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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
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 Fourth Quarter 2017 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 be provided at that time. [Operator Instructions]
I would now like to turn the conference call over to Senior Vice President and General Counsel, Marie Mendoza. Please go ahead.
Good afternoon, everyone and thank you for joining us for the Kratos Defense & Security Solutions fourth quarter 2017 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 and good afternoon. Kratos' fourth quarter and full-year 2017 financial performance clearly demonstrated the continued successful execution of the strategy we began a few years ago to build the technologically differentiated product and intellectual property based business focused on the rapid development, demonstration and fielding of affordable systems for national security. Today's announcement of the pending sale of our public safety and security system integration business for approximately 70 million and expected net cash proceeds continued the successful execution and a position Kratos for the significant organic growth trajectory we are forecasting for our company over the next several years.
The divestiture of PSS will further reduce Kratos' net leverage, improve our financial flexibility and financial matrices going forward including Kratos' growth rates, margins and adjusted EBITDA rates and position Kratos' as a pure-play high-growth defense, technology product and systems company. We believe that the business we have built in Kratos from the portfolio of systems and products we offer positioned our company for future, year-over-year revenue, profit and cash flow growth irrespective of temporary or quarterly bumps resulting from the recurring DoD budgetary delays.
The success of Kratos as business model is also demonstrated in a number of unmanned drone system contract awards, we have recently received including $93 million and $81 million, a $24 million and a $23 million award each of which are sole or single source to Kratos. Importantly and similar to Kratos' AFSAT program with the United States Air Force and our SSAT program with United States Navy each of these recent awards are expected to be multi-year multi-decade programs in length with significant future increases and value expected with 100s and potentially 1,000s of Kratos' drones ultimately delivered.
And additionally, a government agency has recently issued an intent to award Kratos an additional sole source unmanned drone system contract, which we expect to receive in the near future. We clearly believe that our strategy over the past few years of making internally funded investments so that Kratos owns the intellectual properties in our systems and products has been successful and has differentiated Kratos in the market space as most recently represented by the sole source contracts we have received.
Also important to the extremely great future we see for Kratos global defense budget and in particular the U.S. DoD budgets are significantly increasing. And Kratos has positioned and well funded mission critical DoD priority areas including high performance unmanned aerial drone systems, satellite communications, missile defense, training systems in microwave electronics. Each of these markets where Kratos is an industry leader are expected to experience solid growth and continue to represent long-time high priority national security focus areas providing us additional confidence in the future expectations for the Company.
Kratos' Unmanned Systems division Q4 performance was particularly strong with increased production, decreasing investments a very favorable product mix and solid execution by the Kratos unmanned team. In addition to the recently received contract awards that I previously mentioned, we continue to expect to receive production near 14 of AFSAT with the U.S. Air Force with increased quantities and product year two of a confidential program later this year though the extended continuing resolution has pushed the expected award dates of these programs out until the second half after we have a 2018 budget.
We continue to be on budget and on schedule with each of our tactical drone programs, which number has increased since we last reported to you with our Velcro UAS now currently scheduled for demonstration flights in late Q3 of this year. Kratos' Mako UAS program is expected to receive increased funding with the 2018 budget and numerous Mako continued to successfully perform their missions in customer funded exercises. Also tomorrow, we will be formally announcing that the Kratos' Mako is the 2018 Aviation Week Laureate Award winners for the defense Unmanned Systems category.
Aviation Week Laureate Awards honor extraordinary achievements in aviation, aerospace and defense and recognize leaders in the industry for their vision and their innovation. We are all extremely proud of the Kratos' Unmanned Systems team and receiving's truly outstanding recognition. Additionally, on another high performance jet unmanned aerial drone systems platform as most recently reported Kratos' under contract on the new 5 GAT UAS. We are now currently in contract negotiations with the new customer for a multi-year 100 million plus high performance UAS drone contract, and we are now in the capture process for an additional new high-performance jet powered UAS, which could be one of the largest opportunities for us to-date if we're successful.
As you can see the number of opportunities for Kratos' high performance unmanned aerial drone systems is both increasing and accelerating, which is exactly what we envisioned when we set our tactical UAS strategy approximately six years ago when we analyze the strategic UAS roadmap. Also extremely importantly, we remain hopeful for a successful announcement of a Gremlins program Phase 3 award with our outstanding partner Prime and teammate Dynetics. If we are ultimately successful in winning Phase 3 of Gremlins, we believe this will be a game changer for our company based on the information we have most recently received.
To handle the expected significant increased drone production, we envisioned over the next several years we recently announced the opening of the new engineering and production facility in Oklahoma where we have outstanding state, local and congressional support. Our plant at Oklahoma UAS facility is another important step and key element of Kratos' strategy to rapidly provide affordable products and systems for our customers, which we believe is a significant differentiator of our company. Our Oklahoma production facility with the lower cost of living, ample pool of highly skilled labor and an overall friendly business environment is also expected to be a key element of Kratos' profit margin improvement initiatives.
In summary, Kratos' unmanned aerial drone system business continues with outstanding execution and we expect this business to generate approximately 150 million in revenue in 2018 achieving the goal we had previously set of doubling our 2016 UAS revenues in two years and with increasing year-over-year margins anticipated. For 2018 similar to 2017, we expect the second half of 2018 for our unmanned business to be much stronger than the first half as a result of the existing extended CRA, which as you know delays new and increased production quantities until the 2018 DoD budgets in place.
