Kratos Defense & Security Solutions, Inc.
Q3 2013 Earnings Call Transcript

Published: 8 Nov 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2013 Earnings Conference Call. [Operator Instructions] And as a reminder, today's conference is being recorded. And now, I would like to introduce your host for today, Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary. Ma'am, please go ahead.

[Deborah S. Butera:]

Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Third 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 the 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 shutdowns 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 statements 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, including adjusted EBITDA and the associated margin rates, pro forma EPS from continuing operations excluding restructuring and acquisition-related items and other, unused office space and others, amortization of purchased intangibles 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 third quarter of 2013. 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, and good afternoon. Despite of the continuing challenging near-term budget environment, Kratos delivered solid third quarter results, our bid and proposal pipeline increased to $4.6 billion, our backlog remained constant at $1.1 billion and we are forecasting 10% sequential increases in both the revenue and adjusted EBITDA for our fourth quarter. Additionally, Kratos has not lost or had canceled any significant existing or expected contract, program or customer opportunity as a result of the Federal Government budgetary situation, though we have experienced delays in Order Flow, expected new contract awards and cash receipts, particularly since October 1, when the now resolved Federal Government shutdown began. In the third quarter, Kratos was a Prime Contract Awardee on the Department of Homeland Security's 5-year, $6 billion MAC BPA continuous monitoring cyber program. We believe affirming Kratos' position as one of the leading cyber security solutions providers in the industry and providing Kratos a significant new potential future growth vehicle and opportunity. We believe that the winning Kratos DHS program team, which exclusively includes Microsoft and Dell, along with our proprietary NeuralStar and dopplerVUE software products, is uniquely positioned for the delivery of continuous monitoring services and solutions under this new contract award. We expect release of initial task orders under this contract over the next few months, at which time, we will begin to get a feel for our team's positioning. We received approval today to announce that Kratos is a key member of a team awarded a $450 million single-award, 5-year plus 5-option year MDA contract, where Kratos has a committed and defined scope of work. Though this single-award contract is now under a protest, this is another new opportunity for Kratos and we are hopeful that our prime leading the team will be successful in sustaining our team's win in this new growth vehicle for our company. In Q3, Kratos was awarded a large new security-related program with a certain U.S. government agency for specialized security-related systems, which are now in production. This new program, which we are not able to formally announce, is expected to last many years and be worth tens of millions in revenue to our company. Kratos was recently awarded a contract by Sikorsky Aircraft for CH-53K maintenance trainers, with the CH-53 being the U.S. Marine Corps heavy lift helicopter program. This CH-3 award is important, as this is a long life strategic platform that Kratos will be supporting. In the third quarter, Boeing and the USAF successfully conducted the first unmanned QF-16 aerial target flight test, another major Kratos supported program, which just went into LRIP and which we believe could also go on for many years into the future. In Q3, Kratos' critical infrastructure security business continued its solid year-to-date organic revenue growth generation, with the fourth quarter of 2013 currently looking particularly strong for this business, with approximate 15% year-over-year organic growth expected for Q4. Our PSS business profit margins were below our expectations in Q3, primarily related to a certain geographic region's performance, we are taking the appropriate actions to address the situation and we currently expect PSS EBITDA margins to expand in Q4. Kratos' critical infrastructure security business, opportunity and bid pipeline are near record high levels and we remain in pursuit of several large opportunities we are currently expected to be awarded in early to mid next year. At this time, 2014 looks like it will be another solid organic growth year for our commercial customer base critical infrastructure security business, which comprises approximately 22% of our company's revenue. Over the past few months, Kratos has made important progress with 2 of our most important long-term strategic initiatives

[Deanna Hom Lund:]

