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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call will be recorded.
I would now like to introduce your host for today’s conference, Ms. Marie Mendoza, Senior Vice President and General Counsel. You may begin.
Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions second quarter 2018 conference call. With me today is Eric DeMarco, Kratos’ President and Chief Executive Officer; and Deanna Lund, Kratos’ Executive Vice President and Chief Financial Officer.
Before we begin the substance of today’s call, I’d like everyone to please take note of the Safe Harbor paragraph that is included at the end of today’s press release. This paragraph emphasizes the major uncertainties and risks inherent in the forward-looking statements we will make this afternoon. Please keep these uncertainties and risks in mind as we discuss future strategic initiatives, potential market opportunities, operational outlook and financial guidance during today’s call.
Today’s call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G. Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP. Accordingly, at the end of today’s press release, we have provided a reconciliation of these non-GAAP financial measures to the Company’s financial results prepared in accordance with GAAP.
With that, I will now turn the call over to Eric DeMarco.
Thank you very much, Marie, and good afternoon, everyone.
In Q2 we continued the successful execution of our strategy to be the affordable alternative prime platform and system provider in our core C5ISR market areas including high-performance, unmanned aerial drones, training systems, microwave electronics, satellite communications and rocket systems.
In the past five months, we have announced approximately $380 million in new contract awards, including $220 million in the second quarter, leveraging off of our technology and intellectual property, and reflecting the strength of Kratos’ business model with the vast majority of these contract awards related to long-term multi-year programs and platforms where Kratos is the prime contractor and system provider.
In Q2 Kratos’ bid and proposal pipeline increased $0.5 billion from $6 billion to $6.5 billion, representing the increasing alignment Kratos has with the U.S. and its allies’ national security priorities, all providing confidence in our 2018 financial forecast and future growth trajectory.
As I discussed at the beginning of this year, we are focused on increased margins and free cash flow, and we are making decisions for the business specifically focused on these objectives. And in Q2, Kratos’ gross, EBITDA and operating margins all increased as production programs ramp up and investments in unmanned systems wind down. We expect each of these financial performance matrices to continue to improve in the second half of 2018 and we continue to expect Kratos to return to positive free cash flow generation in the fourth quarter of this year.
Since our last earnings call, Kratos’ unmanned systems business delivered our first production BQM-177 SSAT drone to United States Navy under Low Rate Initial Production or LRIP Year 1, which we received in 2017 for 35 drones. Earlier this year, we received SSAT program LRIP2 for an additional 25 drones which we expect to deliver in 2019 and 2020. And just recently, the U.S. Navy publicly announced their intention to award Kratos SSAT LRIP3 sole source for upto 60 drones with execution, production and delivery expected to follow LRIP2. Following LRIP3, we expect to receive a multi-year SSAT full rate production award with even higher annual 177 quantities. And we expect U.S. Navy SSAT program to drive Kratos’ organic growth over the next several years, as we transition from low rate to full rate reproduction.
We recently announced a receipt from the United States Air Force production years ‘14, ‘15 and ‘16 for the AFSAT program Kratos BQM-167 target drone for a value of $109 million with the total expected value of the AFSAT program to be tens of millions of dollars greater than this over the next three-year period, including payload spares and ancillaries. Though we received this sole source contract toward somewhat later than we had originally anticipated, as we had to ensure that the financial and other Ts and Cs aligned with Kratos’ margin and cash flow criteria, we have it now, which is key element of Kratos affirming our fiscal 2018 full-year financial guidance today, with Q4 now expected to be somewhat stronger than previous [technical difficulty] due to the delay.
The quantities in BQM-167s we expect to deliver under this Air Force sole source three-year production contract award are expected to be significantly increased over the previous annual AFSAT production quantities based on recent discussions with our [technical difficulty] with the AFSAT program also expected to drive Kratos’ future organic growth.
Execution for our U.S. Army customer remains on-schedule and on budget for Kratos’ MQM-178 target drone and the modified BQM-167 target drone programs. We are beginning to ramp up for the U.S. Army under the $93 million single award contract Kratos received earlier this year. And we expect this program to also be a significant future growth driver as full rate production quantities are achieved.
At the Farnborough Airshow few weeks ago, we announced a 10-year agreement with QinetiQ for Kratos’ Firejet MQM-178 target drone. We expect to deliver numerous Kratos’ Firejets annually to QinetiQ over the 10-year contract term, beginning in 2020, with the contract’s ultimate value to Kratos’ expected to be multiple tens of millions of dollars. We are currently in discussions with another international customer regarding the potential for Kratos to provide approximately 20 target drones of different types in 2019.
The global macro industry factors are strong for Kratos’ target drone business, including the recapitalization of strategic weapon systems as United States and our allies prepare for peer and near peer adversarial threats with Kratos target drones utilized to exercise and test strategic weapon systems, including radars, surface to air, and air to air missiles, fighter aircraft and other systems.
