipment-based, those DSOs can vary from quarter-to-quarter as we saw during 2014, and that was something that we remark that we expect that type of variability in the future. It is down from 107 days in the third quarter to 102 days in the fourth quarter, but there could continue to be variability just because of the way our shipments and milestone contractual billing terms are negotiated with our customers.

[Unknown Speaker:]

Because of the timing, you just don't know when exactly they come?

[Deanna Hom Lund:]

Correct. Correct. Yes.

[Unknown Speaker:]

And then I know you can't say a ton about asset sales, but absent an asset sale, could you guys still pursue buying back bonds?

[Eric M. DeMarco:]

Very candidly, we have not put any thought into that path at all right now.

[Unknown Speaker:]

You're focused on the asset sale?

[Eric M. DeMarco:]

We are focused on executing the strategic alternatives review that our board has set for us.

[Unknown Speaker:]

And then finally, your change in strategy on PSS, does that change attractiveness to suitors?

[Eric M. DeMarco:]

In my opinion, it definitely should because the margin and the liquidity presentation of the business has already begun to improve. However, hypothetically, there are some people that like lots of revenue growth and then they'll figure it out later, there are other people that like high margin revenue growth. So, it would be hypothetically in the eye of the beholder. But this is the right – in our opinion, the right way to run the business, and that's what we're going to do.

[Unknown Speaker:]

And then I'm sorry I lied but just one more. Do you guys disclose what that business did in profit, and then how big are these, the cost savings you guys are putting through?

[Deanna Hom Lund:]

Yes. So we do disclose that, Eric (47

[Unknown Speaker:]

And then, do you have any – like how many people are you guys letting go? Is there any way to calculate what the cost savings would be going forward?

[Deanna Hom Lund:]

As Eric had mentioned, he said that we have made over 100 head count reductions since the beginning of the year with a significant piece of those reductions related to the Public Safety business.

[Unknown Speaker:]

And is there any cash severance that will hit free cash flow, and then I guess that's in your free cash flow guidance. So...

[Deanna Hom Lund:]

Yes.

[Unknown Speaker:]

...it would be in that.

[Deanna Hom Lund:]

Yes.

[Unknown Speaker:]

All right. Hey, thanks a lot.

[Deanna Hom Lund:]

Sure.

[Operator:]

Our next question comes from Tyler Hojo with Sidoti & Company. Your line is now open.

[Tyler E. Hojo:]

Yes. Hi, good evening. Just to kind of stick with Public Safety for a second. Get the strategy, get that it's going to be a headwind in terms of the top line in 2015. I was just hoping that maybe you could quantify kind of how big of a headwind we're talking about as it relates to kind of the flat to slightly lower revenue guidance for the whole company.

[Eric M. DeMarco:]

I would look at it, Tyler, as a similar quarter to what we just clicked off in Q4.

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

In that ballpark, maybe a little less because we initiated the plan of focusing on higher margin work there, so, maybe that, to a little less, is how I look at the run rate.

[Tyler E. Hojo:]

Okay. That's good. And in light of kind of current run rate, could one assume that there are going to be additional cost savings actions taken in 2015?

[Eric M. DeMarco:]

Absolutely.

[Tyler E. Hojo:]

Okay. Okay, got it. And then just in regards to the conversation around IR&D, it's going to be a headwind. I think it was like $6-point-something-million in Q4. First, what was it for full year 2014, and how big of a headwind are we talking about for 2015?

[Deanna Hom Lund:]

Yes. So, Tyler, for 2014, it was $23 million. It's been that the last three quarters have been about $6 million per quarter. That compares to 2013 at $21.5 million.

[Tyler E. Hojo:]

Okay. And what are we talking about for 2015?

[Deanna Hom Lund:]

We haven't given specific guidance on that, but I would say it would be in about that same ZIP Code.

[Tyler E. Hojo:]

Around the $23 million mark?

[Deanna Hom Lund:]

Yes.