Thank you, Eric. Good afternoon. Our third quarter revenues of $226.4 million came in our expected range of $220 million to $240 million. Our revenues decreased year-over-year 18.1% from $276.3 million in the third quarter of 2012, reflecting the impact of the current DoD budgetary environment, which had caused certain delays and orders and awards, as well as due to the timing of product shipments and the continued contraction of our legacy Government Services business, which continued to contract approximately 18.5% compared to the third quarter of 2012. However, consistent with the previous quarter, our legacy services business remained fairly stable on a sequential basis compared to the first and second quarters of 2013. From an annual run rate perspective, our legacy services business is currently operating at approximately $88 million, down from approximately $100 million for 2012. Operationally, we remained focused on cost reductions and efficiencies and in the third quarter, we recorded nonrecurring credits and charges related to our legacy services business, excess capacity caused in part by the delays in procurement and awards, excess facilities, severance, legal and the previously mentioned contract design retrofit cost. In Q3, Kratos' headcount was reduced by approximately 100 personnel from of 4,000 to 3,900 and year-to-date, Kratos' headcount has reduced by approximately 10% from 4,300 at the end of last year. Similar to previous reports, we exclude such nonrecurring or non-core business credits and charges from our adjusted EBITDA. Our adjusted EBITDA of $24 million for the third quarter is from continuing operations and excludes a credit of $6.8 million related to a change in our unused office space accrual and excludes $5.4 million of contract designs, retrofit costs, related to the recent test failure of one of our aircraft that Eric mentioned earlier and excludes $3.5 million of restructuring and acquisition-related items, primarily comprised of excess capacity and restructuring and severance cost. From an operational segments perspective, our Government Solutions segment generated $174.6 million in revenues and $21.1 million in adjusted EBITDA or a 12.1% adjusted EBITDA margin. Our Public Safety & Security segment generated $51.8 million in revenues and $2.9 million in adjusted EBITDA or a 5.6% adjusted EBITDA margin. On a GAAP basis, net loss for the third quarter was $9.9 million, which included a loss from discontinued operations of $400,000, $9 million of expense related amortization of intangible assets, as well as a $200,000 income tax provision. We continue to believe that it's also meaningful to provide our earnings per share excluding the amortization expenses in reflecting our cash pay income tax and excluding nonrecurring items. On a pro-forma basis, EPS from continuing operations, excluding the amortization, restructuring and acquisition-related items, excluding the credit for unused office space and excluding contract designs and retrofit costs, utilizing the estimated average quarterly cash pay income tax provision of approximately $800,000 was $0.02 per share for the quarter. Moving to the balance sheet and liquidity, our cash balance was $49.8 million at September 29 plus $5 million in restricted cash. For the third quarter, we generated $2.6 million in cash from operating activities and a use of $2.3 million of free cash flow after taking into consideration capital expenditures of $4.9 million. Our DSOs increased 6 days from 102 days at the end of the second quarter and it has increased 14 days on a year-to-date basis when compared to the 94 days at the end of 2012. The increase in DSOs is a result of the current budgetary environment, as well as the shift of certain contractual billing milestones into 2014. The increase in 14 days is equivalent to approximately $35 million in impact to our cash flow as each days turn is equivalent to approximately $2.5 million. As a reminder, our second and fourth quarters are the quarters that we pay the semiannual interest payments under Senior Notes, so those are typically our lower cash generation quarters before taking into consideration the current budgetary environment. We continue to target DSOs of approximately 90 days on a long-term basis which we believe is achievable in a stable budgetary environment as we expect that the milestone-related contractual payments billing terms are met that we will be able to continue to reducing overall DSOs and generate additional operating cash flow. As our revenue mix is more products-focused now, our DSOs can tend to fluctuate due to the timing of shipments and satisfaction of billing and contractual milestones. Our contract mix for the third quarter was 82% of revenues generated from firm fixed price contracts, 13% from cost plus fixed fee contracts and 5% from time and materials contracts. Revenues generated from contracts with the Federal Government were approximately 63%, including revenues generated from contracts with the DoD of 59% and revenues generated from contracts with non-DoD Federal Government agencies of 4%. We also generated 7% of our revenues from state and local governments, 21% from commercial customers and 9% from foreign customers. Backlog at quarter end was $1.1 billion, with $543 million funded. Backlog at the end of Q2 was $1.1 billion as well. Today, we updated our previously communicated full year fiscal 2013 financial guidance as follows. Revenue of $955 million to $975 million, adjusted EBITDA of $102 million to $106 million and adjusted free cash flow of $5 million to $15 million. We are also providing fiscal fourth quarter 2013 financial guidance, revenue of $240 million to $260 million, adjusted EBITDA of $26 million to $30 million. The updated free cash flow estimate reflects a few days improvement from the year-to-date increase in DSOs of 14 days, which has impacted our cash flows by approximately $35 million. This is equivalent to estimated cash EPS using an estimated annual cash tax pay of $3.2 million, excluding annual amortization of $36.3 million and excluding restructuring and other acquisition-related items, contract design retrofit cost and the credit for unused office space of $0.10 to $0.20 for fiscal 2013. Kratos' guidance also reflects a continued significant investment that we are making in our internal IT security and infrastructure area, which is being driven in part by perceived increased threat profile as a result of the nature of certain work we are performing and assumes that the operating margins in our public safety and security business will improve sequentially in the fourth quarter back to the levels realized in the second quarter. From a capital structure standpoint, we have been preparing the documents for refinancing our senior notes and continue to confer with our financial advisors and market conditions at the appropriate timing to refinance. As a reminder, if we were to refinance today, there is a 5% premium due of $31 million plus approximately $40 million of make-whole and estimated related fees. The estimated make-whole reduces approximately $5 million each month as we move towards the June 2014 no-call date. As a result, if we were to refinance today, we would refinance an amount greater than the current $625 million principal balance to fund the aggregate refinancing cost I just discussed, after taking into consideration our cash on hand. While a refinancing would result in upfront refinancing cost, we are expecting the refinancing to overall reduce our interest expense, even accounting for the incremental debt and to extend our debt maturity profile. Importantly, we are evaluating options to allow for us to begin reducing debt immediately with our cash generated from operations. As we have discussed on previous occasions, we continue to confer with our financial advisors to determine the appropriate timing of such a refinancing, weighing the various upfront cost versus current market conditions and the benefits associated with the refinancing. If the refinancing is successful, this could significantly increase Kratos' free cash flow and we plan to use the additional free cash flow to further delever our balance sheet, with the goal of increasing Kratos' equity value.