As you know, we have taken Kratos’ industry-leading affordable, high-performance, target drone technology and adapted it to the tactical or combat drone area. Each of our tactical drone programs are on schedule and on budget, and we continue to expect to demonstrate Kratos’ XQ-58A or the Valkyrie in Q4 of this year, which we believe will lead to an initial production order in 2019, based on discussions with our customers. With the planned Q4 2018 Valkyrie demonstration flights, the significant company funded investments Kratos has been making over the past several years in our unmanned aerial drones business will be complete which will result in significantly increased future profit and cash flow generation for the Company.
As a reminder, publicly available pricing and quantities for the Valkyrie are for order quantities of 99 or less, $3 million per aircraft; and for quarter quantities of 100 or more, $2 million per aircraft. I encourage you to Google the recent Popular Mechanics article on July 12th regarding Kratos’ Valkyrie and its future prospects for just one recent available publication discussing the opportunities for Kratos’ Valkyrie platform and why we are so excited.
The Gremlins program, with our prime partner Dynetics continues on track with demonstration of this system currently planned for 2019. As Kratos is not the prime on the Gremlins program, we are limited to the information that we can provide but we fully expect the Gremlins UAS, once successfully demonstrated, to enter initial limited production and to also ultimately be one of Kratos’ largest and most important programs and platforms. Publicly available pricing and quantities for the Gremlin UAS from the government which pertain to the aircraft that would be provided by Kratos are at order quantities of a 1,000, a 700,000 price to Kratos per Gremlin UAS. I encourage you to Google Swarming Gremlin Drone Prototypes Take Flight From US Sales-130, this is very recent, for some of the most recent information on the status of the Gremlins program and the future prospects of this system.
The majority of Kratos’ Mako tactical UAS work is restricted now. Though I can’t say that we expect a new large Mako related contract by the end of 2018. We are now in a position to discuss an additional tactical UAS program that Kratos is under contract on which we refer to as program F where we recently had a very successful series of test flights with our current expectation for Kratos to receive an initial production order in 2019. Similar to Kratos Valkyrie and Gremlins, project F if successful, also has the potential to be a multi-hundred million dollars system or platform to Kratos.
At the funding and priority level, proposed spending for unmanned vehicle systems by the U.S. Military totals approximately $9.6 billion for 2019, an increase of 28% over the previous year and we are continuing to see strong interest for Kratos tactical UAS’s increase across the customer community. We have made numerous recent key hires in our Unmanned Systems division, including an operations, production and manufacturing executive that previously worked on the F-35 program. And we have also hired a retired four-star Air Force general who is focused on Kratos tactical drone success. We will continue to add key, experienced execution personnel and Kratos’ unmanned systems business for the foreseeable future, as a result of the significant growth we are currently seeing and are forecasting for this business.
Finally, in unmanned systems, we’re on track in Oklahoma for production of Kratos unmanned aerial drones in 2019 and we are currently receiving composite aero structures components related tooling from two strategic partner providers.
Kratos’ training systems business, where Kratos is also a prime system and platform provider, continued its solid growth trajectory in Q2, driven in part by the large, long-term, multiyear program awards we have been successful in receiving which are in production, ramping or in delivery including MCAT, KC-46, the Royal Saudi Navy and others. We expect significant positive cash flow generation from certain of these programs beginning in the second half of this year and continuing thereafter as we deliver and achieve milestones. Since our last call, Kratos’ Royal Saudi Navy customer and the U.S. government FMS partner announced significant increased program funding of just under $40 million, which further solidifies Kratos’ training business growth expectations and provide future visibility.
From a macros market standpoint, the recapitalization of strategic weapon systems globally is also driving Kratos’ training business as operational readiness and the war fighters’ ability to operate and maintain very sophisticated weapon systems and platforms is critical.
Kratos’ microwave electronics business had a very strong first half of 2018, supporting major radar, missile, electronic warfare, C-AD, D-AD [ph] communications and other systems with certain customers actually accelerating work Kratos is performing on, which resulted in some revenue and profit shifting from our Q3 2018 forecast into Q2 2018 with the shift to the left, resulting in a somewhat stronger Q2 for Kratos’ microwave business and for Kratos overall.
Kratos microwave electronics business backlog remains near record high levels. And based on current under contract program execution, delivery schedules and order flow, we expect this business to have a solid second half of 2018 and a particularly strong Q4.
The recapitalization of strategic weapon systems, including electronic warfare, radars, missiles and other C5ISR systems is a primary positive macro market factor for Kratos’ microwave business which represented major programs and platforms we support, including the F-16, the F-15, Griffin Iron Dome, BARAK, LRASM and QRASM.