[Eric M. DeMarco:]

Yes.

[Tyler E. Hojo:]

Okay. So, just to dig into that a little bit more, we're talking about increasing spending on UCAS. What's going down to kind of offset that?

[Deanna Hom Lund:]

There is some reductions in some of our – in our Satellite business and a little bit in our Electronic Warfare business.

[Tyler E. Hojo:]

Okay. Fair enough.

[Deanna Hom Lund:]

Okay.

[Tyler E. Hojo:]

And then just on free cash flow...

[Eric M. DeMarco:]

Tyler, let me make another comment on it.

[Tyler E. Hojo:]

Sure.

[Eric M. DeMarco:]

In addition, importantly, because I see how you're trying to analyze this. In the Unmanned Systems business, in addition to the IR&D and the way you're framing that up as a headwind, there is also a significant amount of other costs that are not in IR&D that are related to this business, I think we're...

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

For example, we have a number of executives, including on the consulting side, that are working with customers at very, very high levels. Okay?

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

And in the overhead area, whenever we do test flights that we pay for, we have to rent the weapons range. We have to pay for the team to go out – our team to go out there and do it. Those costs always typically fall in cost of sales or overhead.

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

In that line. Like, for example, the demonstration flights that we're going to do in the fourth quarter of this year, okay?

[Tyler E. Hojo:]

Yes.

[Eric M. DeMarco:]

That piece is not being sponsored. So, that piece, we will be paying for that to happen.

[Tyler E. Hojo:]

Okay, understood. And those expenses are fairly significant.

[Eric M. DeMarco:]

Yes, sir.

[Tyler E. Hojo:]

All right.

[Eric M. DeMarco:]

They're in the millions.

[Tyler E. Hojo:]

Okay. Very helpful. I appreciate that color, Eric.

[Eric M. DeMarco:]

Yes, sir.

[Tyler E. Hojo:]

And then just on free cash flow, I get improving and obviously really nice performance here in Q4, but improving on a full year basis on a negative number, I mean, can you give us a little bit more? I think in the first half of last year, you guys were talking about $25 million to, I think, $40 million in free cash flow. Are we in that ZIP Code here for 2015, or any comments there, Eric, please?

[Deanna Hom Lund:]

Tyler, this is Deanna.

[Tyler E. Hojo:]

Okay.

[Deanna Hom Lund:]

I would say our expectation is that it will be positive, and that's really what I'm limited to saying that since we did not provide that specific guidance in our prepared remarks.

[Tyler E. Hojo:]

Okay. But we are going to be free cash flow positive this year.

[Deanna Hom Lund:]

Correct.

[Tyler E. Hojo:]

Okay, got it. And last question from me. There's been a lot of talk from you guys just in regards to the impact from protests in 2014, and I guess it's nice to see them resolved. But could you maybe just talk high level, like what was the sales impact in 2014? And in context with the impact in 2014, why wouldn't we be better in kind of the base business ex-Public Safety in 2015?

[Eric M. DeMarco:]

Right. So, the impact for 2015 that we're going to get in 2015 that we did not get in 2014, think in the $15 million range.

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

Okay? The one that is still unresolved, I believe, I think it's a four-year contract or a five-year contract. So, that's $10 million a year that – excuse me, $10 million a year to $12.5 million a year that we're still not getting because it's been protested. Okay?

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

We've taken out this Directed Energy opportunity. I think that's another $40 million opportunity over a few years that we've excluded.

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

So, there's an Electronic Warfare one program. I don't think I can mention the name of it. That's been protested. That's probably $3 million a year.

[Tyler E. Hojo:]

Okay.

[Eric M. DeMarco:]

So, it's – when you add them up, it has been significant.

[Tyler E. Hojo:]

And just rough order of magnitude, if you added up everything kind of you're expecting to not get in 2015, would it be kind of similar to what the impact was in 2014?

[Eric M. DeMarco:]

Yes.