[Eric M. DeMarco:]

Very good. Thank you, Deanna. Now, I'll turn it over to the moderator for questions.

[Operator:]

[Operator Instructions] And we'll go with our first question from Mike Crawford from B. Riley & Co.

[Michael Crawford:]

First, what did you do to attract Mike Malone from Boeing? Or what is it that he saw at your unmanned combat division to get him to leave Boeing?

[Eric M. DeMarco:]

Mike, we're making very good progress in this area right now with Jerry Beaman. And Admiral Beaman had a relationship with Mr. Malone and he came on out and he saw what he was doing. He reviewed the aircraft and the performance characteristics and our roadmap. And I believe he believes, as we believe and as I believe that we have a real shot here in this environment to do something significant.

[Michael Crawford:]

Could you also just review again what happened with this aircraft test failure? Was that related to the UCAS division or was that something else?

[Eric M. DeMarco:]

It was not in the UCAS division. It was an aerial drone that has significant, what I'll call precursor attributes potentially to it. And it was an environment that had never -- we had never performed before with this plane. Hadn't been done before. And the type of performance characteristics that these platforms have from time to time, there are going to be setbacks. And that was one. As you know Mike, I always like to look at the glass half full and we've had a number of -- a number of successful flights with their aircraft since we last spoke, including one with this particular aircraft for just under an hour.

[Michael Crawford:]

And Deanna, I think -- did that show up in the cost of products sales?

[Deanna Hom Lund:]

It does, it does. Yes.

[Michael Crawford:]

And then last question, switching gears a little bit. What does it mean to have a Microsoft and Dell-exclusive?

[Eric M. DeMarco:]

Right. Mike, this is how I'm looking at this and how I believe our team is looking at it. The DHS contract is for continuous monitoring of every civilian federal agency. I think there are 33 of them and I think 32 of them have already signed up, the only one that hasn't is GSA and I think they're going to in January or February. This is the successor to FISMA. So instead of point, of data point in time, assessing cyber threats, this is continuous monitoring for cyber threats. A significant number, if not every federal civilian government agency, uses Microsoft or has Microsoft operating system or Microsoft products -- Microsoft Asset Management, et cetera and a significant number, if not all, federal civilian government agencies use Dell hardware. So our strategy was to get them on our team, we're the prime, get them on our team, exclusively, with the thinking that there is going to have to be an inventory, for example, of all of the devices out there by the various agencies and the agencies that decide to move forward with this continuous monitoring contract. If they're going to take an inventory initially, it's going to be cheaper and less costly it they already have licenses to go through it with Microsoft. If they're already running Dell hardware, they don't need to acquire additional hardware to perform certain functions under the contract. So, our angle and we're hopeful we're going to learn this very soon when task orders start coming out and we are already having discussions with customers ahead of the task orders, which is how we need to work this, that we will have our team will have an advantage, a cost advantage and a technological advantage. Cost, because the customers already have a significant asset footprint and technological, because we have the guys that are running the technology on these systems. And they're exclusive to us. And so, we'll see. This is going to be very, very interesting over the next 6 months.

[Operator:]

Our next question is coming from John Nelson from the State of Wisconsin.

[John Nelson:]

Eric and Deanna, I can't remember -- and I've been on these conference calls for many years, when you've given -- you've rattled off as long a list of potential opportunities. And I think that's a good tribute to you and your team. Could you expand a little bit more on the potential timelines for some of these opportunities as far as when they might be, decisions might be made in the scope of next year versus 2015 or later?

[Eric M. DeMarco:]

Yes. I believe right now, our support on the Trident program, which is one of the largest programs in the company, I believe that, that will be determined and will be awarded in Q4 at the latest, Q1. I believe the Air Force contract AFSAT that we're in negotiations now on Lots 11 through 13, we're currently producing Lot 10. The Lots 11 through 13 will be 3 years and those are sole-source because we own the data rights. Right now, current estimated timing on those is mid-2014. I mentioned that there are a number, it's 4 or 5 large opportunities in PSS, our critical infrastructure security business that I'm hopeful we're going to win. We're going to be very competitive, but I'm hopeful we're going to win. I think those are all expected to be awarded right now in Q2 and Q3 of 2014. On the Unmanned Systems side, John, that would be a first half, right now, '15 event.

[John Nelson:]

Is Kratos doing any work with Boeing and Lockheed on the SR-72? Or can't you say? I mean, if you can't say anything, that's okay.