Kratos’ space and satellite communications business performed as expected for the first half and second quarter of 2018 with the second half of this year and Q4 in particular looking to be extremely strong, based on our current execution, delivery and expected order booking schedules. The expected strong second half for Kratos’ space business is similar to prior years, and we believe that this is at least in part driven by the recurring extended continuing resolutions which result in significant funding obligations and order flow in the second half of the year, once the full-year DOD budget is in place which positively impacts Kratos.
Kratos’ in space business is also operating in a growing macro market environment with significant increases in the space and satellite communication budgets in 2018 and forecasted for 2019 to address potential peer and near peer adversarial threats for the U.S. space assets.
Additionally, the growth in the low Earth orbit or LEO satellite area, which is driving a new generation of command, control, signal monitoring and other equipment and requirements is also providing a number of new opportunities for Kratos’ satellite business as our restricted programs. Kratos’ globally owned and operated satellite signal monitoring, interference detection, identification, location and mitigation business also continues to see strong demand for a very unique capabilities with growth in the expected number of LEO and other satellites also forecast to drive Kratos’ business in this area going forward. Major space programs that Kratos supports which we can discuss here include WGS, AEHF, MOUS, SBIRS and GPS.
Kratos’ rocket support services business, where Kratos is the prime system and platform provider for ballistic missile defense targets and other systems continues to execute on-track and on-plan. The missile-defense area is also seeing significant funding and increases, as a result of the threat environment. And Kratos’ affordable technology and our leading BMD targets are seeing strong demand as our customer set is looking to test more at an affordable cost, which is the sweet spot of Kratos’ offerings and our Company’s value proposition.
Similar to Kratos’ unmanned system business, Kratos RSS business owns important intellectual property, market and system rights, which we believe will become increasingly important and valuable to our Company, especially in the hypersonic systems area as we move forward.
Kratos’ Modular Systems business, where we support missile-defense and other C5ISR systems including Patriot and FAD is starting to see multiple new opportunities, as a result of the increased global threat environment and the resulting recapitalization of strategic weapon systems I have discussed previously. The number of qualified C5ISR opportunities our Modular Systems business is currently pursuing is the highest that we have seen in quite a while, with additional opportunities expected based on discussions with our customer partners. And we are focusing accordingly as we expect to receive a number of large system awards by the end of this year to achieve MSD’s forecast.
As a result of the opportunities we are seeing in the C5ISR area, we have recently made the decision to exit the non-DOD or non-C5ISR area of MSD, which has been focused on commercial and non-DOD markets. With the exit of this non-core business area, we will be consolidating facilities, retiring capital equipment, tooling, related expenditures and other related assets and reducing headcount in the third quarter of 2018 which will result in a onetime non-operating charge which sees actions reducing our future cost structure and increasing our future profit margin from cash flow.
As was recently reported in an interview with the Defense News Lieutenant General Charles Hooper, Head of the Defense Security Corporation Agency said that through the first two quarters of this fiscal year, the U.S. has signed $46.9 billion in weapon sales to foreign partners and allies, smashing past the $41.9 billion figure for all of 2017.
With the increase in U.S. international weapon sales, it is important to understand how this is directly and positively impacting Kratos, which today generates approximately 20% of our revenue internationally. When a major prime like Raytheon or Lockheed Martin makes a Patriot or FAD missile-defense system sale internationally, this is directly positive for Kratos as Kratos provides significant hardware and subsystems for both of these platforms. And customers acquiring these systems like to exercise the weapon system against Kratos target drones and ballistic missile targets.
When a country like Saudi Arabia acquires C5ISR systems from the United States, this provides Kratos training business opportunity, including solutions like with our large Royal Saudi Naval program. When a country requires weapon systems from the United States like an F-35, this provides significant opportunity for Kratos’ unmanned aerial target drone business as the F-35 is the highest technology fighter flying today, which is designed to defeat the leading threats of the United States potential adversaries and Kratos target drones represent these potential adversarial threats. When a country like Australia requires a WGS satellite from Boeing, this provides Kratos satellite communications business the opportunity to provide our command and control, signal monitoring other products in support of the satellite system. And finally, when a company acquires a U.S. combat system like Lockheed Martin’s Aegis system and the related Raytheon SM-3 missile, this provides opportunity for both Kratos’ ballistic missile targets business and our unmanned aerial target drone business as well as recently demonstrated at the Formidable Shield 2017 exercise where numerous Kratos BMD and UAS target drones were utilized to exercise NATO and fleet weapon systems.
I walked through this as I believe that it is important to understand how embedded Kratos’ systems, platforms, products and solutions are with both the United States, DOD, and our international partners and allies requirements, and how the increased sales of U.S. weapon systems internationally is directly and positively impacting Kratos.
In closing, Kratos’ business is on track and performing well. We announced $220 million in contract awards in Q2, approximately $380 million in contract awards in the past five months, and our bid pipeline is increased $500 million up to $6.5 billion, all giving us confidence in our 2018 forecast and our long-term growth trajectory.