[Tyler E. Hojo:]

Okay. Very helpful. I'll hop back in the queue. I appreciate it.

[Eric M. DeMarco:]

Thank you.

[Operator:]

Thank you. Our next question comes from John Nelson with State of Wisconsin. Your line is open.

[John F. Nelson:]

Hi, Eric and Deanna. It's nice to hear I think a more positive tone coming from you two, than previous, the last few calls. And I mean, it sounds like the pipeline is quite exciting. And for both of you, I'm curious as to what you think of the – if there's going to be much change in the new Defense Budget on anti-ballistic missile systems given the problems with Russia and Eastern Europe. And then whether or not there's a treaty with Iran that either way there becomes a greater focus again on anti-ballistic missile systems.

[Eric M. DeMarco:]

Right. John, thank for your initial comment on that. We have routinely said that we thought 2014, 2015 from an industry standpoint and for us would be the trough and that we would see us turning out of it in second half of 2015, 2016. And that is what we're seeing. And we're seeing it in the orders, which is why our funded backlog has gone up so much and we're seeing it in the pipeline and the opportunities. So, your sense of a little more confidence as we see us coming out of this in the second half of this year and growing from there as a number of these programs that we've won, ramp up and the other ones that we're going after which a lot of them are sole source and if there are not, it's on us and one other guy, we're going to get them. So thank you for that. Now, on your comment; absolutely on the BMD, the Ballistic Missile Defense area, we are seeing a significant amount of that of increased activity in the BMD area. As I mentioned in my prepared remarks, we're going to be able to put out a formal announcement, I believe, on Monday where just a few weeks ago, we had three of our Ballistic Missile Targets fired within seconds of each other in a raid format at the fleet. We are working on some very interesting things, very recently with the Missile Defense Agency that is specifically related to some of the things that you mentioned. Aegis Onshore (58

[John F. Nelson:]

Okay. Good. And you've talked often about the UCAS program and this being a significant part of the future of the company. Can you give us any sense of the size of the UCAS market versus kind of ex-ing out that portion that would be – I mean, UCLASS versus UCAS?

[Eric M. DeMarco:]

Right. So, John, let me say something relative to the first part of your question. We are definitely making a big investment in our Unmanned Combat Aerial System initiative. However, a very big part of our future that is under contract is our SSAT program, and today, for the first time, I was able to mention that we are on another very large program that is confidential, but I was able to mention it today that LRIP on that is being pulled in to 2016 as well, and full rate production will begin after that. So, our targets work, our Unmanned Aerial Drone Target business is going to be a very, very big part of our future and most of that is under contract and we're heading into production on what will be the largest production program in the company, and the second one will be right up there with it. On the UCAS, the Unmanned Aerial System market is very, very large and there's a lot going on – it's multi-billion, so a lot – there have been $5 billion number thrown around it, there have been $7 billion number thrown around it. It's very large. There's a lot going on within those pockets and those budgets right now and that has to do with the move away from asymmetric warfare and flying in uncontested airspace to nation state or near peer-to-peer warfare and flying in fully contested anti-access aerial-denied airspace, and that takes a different type of a vehicle. And there's been a lot of RFI and RFP activity out there for the next generation types of Unmanned Aerial Systems that can perform their mission in those contested environments. We believe that this is going to – this is and is going to be – this is outside of UCLASS, outside of that. This is going to be a multi-billion dollar budget-funded area because of the mission requirements. And if we can get a small piece of this, this could be a few hundred million dollar a year business for us.

[John F. Nelson:]

Okay, great. Thank you. Thanks very much.

[Eric M. DeMarco:]

Thank you, sir.

[Operator:]

Thank you. This concludes our question-and-answer session. I would now like to turn the call back to Eric DeMarco, President and CEO, for closing remarks.

[Eric M. DeMarco:]

Excellent. Thank you very much for joining us today. We will obviously speak with you when we report our first quarter in May unless there is a need to call a meeting prior to that. Thank you very much.

[Operator:]

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