[Eric M. DeMarco:]

Yes, thanks -- thank you, sir.

[John Nelson:]

How about any additional information that you can provide us with on the UCAS program, as far as near-term plans or/and scope?

[Eric M. DeMarco:]

Near-term plans are, we are working, we have been working and we're continuing to work with customers and potential customers on mission and requirements and performance characteristics for the aircraft. We have a very -- Beaman has a very good idea and a very solid vision of where he see is this going and his recent discussions with a number of entities is literally confirming it every week. Our success bringing in Vice-Admiral Malone on board, I look at it as huge coup. He gives us access to additional customers and potential customers that Admiral Beaman can't interface with for another, I think 8, 9, 7 or 8 months because of the 1 year limitation, because he left, he retired last August. So and over the next, as I mentioned, over the next 5 or 6 months, a number of flights with, John, I'm going to use the word precursor aircraft, I'll use that for now. That may change in the future, that have characteristics that are directly -- with the directly attributable to the final airplane.

[John Nelson:]

And if things went according to plan, do you have any timeline or estimate as to when you would have a product ready to introduce to the government, present to the government?

[Eric M. DeMarco:]

You can see me, I'm smiling and I'll answer this way. I can assure you that Admiral Beaman's timeline is much, much more aggressive than mine. But right it -- I don't want to say it. I think we'll feel a lot more comfortable talking about it either in Q1 or Q2 after some more flights.

[John Nelson:]

Okay. And then just -- can you expand a little bit more on what's going on with the nondefense security systems integration business?

[Eric M. DeMarco:]

Yes. The opportunities, John, remain extremely robust. It's amazing how security-conscious, commercial, critical infrastructure security companies and entities, chemical companies, oil companies, rail companies, how conscious they are right now because of the threat profile in the information that they're receiving. Additionally, the threat profiles on Metropolitan areas and mass transit relative to them. It's as robust as I've seen since I've been with the company and we've built this. There are -- it is getting more and more competitive. There's no doubt about it. However, our past performance qualifications with some of the cities that we have in the mass transit, enterprises that we have are second to none and that has helped see us through on a lot of these. I'll tell you, we -- I like to say the bad with the good. We just recently lost 1 at a city up in the kind of sort of near the Northwest where were underbid and we're seeing that here and there. But I believe, I truly believe, John, this business is going to continue to grow organically very, very strongly into 2014 and we are going to manage the heck out of it to get to improve those margins.

[Operator:]

And our next question comes from Mark Jordan from Noble Financial.

[Mark C. Jordan:]

Question relative to the contracting environment. We started to see push out and delays in 2012 in anticipation of sequestration and budget cuts and that seems to have obviously continued and be accentuated here in October with the shutdown. Has the DoD responded to those pressures? They were -- they focused on the shorter-cycle procurement programs, many of the things that you do, which are -- where you can postponed contracts, postponed deliveries. But over the longer term, if you're going to live within a lower budgetary environment, you need to address some of the long-cycle procurement items like playing ships, absolute headcount of the military, things of that sort, which are only changeable over the longer-term. With that preamble, my question is, as we move into 2014, do you think there'll be more predictability in your shorter-cycle procurement businesses moving forward compared to the uncertainty in '12 and '13 as the DoD focuses on other areas for efficiencies and cost reductions and you get more visibility of your base longer-term programs?

[Eric M. DeMarco:]

Mark, if it was July or August, I would have said to you, absolutely yes. I would've said to you that sequestration is going to be here. We're going to a have $408 billion base defense budget, we're going to get a budget on October 1 of '13 for Federal fiscal 2014 and then we're going -- it's going to give us some predictability. Then we went through September 30 and October 1 with the shutdown, a CRA that only goes through January 15 and a federal ceiling limit through February 7. I don't know right now. I just don't know what's going to happen and our customers don't know what's going to happen. They're very cautious. That's the tone, cautious, right now. If they've got $100 to spend or obligate, they're spending or obligating $70 and they're holding $30 in their pocket to see what's going to happen. And that's kind of what we see right now. So right now, Mark, if I had to speculate, I think '14 is going to be choppy on the DoD side, that's 60%, 65% of our business. We're on some great platforms, so our choppiness is banded. There's a band around it, which is very reassuring to us. And that's one of the reasons I went through a lot of those programs today. I wanted to reiterate to people that the programs we're on are fundamental to the national security of the United States. We're not going to be de-orbiting satellites. We're not going to be decommissioning Trident, ballistic missile submarines, thing with product operates etc. within the band is going to move around a little bit, but it's funded, it's going to be solid. And when we get clear of this environment, whenever that this, we're going to be really, really well-positioned. And thank -- I thank the Lord literally every day that 35% of our business is security -- is commercial security customer-focused or international-focused, especially in the missile and the radar area because people are arming to the teeth right now.

[Mark C. Jordan:]

Okay, with the UCAS program, have you demonstrated, extended on station capabilities?