In Q2, our gross operating and EBITDA margins all increased and are expected to further increase in the second half of the year, with the expectation of the Company returning to free cash flow positive generation in Q4 2018. Kratos’ tactical drone programs continue to progress. We expect to receive initial production orders in 2019, which once ramped, will add significant further organic growth over and above the already significant growth we expect to generate from our target drone and other core businesses. We are focused on execution and achieving or exceeding our forecasts.
Deanna?
Thank you Eric. Good afternoon.
Kratos’ second quarter 2018 revenues of $151.2 million were above the range of our forecast of 140 to $150 million. And our adjusted EBITDA of $12.1 million exceeded our forecast of $9 million to $11 million. Additionally, Kratos’ adjusted EPS of $0.02 also exceeded our forecast of breakeven to $0.01 for the quarter.
Second quarter year-over-year consolidated organic revenue growth of 2.2% was driven by growth of 60.4% in our unmanned systems business including Low Rate Initial Production 1 of our BQM-177 or SSAT aerial target. In the second quarter, Kratos Government Solutions division or KGS, generated revenues of $115.6 million, adjusted EBITDA of $8.5 million and operating income of $5 million, all of which were down slightly from the prior year due primarily to the continued decline in Kratos’ legacy government services business.
From an accounting standpoint, Kratos was required to adopt a new revenue recognition practice, beginning January 1st of this year which can affect the timing of revenue recognition for certain contracts. As a result of the adoption, Kratos realized approximately $3.6 million of increased revenues in the second quarter with approximately $900,000 and $2.7 million in the increase related to the KGS and KUSD divisions respectively.
On a year-over-year basis, our Q2 ‘18 adjusted EBITDA increased 18.6% or $1.9 million from $10.2 million in the second quarter of ‘17 to $12.1 million in the second quarter of ‘18. Our adjusted EBITDA for the second quarter is from continuing operations and excludes non-cash stock compensation cost of $1.7 million, severance related costs of $200,000 and $2.8 million related to the pending legal settlement and related legal costs associated with the matter involving a former employee that was part of an acquisition of a legacy government services company in 2006.
Kratos’ operating income increased 73.3% from $1.5 million in the second quarter of ‘17 to $2.6 million in the second quarter of ‘18. With this improvement primarily due to the increase in gross margins from 25.4% to 26%, coupled with a reduction of SG&A for the same period, primarily resulting from cost reduction actions we have taken. On a GAAP basis, net loss for the second quarter was $7.7 million which includes a loss from discontinued operations of $3.9 million which reflects approximately $1.6 million of transaction expenses related to the divestiture of PSS.
We have recorded a net breakeven position on the sale of PSS after current estimates of working capital adjustments, changes in the retained net assets or other adjustments. Any future changes to the working capital adjustments or the retained net assets and the completion of those related projects will be reflected in those future periods.
Moving onto the balance sheet and liquidity. Our cash balance was $182.8 million at July 1st which reflects the net proceeds from the PSS divestiture which closed on June 11th of approximately $67.9 million, plus $3,000 in restricted cash. At quarter-end we had zero amount outstanding on our bank line of credit and $9.3 million of letters of credit outstanding.
Cash flow used from continuing operations for the second quarter was $5.1 million which includes approximately $700,000 of internal non-capital expense related development costs, related to the LCASD program. Capital expenditures were $4.3 million including approximately $2.7 million related to the Unmanned Systems division, primarily reflecting the two LCASD Kratos owned aircraft and related equipment that we’re building. And we expect this capital to be complete in the fourth quarter of this year. On accounts receivable, DSOs increased from a 133 days at the end of the first quarter to a 137 days at the end of the second quarter.
Our DSOs include long-term delivery projects where we invoiced amounts at the completion of certain milestones and/or the final delivery of the product. And we are forecasting a number of billing milestones to be made and paid upon completion of contractual milestones in the second half of the year. Our contract mix for the quarter was 86% of revenues generated from fixed price contracts, 9% from cost plus contracts and 5% from time and material contracts.
Revenues generated from contracts with the U.S. federal government during the quarter were approximately 71%, including revenues generated from contracts with the DOD and with non-DOD federal government agencies. We generated 9% from commercial customers and 20% from foreign customers with our aggregate non-DOD revenues comprising 29% of our total revenues.
Backlog at second quarter end was $501.9 million with $452 million funded and $50 million unfunded. And our book-to-bill ratio was 0.7 to 1 for the second quarter and 0.9 to 1 for the 12 months ended July 1st.
As we mentioned on our last quarterly call, we do not include the full value of contract awards in are bookings or backlogs until tasking or funding is received. Also importantly, number of Kratos’ systems and products are designed in on and support long-term multiyear multi-decade programs platforms and systems which provide solid operational and financial forecasting visibility.
Today, we are providing third quarter revenue guidance of 150 to $160 million, adjusted EBITDA guidance of $12 million to $14 million, and adjusted EPS guidance $0.02 to $0.04.
We are affirming Kratos’ full-year ‘18 revenue guidance of $640 million to $650 million, and adjusted EBITDA of $55 million to $59 million even after the exit of the non-DOD business in our Modular Systems division that Eric mentioned, representing the strengths of our core businesses. We are providing full-year 2018 adjusted EPS guidance of $0.15 to $0.19. We continue to expect our capital expenditures to be in the range of $23 million to $26 million for FY18 with approximately $14 million to $17 million related to our unmanned systems business.
We expect our estimated cash taxes to be approximately $3 million to $4 million for FY18 and expect the impact of tax reform to be fairly insignificant to our estimated cash taxes due to our $380 million of net operating loss position. We are also affirming Kratos’ full-year cash flow from operations guidance, including the expected collection of networking capital proceeds of the PSS business retained by Kratos of total $35 million to $45 million, and we expect to generate free cash flow of $12 million to $19 million for FY18.
Thank you, Deanna. We will now turn it over to the moderator for questions.
[Operator Instructions] Our first question comes Mike Crawford with B. Riley FBR. Your line is open.
Thank you. Eric, you talked about this, I believe you called it program F that had test flights that could lead to orders in 2019, it could be a multi-hundreds of millions of dollar platform. Is that -- did I hear that correctly? And then, secondly, what is the competitive picture regarding this program. So, is this the case where you’re falling off against someone else, or maybe the customer is deciding whether to do this or potentially to go in somewhat different direction, can you just add some more color on to that?
Yes. So, on the first part, Mike, of what you said, the flights have occurred and they were 100% successful. The competition has already occurred relative to this system, I have to be very careful here. And us and our partner with the system were successful. We were victorious. And now, we -- as we head into ‘19, as I indicated that we have to do some things but we are hopeful for an initial production order in 2019.
Okay. Maybe a segue there. Is that -- I think it’s probably mid ‘19 when you might see the first planes come off of the line in Oklahoma? Is this something you would build there?
Theoretically, this is something we would build there. Yes, absolutely.
And then, final question just relates to this. I guess, I’d call it historic and NDAA. It’s been 22 years since we got a budget on time. I mean, I know, it’s not quite so critical, now that you already own LRIP 1 and 2 and AFSAT. But, awarding [ph] a budget in place by September 30th pull in some stuff that might otherwise be pushed for you?
Yes. Mike, the 2019 NDAA, if it holds, looks great for Kratos. It looks great. And I’ll just name one or two programs, the SSAT program, under a continuing resolution, there’s no increase in production, the previous year production rolls over. So, the sooner a 2019 budget is authorized and in place, the sooner we would receive the increased production quantity funding, which would drive our revenue. That would be exactly similar for AFSAT with the Air Force. The sooner 2019 budget is in place, the sooner the increased quantities above the 2018 quantities are funded, so the sooner we would see that growth. So, two points again. 2019 NDAA looks fantastic for Kratos right now, and we are very hopeful as you alluded to that we will not have an extended continuing resolution this year.
And our next question comes from Ken Herbert with Canaccord. Your line is open.
Eric, I wanted to ask you first, margins in the Unmanned Systems segment, nice sequential increase, 15% to 16% incremental margins there. Was that really just volume at the Sacramento facility or was there anything else unique in the quarter that we should keep in mind around the margins?
There was one unique item. We had one very successful mission that was a positive. Now, we have similar mission scheduled in the second half of the year and in the first half of ‘19. So, I don’t want to leave you with the impression that it’s a one-off. These types of missions could and very well may reoccur, but that was one that occurred and it was the first one of its kind.
Okay. And I guess the implication of that would be sort of a one-off positive from a mix standpoint?
That’s how I would take it from now. Yes.
And for the full-year, as you -- maybe you got another one of these, but it sounds like as some of the programs ramp, when I think back to the first quarter, you called out really sort of three items that will drive margins in the segment over time. FMS being one, obviously Sacramento volume, and then the third being Oklahoma City. But, it sounds like this year it’s really maybe these one-off items, but then missions, but then more specifically just Sacramento having an impact. Are we in position to see the second half step up that you talked with everything else largely coming out of Sacramento on the target drones?
Absolutely, we’re looking in the drone business, particularly Q4, and that has to do with the timing of the receipt of these big programs that we just got. But Q3 right now, we’re looking to be about the same, up somewhat to Q2, but then Q4. As we start delivering out and executing on these new awards, this is under contract, we just have to execute, we see a significant step up, and then continuing that into ‘19
So, top line in the segment is similar in the third quarter to the second quarter?
I’d say approximately similar. We may do better -- it’s execution. We got a lot -- we have a lot of wood to chop and we’ve got the wood right with us.