[Eric M. DeMarco:]

We have not.

[Mark C. Jordan:]

When would you expect that to occur?

[Eric M. DeMarco:]

I would rather, as I mentioned to Mr. Nelson, we'll probably be in a better position to discuss that in the middle of next year, sir.

[Mark C. Jordan:]

Okay. Could you say in that program or initiative area, do you have a sense of what you work on that investment has it -- has been in 2013 and sort of a band of what it might be in '14?

[Eric M. DeMarco:]

On the IR&D side, the investment...

[Deanna Hom Lund:]

IR&D for 2012, Mark, is roughly, it's about $10 million.

[Eric M. DeMarco:]

In '13?

[Deanna Hom Lund:]

Yes.

[Eric M. DeMarco:]

In '13. So the IR&D side, Mark, it's about $10 million. In addition to that, there is the cost of flying. And when I use the term Blue Sky flights, those are noncustomer flights. Those are internally funded flights where we fund them. We fund the rain cost, we fund the people that are out there, we fund the aircraft. So I'm going to guesstimate that on top of the $10 million, there is an additional $5 million or so.

[Deanna Hom Lund:]

Yes, and the $10 million that I mentioned, Mark, there's a portion of that, that's actually in R&D line. There's some in-cost of sales as well.

[Mark C. Jordan:]

Right, yes. I'm looking at fully loaded program costs. So you would say, it's probably in the $15 million range. Would you hazard a guess of what that might be for both parts in 2014?

[Eric M. DeMarco:]

I don't -- it depends on what happens over the next 6 months with the flights. That'll drive it. That will drive it. That will drive a lot of it.

[Mark C. Jordan:]

All right. A final question for me. Relative, as you've said there seems to be a growing understanding of need for a different form of UID that can live in contested airspace. Has there been a movement by the DoD to formalize a program of record an solicit folks to get involved in this initiative? Or are you truly the only one out there addressing it now with -- in essence is more of a commercial model versus a DoD-sponsored initiative?

[Eric M. DeMarco:]

Mark, for competitive reasons, I don't want to get into too much on that topic right now. But there is -- in the public domain, particularly in the last 3 months, there is definitely an increased awareness happening now that I go back to the famous saying that one leader said "quantity, the quality all of its own" And we may have one, our country may have one platform that can take out 100 of the bad guys but then there are another 300 that come and people are starting to be aware of that, especially operating in contested environments. So that's again, for competitive reasons, that's probably all I should say on that right now, sir.

[Mark C. Jordan:]

Okay. Final question, relative to refinancing. You obviously gave a lot of specifics, but would it be fair to say that you would be disappointed if your company did not enter 2014 with a different capital structure?

[Eric M. DeMarco:]

We will be disappointed. We will be disappointed if we don't refinances debt at a significantly reduced rate that significantly increases the cash flow of this company that we plan on letting accrete to the equity. And if all of those points mean we can get those terms and those conditions between now and the end of the year and we don't get it done, I will be very disappointed.

[Operator:]

We'll take our next question from Tyler Hojo from Sidoti & Company.

[Tyler Hojo:]

Just firstly, I'd like to visit the reduced free cash flow guidance for this year. It looks like the biggest delta there is really predicated on kind of the inability to cheat the DSO target. Just in context with some of the conversations you've had with some of the other questioners, I'm just kind of curious, if you can't reach 90 days under a stable environment, and you don't expect a stable environment in 2014, is free cash flow just going to remain kind of lackluster here for the foreseeable future?

[Deanna Hom Lund:]

Well, there's a couple of pieces, Tyler. So, there's the unstable environment but there is also contractual milestones that will allow us to bill. So once we hit those contractual milestones, we should be able to reduce the DSOs. It's outside of a stable or unstable environment. So that piece can and will and we do expect to happen. In addition, we've got some increased DSOs in our Public Safety business, which is really driven by focus, which we plan on putting a lot more focus on it from a cash collector's perspective that we can drive in any type of environment from a DoD perspective.

[Tyler Hojo:]

Okay. Eric, I'm just kind of curious. I mean, we've talked about this being -- thinking about this business as a $50-million-a-year free cash flow business. I mean, has that changed a bit? I mean, how should we think about the business on a go-forward basis, from a cash flow perspective?

[Eric M. DeMarco:]

Right. I don't believe it's changed because I can see it sitting in receivables on the balance sheet. I can see it sitting there. And on the government side, on the government side, when DFAS walked off the job, or they were furloughed and they couldn't come out and sign off on shipments, that started moving things out. That's number one. Number two, we were sitting here today, we have 2 significant milestones with 2 international customers, international. These have nothing to do with the U.S. DoD. They've moved from Q4, right now, the execution point is targeted for Q1. Nothing to do with the DSD -- DoD. But most importantly, it's what Deanna said, that's very -- and it's disappointing to me. Our critical infrastructure security business. Tyler, the business has been focused on growing. And it's been doing that. It's incredible. I mean, I believe we're going to achieve 15% year-over-year growth in Q4. Okay? The eye has been taken off the ball on collecting the receivables. And what makes it even more frustrating is a good number of these receivables, they're not with mom and pops, these are with national financial institutions, national energy companies, large metropolitan areas. And it's just sitting there. And you can see it. And so that's why I'm getting a little emotional here because I'm not happy about this, because I can see it sitting here and it's up to us to go get it and I can assure you, over the next 2 quarters, that's what we're going to do.