And then, if I could, for you or Deanna, you’ve talked earlier this year, and it sounds like you’re on track considering the reaffirmation of the free cash flow guidance, but some notable working capital opportunities. Can you maybe just give an update on your progress here and thinking around working capital as a source of cash through this year and next year?
There’s a number of very large platforms that we are prime on, specifically in the training side on -- and as well as on the unmanned that we expect those milestones to be collected in the fourth -- third and fourth quarter. So we have a very good visibility on that, and also some also on the Modular Systems side.
Okay. Because it sounds like all of the -- or really all the upside and -- or to hit the full-year guidance happens in the fourth quarter, which clearly brings some risk. But, I guess, it’s fair to say you’ve got very good visibility on sort of the second half and fourth quarter in particular?
That’s correct.
We have at this point, we probably have the best visibility into the next six months that we’ve had in several years.
And Eric, just one final question, there’s been a lot of discussion lately on hypersonics, and I am sure you’re probably limited just to what you can say, but maybe not an opportunity near term. But, can you just talk about how you’re positioned? Is this market really seems to be seeing some great opportunities here near-term and longer-term? But how do you think about that market relative to Kratos?
With Under Secretary of Defense, Griffin and his push for more testing, don’t do one -- I am making -- this is an example, don’t do one exquisite test every 5 or 10 years and if it fails, you’re put back 5 or 10 years or similar to what Dr. Roper said very recently, in the past few days. He wants to change the thinking that you can have a successful failure, successful failures. In these areas that you mentioned, there is going to be far more testing. Test, test, test, test, get it right. This is the sweet spot for Kratos’ affordable, low-cost rocket support stacks. This is what we do in the ballistic missile target area. We believe we have the absolute right product at the right time that gives the right profile for this mission at the right price. And this could be a new, significant growth area for us over the next few years as the hypersonic programs ramp up.
Thank you. And our next question comes from Josh Sullivan with Seaport Global. Your line is open.
Can you just comment on the assets you’re winding down here, what the revenue impacts would be?
For -- depending on what we may do with these and rather not talk about that now, but Josh, it’s millions -- it’s not insignificant, it’s millions of dollars. It’s millions.
And then, just on unmanned side, I mean, you’ve been very successful winning lot of these awards. Can you just talk about the competitive environment? I mean, are you seeing any competition on the horizon? I mean, how your peers responded to your position?
Okay. So, I’m going to break that into two pieces, the target drone and the tactical drone. In the target drone, we have the three largest customers in the world, the United States Navy, the United States Air Force, and United States Army. And we won all competitive solicitations; we’ve won them and we’ve got them. As we just announced a few weeks ago at Airshow, we’ve now got the UK Ministry of Defense via QinetiQ who has the cash contract. They are also in the top -- putting the U.S. aside, top 3 or 4 other target users.
We are chasing, for competitive reasons, I’m not going to mention, a very large one, not the one I mentioned in my prepared remarks that’s going to come down next year. But, this customer is buying U.S. weapon systems and they’ve already approached us. So, they want to execute -- they want to exercise those weapon systems against our targets because ours are the most direct representative. In our class of target drone, there is nothing like them, nothing. And so, the competition in the U.S. is nil; and internationally, it’s very limited because we’ve got the platforms.
Now, on the tactical side. Similarly, on the target side, we have the one competitive solicitations. We won them, either as a prime like the Valkyrie or with our partners, Gremlins or program F that I mentioned. We are very aware of our customers, what the potential competitors are doing. However, our -- we have two primary competitive advantages. Number one, we are the leader. We were here first with these platforms. And number two, the affordability. We are going from a target drone which is designed to be attritable or shot down, so it’s low cost and going up to a tactical drone versus the competitor that’s going from an exquisite manned aircraft or an exquisite multi tens or hundred million dollar drone down to an attritable drone. That gives us an advantage because of the path we take. So, we’ve got to execute, we cannot step on our toe, we’ve got to meet our customers’ expectations and we are going to be successful.
Thank you. And our next question comes from Ben Klieve with NOBLE Capital Markets. Your line is open.
First, just a quick clarification question, and I apologize for making you repeat yourself. But my audio is little spotty here. What did you say the charge was you are expecting in the third quarter from the exit of your non-core business?
We did not mention the dollar amount. Okay? But, we do not expect this to be a gigantic charge.
Okay.
A couple of million bucks or something. That’s what we’re thinking, from a equipment standpoint, et cetera. From an equipment, personnel that type of a thing, pack [ph] facility, the facility closure, those types of things. That’s what we are looking at.
And then, in [technical difficulty] couple of questions here. One, are you able to elaborate the level of which revenue go pulled in from the third quarter to the second quarter?
I’d rather not get into the details on that because it’s all combined within the one segment, KGS.
Okay. That’s not a problem. But, I guess a follow-on question to that then. Is the -- did that dynamic at all impact what you see kind of the growth trajectory of the microwave business here over the next couple of quarters and into next year, or do you simply think that that was just kind of one-time timing thing of pulling revenue in from the third to the second quarter rather than a step function in the demand?
We are significant activity in the microwave electronics area, specifically related to missile and radar systems. There was an article just in the past few days on David’s Sling. We are designed in on David’s Sling. There was there was a successful intercept in India recently of new surface-to-air missile of theirs, we’re designed in on that missile. So, from a trajectory standpoint, we are looking at a solid, long-term growth trajectory. I’m going to go year-over-year because we are the subsystem or the component manufacturer that go into the system. So, we are like the tail behind the dog. We are not the dog driving the thing. So, on an annual basis year-over-year, the trajectory looks very, very solid here. So, I don’t look at that move to be a left as a one-timer in the grand scheme of what’s going on.
And our next question comes from Michael Ciarmoli from SunTrust. Your line is open.
It’s actually [indiscernible] for Michael. So, I just wanted to get started, get a little bit of update on the Oklahoma facility. So, perhaps if it’s going according to your plan, any hiccups there? And also if you can quantify any additional investments to meet the capacity on unmanned side?
Yes. No, absolutely no hiccups at all. If anything because of the support we are getting at the federal level, the state level and the local level in Oklahoma, it is going absolutely on track, on track. Now, on your investment standpoint, I’m not going to get into the details on credits, et cetera and things like that that we are getting. Let me say this to you that depending on quantities, we are looking at over two-year period of $4 million to $5 million investment, but we get that back through incentives in the following years. Okay?
Now, this is a hypothetical. If each one of our tactical programs meet or beat the expectation we are seeing, it’s possible that 4 million or 5 million would have to increase but that would be a good problem to have, then we would revisit the incentive structure.
I guess, one from the supply chain. We heard a couple of players out here on industry now, there is some constraints in supply chain. I’m not sure if it will impact to you guys at all. But are you seeing anything coming in as far as raw material, especially the tariffs, any kind of components demand that’s driving some of -- a lack of capacity there for you guys? Just any comment there?
We are seeing zero adverse impact at all. Remember, on the key subsystems on our drones, we do virtually all the avionics and electronics internally. In addition to that, on the turbo fans and the turbo jets, we have exclusive or special agreements with our providers. I just recently met with them. We’re under long-term bolt-in agreements. So, we are -- no impact.
Thank you. Our next question comes from Greg Konrad with Jefferies. Your line is open.
I just wanted to revisit Oklahoma. In the past, you talked about maybe partnering with an outsourced partner for some production. Any update on that?
Yes. In my prepared remarks I mentioned that we are now receiving product, structures, components, related tooling from two partners. And I called the strategic partners. So, it has -- the beginning -- the initial has begun.
And then, I mean, it’s -- if I look at the cash on the balance sheet, the debt, you’re probably going to be mid ones net debt leverage at the end of the year. How should we think about capital deployment, now that the balance sheet is [technical difficulty]
So, I think we’ve discussed this on the last call. Our expectation is to fund growth initiatives, especially on from a working capital perspective, especially at some of these large procurements, we’re fortunate to win those. We would have some working capital requirements, especially on the unmanned side where the long lead materials are engines as that’s one of large items and the building materials that we do not manufacture ourselves and that typically requires anywhere from a 12-plus-month long lead time order and deposits that are required. So, that we do expect to utilize our working capital and cash on hand to be able to fund some of those growth opportunities.
And then, just last one for me. I mean, you talked about Patriot and FAD in your prepared remarks. I mean there’s a number of large pursuits by the primes in terms of those two programs. When we see some of those contracts closing, what’s typically the lag time where you’ll start to see those contracts?
I have to be -- I don’t want to get ahead of our primes here, buddy. It’s not -- let me just say, it’s not significant and give me a lot of wiggle room on that. Okay? I don’t want to get into it. Because we’re not the prime.
Thank you. And our next question comes from Seth Seifman with JP Morgan. Your line is open.
I wonder if you could talk a little bit more about LCASD specifically and the opportunity next year. You talked about the possibility of an order and quantities around that? I mean, is this something where it kind of starts off -- starts off kind of slow and small in terms of what the order quantities might be or is this something where all of a sudden it’s a program of record where we’re above that 100 unit threshold?
Right. Because -- obviously we’re small defense company. To us, if we were to get an initial order in 2019 on the Valkyrie of 25 drones, that’s significant to us. And so that’s kind of how we are looking at it right now. That if we were to get a -- like you said, an initial order, I’m going to use an example of 25 drones next year and that order ramp up 50 up to the 100, that’s a -- obviously that’s very significant to us.
And then, just one more follow-up for me. The bookings, especially, I mean bookings are very strong on the unmanned side, but for the government systems business, how should we think about where the book-to-bill is going come out for the year?