[Deanna Hom Lund:]

And Tyler, just as a reminder from a DSO perspective. At the end of last year, we were at 94 days. So it is --90 days is not impossible to achieve. We were there 9 months ago and our focus is to get back to that level. Obviously, with a more product-centric mix business, that is a little choppier from a collections' perspective, but as Eric said, there's some fairly sizable billing milestones with foreign government customers that once we hit those flights, we should be able to build those in their sizable amounts, which should bring the DSO down.

[Tyler Hojo:]

Okay. All right. Well that's something to look forward to in the near future.

[Deanna Hom Lund:]

Yes.

[Tyler Hojo:]

Okay, wonderful. And just moving onto something else. I just wanted to get, if you can provide, a little bit more detail into what impacted the PSS margins in Q3? I mean, you've made some kind of vague commentary around that. But if you could be a little more specific, that might be helpful.

[Eric M. DeMarco:]

I will be as specific as I can, considering the circumstance. There was a management issue, number one, that has been addressed definitively. That has been addressed. That's number one. But number two, in this area, we are back to the growing. We're growing, growing, growing. And it's great to sell this stuff and it's great to put together the EAC and put together the deployment plan and the labor plan and everything. But then we have to manage it to what we submitted. And we didn't do that. And we are going to do that and we are readdressing the cost structure. We are looking at it again. As you know, we looked at it that the end of Q1 and Q2. We made some adjustments and in Q2, I think our EBITDA margins went up 300 basis points. I am confident that we're going to achieve that similar type of expansion in Q4 than we're going to sustain it going forward.

[Tyler Hojo:]

I mean, is this a function of the competitive environment is just getting much more competitive on some of the new wins you're having so you basically need to react by lowering the cost structure of once the contracts are in? Is that the right way to think about it?

[Eric M. DeMarco:]

That is absolutely a piece of it, which is why I said we're going to be revisiting the cost structure. Absolutely, Tyler.

[Tyler Hojo:]

Okay, that's great. And then the last one for me, I guess for Deanna, if we look at the delta in terms of the cash EPS guidance, what is the biggest incremental expense that's moving that?

[Deanna Hom Lund:]

Well, obviously, we're working with a lower base EBITDA. So that's driven by some SG&A. So we had some increased SG&A as a result of enhancing our internal Cybersecurity protection. That's part of it. It's part of the infrastructure costs and compliance related to that. And as a function of revenues, R&D, the investments in certain of these key areas, is also driving that EPS as well.

[Tyler Hojo:]

Okay, and that's part of that $15 million that we were just talking about?

[Deanna Hom Lund:]

That's correct.

[Operator:]

And our next question comes from Greg Konrad from Jefferies.

[Greg Konrad:]

I was hoping just to talk a little bit about fiber. You mentioned it in relationship to the DHS contract but I was just wondering, kind of how would you size that business and overall opportunities outside of DHS?

[Eric M. DeMarco:]

How would I size our current cyber-related business?

[Greg Konrad:]

Correct.

[Eric M. DeMarco:]

Both terrestrial and space-based, I'm going to guesstimate around $100 million is the current business size.

[Greg Konrad:]

And do you see a lot of opportunities to kind of grow that business outside of the DHS contract?

[Eric M. DeMarco:]

We do in certain niche areas, the general Cybersecurity environment is commoditizing, just like all the other government services. It's commoditizing right in front of us. It's all turning into a cost shootout, which is why we have had made and we're continuing to make significant investments in our software products, NeuralStar, dopplerVUE and a new suite that we announced about 2 months ago where we're starting to see some traction, all right. I don't see for us outside of that DHS area, that the Cybersecurity opportunity is huge for us. I think that we're going to have and we're going to continue to have some moderate success because of the target markets we're going after with these specialized products is small, with our software products that bring very high margins. Potential flywheel for us will be that continuous monitoring contract and the consolidated and of all the continuous monitoring oversight by the DHS and the matching money that they're going to give other agencies. And also importantly, and I didn't mention this before but I should have, this contract vehicle also allows municipalities and state and local governments and other agencies to use it. And as you know, we have significant access to that customer base for our PSS business.

[Greg Konrad:]

And then just when I think about Q4 and the range for guidance, how much visibility do you have for the final quarter of the year? I guess I'm just kind of thinking about what's in backlog and what type of orders are at risk and how you guys from the bottom to the top end of the range?

[Eric M. DeMarco:]

Right now, we are very comfortable with the ranges we have given. Very comfortable.

[Greg Konrad:]

Okay, and then can you just remind us, do you have a position on AMDR and any opportunities as that program gets moving to meet -- maybe pick up share?

[Eric M. DeMarco:]

As I said in the prepared remarks, and I said very carefully, we have contractual relationships or strategic relationships with all of the primes on programs like NGJ, AMDR. And we are very pleased. Very pleased. That NGJ was awarded and that AMD albeit protested, that AMDR has been awarded albeit protested and its upwork has been issued and hopefully see what Block 3 was going to be awarded in the next couple of months because those are the types of areas, as you know, our microwave business in my opinion, a second to none at.

[Greg Konrad:]

Okay, and then final question, I don't know how much visibility you have in this, but when you think about the microwave business, talking to other contractors, it seems like there's been some difference between kind of the spares and repairs business and the OE newbuild business. Have you seen additional weakness kind of in that more spares and repairs business?

[Eric M. DeMarco:]

The biggest part of our business is not spares and repairs. Right now, the big pieces were in full rate production like on Trident, in EA-18G and Iron Dome and Spider and Barak in those systems. I'm thinking, I can think of one area where we've seen some weakness. And it was on F-16 radar, in the spares and repairs, one. But it's not jumping out at me.

[Operator:]

And our next question comes from Michael Ciarmoli from KeyBanc Capital Markets.

[Kevin Ciabattoni:]

It's actually Kevin on for Mike. Most of my questions have been answered, just a couple here. Looking again, you touched on the R&D spend in the U.K., instead of the young men's products. I'm just wondering if you could give us an idea of how much of that is being spent for work that's already kind of assigned to customers versus work that you're still competing for, kind of internally versus customer funded, I guess, as another way of looking at it.

[Eric M. DeMarco:]

Right. The vast, vast majority of the IR&D spend, as the acronym says, Internal Research and Development. That is not customer funded. In other words, we are not getting a check from a customer on it. But it very well may be or is customer-targeted where we are doing something for a particular customer or customer set to achieve a requirement. We received a significant amount of money across the company, in the microwave area and the SATCOM area any and in the drone area that you -- one could call funded R&D or funded development that's in revenue and it's in cost of sales.

[Kevin Ciabattoni:]

Okay, that's helpful. And then, what did you see once the government shutdown ended? I mean, what have bookings looked like? Did flow really pick up right away? Was it sluggish to pick back up? And maybe, if you could give us some idea of how much of this shift in the EBITDA and cash flow outlook for this year was kind of directly attributable to the shutdown versus other reasons?

[Eric M. DeMarco:]

Right. The biggest part of the receivables are those international milestones, which is not related to the shutdown. That's the biggest part, where we need to achieve some objectives. We're currently scheduled to get up, back out there and achieve them in the first quarter, I believe. There's that piece. They're -- to the first part of your question. Leap right up the 2 weeks prior to end of the fiscal year, but most importantly after the shutdown has happened and continuing, things are choppy. There are orders where we are designed in. We're designed in on the platform or on the program. We had a commitment schedule. In particular, this is in our Modular Systems Division, where the order has not been placed. It's sitting there. And I analogize that to the statement I used a few minutes ago on caution. There's still caution out there and I can understand it because we're operating under a CRA that goes 15 days after 12/31 and then we saw what happened before, the customers are cautious. And it's just choppy right now. It's very choppy.

[Kevin Ciabattoni:]

Okay, understood. And then the last one for me. Just wondering there if you can give us some color on what you're seeing internationally in terms of opportunities and new business pursuits?

[Eric M. DeMarco:]

Yes. Internationally, the opportunities are in missiles, primarily in missiles and radars. And these are offensive missile systems and missile-defense systems, both tactical and ballistic missile defenses. The opportunities are significant. We've been seeing many of them in the press recently. What's going on with that? What's going on with Patriot? There aren't a lot of specific announcements out of Israel relative to what's going on there but Iron Dome is growing. Arrow, Arrow 1, Arrow 2 and Arrow 3 are all growing. Missile systems related to India from Israel are growing significantly. So there are significant opportunities in the missiles and related radar areas out there and I think virtually every system I just mentioned to you, we're designed in and on them. And so as the OEMs, God willing, are successful in these areas, so are we and we go with them.

[Operator:]

[Operator Instructions] And we'll take our next question from David Olkovetsky from Jefferies.

[David J. Olkovetsky:]

I wonder if you could just give us a bit more sense on what's happening with the expected milestone payments with regard to the production contracts, now that we're 48 days into calendar as last fiscal 4Q. Have you been able to collect on any of those yet? Are you seeing any more pushback with respect to your receivables?

[Eric M. DeMarco:]

Right. Yes. We have continued to collect milestones in many areas across the company. The 2.5 or 3-week delay did gum things up, especially relative to DFAS coming out and signing off things that resulted in shipment and then you achieved the milestone to bill it. But those are occurring. They are happening. Foreign ones are the ones where the events aren't scheduled to occur to achieve the milestone until the first quarter.