So, I’ll let Deanna talk about the details on the accounting and everything. But, as I think we’ve put in our press release and as I said, over the past five months, we’ve received contract awards of over $400 million. The vast majority of those are sole source to us. Let’s take the AFSAT program for example. I think that was $100 million -- 100 something million dollar contract award over three years. We know what the uptempo was, so we know what the demand is, so we know 100% of that, if not more is going to be utilized. But, on that award, we will probably only put into backlog year one, when it’s funded which is tied to the fiscal budget; then year two when it’s tied to our fiscal budget. So there is a disconnect between the contract awards we’re getting, not -- which are not IDIQs or not Max. They are single award sole source to us, and what that book to bill shows. So we are extremely comfortable with what the build plan and the execution plan looks like relative to our growth expectations.
Okay. And then, anything further on the government system side?
Yes. So, just to elaborate on that, Seth. So, as Eric has mentioned in our prepared remarks, we have announced $160 million of contract awards since our quarter-end. There are a number in Q that we have not announced yet specifically on our training solutions and our satellite business. So, we do expect to see a rather sizable incremental increase in bookings in the KGS portion of satellite and training in the third quarter, as compared to the second quarter. And just a reminder, our government service business, which is about $60 million to $70 million business, which unfortunately is continuing to be commoditized and we see reductions on a quarter-over-quarter basis, that is unfortunately dragging down some of the book-to-bill ratio within KGS as well.
[Operator Instructions] We have a question from Brian Ruttenbur with Drexel Hamilton. Your line is open.
So, a couple of questions. First of all on book-to-bill, you just talked about that being weak in the one division but very strong in unmanned. Do you anticipate that there’s going to be pick-up in your overall book-to-bill in the third quarter as is seasonally normal.
Yes, we do. And if it doesn’t happen in the third quarter, it’s only because it slips into Q4, but between Q3 and Q4, absolutely.
And then, I have a bunch of questions around program F, which you won’t be able to answer but I felt compelled to at least ask some of them. Is this -- and we are going to play the game, is this this or is this that? Is it a DoD program, or are you the prime on it? Can you answer any of that?
We are the prime.
Is it a U.S. program?
We are the prime.
Okay. Well, I always get something out of that game. Okay. Moving on, your largest new program revenue contributor, can you talk about that what you see in ‘19 and ‘20? Is it going to be potentially in ‘19, is it going to be Gremlin? Is it going to be program F? Is it going to be Valkyrie? Maybe point us in the direction of where the biggest potential is in ‘19 and ‘20?
Okay. So, the biggest potential in ‘19 is the U.S. Navy SSAT. Okay? That’s the biggest revenue potential in ‘19. The biggest revenue potential in ‘20 is in the tactical area. If we get those awards or an award, an award or awards in ‘19, the greatest potential absolutely is tactical in ‘20.
And that’s Gremlin or program F or Valkyrie?
Exactly. And I love them all. So, I don’t want to handicap them.
And we are going to follow-up from Ken Herbert with Canaccord. Your line is open.
I just wanted to follow up on the Mako. And maybe you can’t talk much about this program either, but few months ago you got approval to sell this program internationally, this aircraft. And I’m just curious, I know obviously the U.S. is focused on Valkyrie. But, is there much of an international opportunity for Mako you could talk about? Because it sounds like that program is maybe a little bit further along with DIUx than -- and with the flight test that we’ve been maybe anticipating?
Ken, relative to the domestic opportunities that we have with Valkyrie, Gremlins, program F and Mako, the international opportunity, though it’s millions, it’s not tens of millions or hundreds of millions. And so, I expect, I believe we’re probably going to get some orders and order some orders internationally for Mako in 2019. I think, we will. And then I think it will grow in ‘20, it will grow in ‘21. But I think it’s going to be -- and I’m hopeful and I believe it’s going to be dwarfed by what’s going to happen on the domestic side.
And then, just one quick follow-up on Gremlins. I know there’s been a number of details put out by Dynetics and the customer, and what they are looking at in 2019 and the flight test program. The ability to retrieve the four aircraft and under 30 minutes by the end of next year seems fairly ambitious. But, between now and early next year with the first real test flights, are there any other important milestones you’d maybe just highlight or that we should be aware of as we think about the next six months and into ‘19 on this program?
Ken, I’m sorry. But because we are not the prime, I just -- I cannot and I will not get ahead of Dynetics who has just been an outstanding partner here. But, I -- since you mentioned, I do encourage the group to go to the Dynetics website and see the video that they’ve put out of the plane -- of the Gremlin systems in the air. And I also encourage the group to go see the DARPA videos that have been put out to also show the potential here and how far beyond just to C-130 this goes.
Thank you. And I am showing no further questions at this time. I’d like to turn the call back to Mr. Eric DeMarco for any closing remarks.
Great. Thank you everyone for joining us this afternoon. We truly appreciate it. We will -- unless something comes up, we’ll be chatting with you when we report Q3. Thank you.
Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone, have a great day.