[David J. Olkovetsky:]

Got it. Okay. And I just want to make sure I'm looking at the numbers correctly. Are you anticipating a further working capital outflow in the fourth quarter?

[Deanna Hom Lund:]

No.

[Eric M. DeMarco:]

Oh no.

[Deanna Hom Lund:]

No, we're assuming a moderate reduction in DSOs of a couple of days.

[David J. Olkovetsky:]

And that's $2.5 million per day, correct?

[Deanna Hom Lund:]

That's correct. And it also reflects the interest payment. So we do have the quarterly interest payment that's due the first week of December on the bonds.

[David J. Olkovetsky:]

Got it, okay. And then switching gears a little bit. With respect to your capital structure, I just wanted to get your thoughts, what is your ideal structure look like at this point? Are you thinking of possibly switching to a term loan or are you planning to stay with senior secured notes?

[Eric M. DeMarco:]

It obviously would depend on the terms and conditions that we could get off of each and strength in each market at the time. I mean, if the term note market is strong as hell and we could get an incredibly low rate in the term note market, I'd consider going and getting as much possible term notes as I could get at the lowest possible rate because I can pay them off. It's like 1% a year, as you know, for 6 or 7 years, then a bullet at the end. That would be really good. Similarly, on the bond side, bond rates have been -- and bond terms and conditions are back to where they were in May and as you know, some of the bond structures out there, you can actually take out bonds now and you can pay off 10% a year at 103. Well, depending on what that rate look like and those have very few terms and conditions, I'd have to look at that but we may play them off each other and try to get the best on each. I know that's not a direct answer but we're going to put in place the lowest-cost capital structure, including the flexibility to pay things off so we can execute this business plan that we can.

[David J. Olkovetsky:]

Okay, that's very helpful. And then what is the minimum level of cash that you're comfortable sitting with?

[Deanna Hom Lund:]

About $50 million.

[David J. Olkovetsky:]

About $50 million.

[Deanna Hom Lund:]

Yes.

[David J. Olkovetsky:]

Okay. And then with respect to capital expenditures, I don't know if you're done with budgeting process yet for 2014, but are you thinking somewhere along the line of what you've seen so far in 2013?

[Deanna Hom Lund:]

There probably should not be any material changes from '13's levels.

[David J. Olkovetsky:]

Okay. Got you. And just on a free cash flow side, I understand that there's a lot of uncertainty with respect to what's going on in the Federal government. Excluding any changes to the capital structure, do you envision any strengthening in free cash flow generation in 2014 relative to 2013 or is it just too early to tell?

[Deanna Hom Lund:]

Yes, we do expect that to occur as the DSOs both from the international customers as well as PSS, that will, on its own, drive the free cash flow generation, as well as on the DoD side.

[David J. Olkovetsky:]

Okay. And then just on that DSO front, what is the approximate level of days that you actually anticipate achieving? Or any sort of look in a conservative case scenario, what's the level of DSO reduction do you anticipate?

[Deanna Hom Lund:]

Our long-term goal is to be at 90 days and we were at 94 days at the end of last year. So we know that's achievable and that's our expectation to get back to that level.

[David J. Olkovetsky:]

So you view 90 days as a reasonable level to get back to in 2014 or is that more of a 2015, 2016 type event?

[Eric M. DeMarco:]

That would be our target.

[Deanna Hom Lund:]

Yes.

[Eric M. DeMarco:]

Absolutely.

[David J. Olkovetsky:]

Got you. And then exclusive of changes to working capital, can you give me a sense for free cash flow generation outside of that?

[Deanna Hom Lund:]

You mean other than working capital?

[David J. Olkovetsky:]

2014, relative to 2013. Or if it's too early to tell about that. That's the...

[Eric M. DeMarco:]

We haven't given -- provided any guidance yet for '14 for the obvious reasons, because we're waiting to see what's going to happen in January and in February. But if you -- Deanna has walked through in the past, if you use a $110 million of EBITDA or $105 million of EBITDA and you assume an interest rate and that, as we've talked about very well maybe changing with the refinancing, subtract the interest rates, subtract the cash -- the CapEx. We pay cash taxes, I think $3 million or $4 million a year, in that ballpark. This is excluding any DSOs. You get -- you come to a number. You should -- I don't want to give the guidance for next year. You should run the math, but that's the way to look at it.

[Operator:]

So I'm showing no further questions. So I'd like to turn the call back to Eric for any concluding remarks.

[Eric M. DeMarco:]

Thank you very much for joining us. We're truly looking forward to speaking with you again when we report Q4 and Q1 to provide progress on how the business and some of these initiatives are doing. Thank you.

[Operator:]

Okay, ladies and gentlemen, this does conclude your conference. You may now disconnect and have a great day.