Kratos' satellite communication business also have an outstanding fourth quarter exceeding virtually everyone of this business is operation and financial objectives. Kratos' satellite communications business is the industry leader in its core competency areas of command, control, communications RF interference identification, location and mitigation. This business is the cash flow engine that is enabled us to build Kratos' as it is today. Kratos' satellite team is one of the most technologically advanced in the industry and they are the go-to-provider for virtually all of the world's leading satellite system operators including the United States Air Force due to their specialized products, technology and systems.
The leadership team of Kratos' satellite business is second to none in the industry in my opinion. With the increasing U.S. DoD defense budget space and satellite communications is receiving some of the largest increases as a result of the perceived Russian and Chinese threat to U.S. space assets and Kratos satellite business is extremely well positioned to continue to benefit from this increased budgetory environment. Kratos is globally owned and operated spectrum or satellite being monitoring business continues to be one of the fastest growing most profitable and value-able businesses of our company. Kratos expect the monitoring business grew approximately 35% in 2017. We continue to add new customers and aggressively integrate new capabilities and technologies into this unique and extremely valuable asset.
Our satellite business also remains focused on the new and rapidly growing nano cube and small SAT market and related low earth orbit command control, RF interference and signal monitoring requirements. Major programs we can talk about the Kratos satellite business supports are the early missile warning constellation Space-Based Infrared SBIRS, Wideband Global or WGS, Advanced Extreme High Frequency or AEHF, and Multiple Objective User System or MOUS. Similar to Kratos' unmanned aerial drone system business, Kratos satellite communication business supports multi-year multi-decade programs, and along with the increasing DoD budget for space, we anticipate a long-time year-over-year growth trajectory for this business.
For Kratos' satellite communication business for 2018, we are expecting year-over-year growth above 2017. With the second half of 2018 being significantly stronger than the first half of ’17 -- excuse me the first half of ’18 due primarily to the existing extended CRA. Kratos' training systems business had a very solid Q4 as we continue to execute on a number of new programs including MCAT and KC-46 and we expect this business where margins are somewhat lower than our other core businesses to continue a very solid growth trajectory in 2018 including in Q1 as a result of the significant international training programs we are supporting.
Along with our Unmanned Systems business, we expect our training systems business to be one of the fastest growing businesses in the Company, as a result of the significant number of large long-time multi-year program awards we have received which we are now executing on. Also similar to Kratos Unmanned Systems business our training systems and management team generated a strategic plan a few years ago to be an industry leader in four fatality air crew training systems and grow the business for approximately 100 million in revenue and they have been tracking to this and executing flawlessly.
Kratos' Microwave Electronics business fourth quarter financial performance was as strong as the 2017, with significant deliveries and support of missile radar, missile defense, EW, communications and other systems. Since we last reported to you, we have now received the initial 20 million production award in support of the electronic warfare suite of a new 4.5 generation fighter aircraft. We expect to begin work on this new program in the first half of 2018 with deliveries expected to commence in 2019 and we expect the ultimate size of this program for Kratos to significantly increase over the next few years up to several 100 ship sets.
Additionally, we have just recently been informed that we have now been selected to support the electronic warfare suite on a separate tactical aircraft system and we are hopeful of receiving initial production on this new program opportunity in the second half of 2018. We also continue to expect to receive our initial production award on the Barak missile in approximately the middle or second half of this year. Representative programs at Kratos' Microwave Electronics business supports include Iron Dome, Arrow, Spider, Sling of David, Barak F-15 and F-16, and Griffin.
Based on these recent and expected new production award wins and the related deliveries schedules, we expect Kratos' microwave electronics business in 2018 to be similar to slightly increased as compared to 2017 with Q4 once again being by far the strongest quarter of the fiscal year with an expected growth trajectory beginning in 2019 concurrent with the expected new program production execution and deliveries that I just went through with you. Kratos supports numerous ballistic missile defense initiatives. Systems and programs across our entire company including BMD targets, Patriot, THAAD, Aegis, SM-3, SM-6, High-Energy Lasers, Electromagnetic Rail Gun, Arrow, SBIRS and Others.
Missile defense funding in the DoD budget as well as internationally is seeing significant growth as a result of the increase global threat environment and Krato's Missile defense related businesses have performed and are expected to continue to perform very well in this environment. A key Kratos offering in this area is our low cost ballistic missile target systems where we are seeing significant increased customer interest due to the affordability of Kratos' targets as compared to our competitors. Today we reported a non-cash goodwill impairment charge related to our legacy government services business which as you know Kratos' deemphasized with our strategy change in 2010 for Kratos to be a technological and intellectual property and systems focused company.
Specifically we have been focused on building the high growth, high margin business which we believe our fourth quarter results clearly demonstrated. Kratos' services business building a great cash flow generator and which has allowed us to successfully execute our strategy and build the technology product and systems company that we have today as historically adversely impacted the Company's book-to-bill ratio and our growth rates due to our de-emphasis and the related reduction in new contract awards. The corporate and unexpected decline of this business including our loss of two new large opportunities in the fourth quarter that we have been pursuing has impacted our initial production to 2018 but it is ultimately expected to result in increase longer-term future margins as our core businesses continue to ramp and replace this much lower margin business.
As we began 2018 we're focused on execution, operational excellence and improved financial performance including most importantly liquidity and cash flow. We expect Kratos investments to wind down. Our revenues and adjusted EBITDA to continue to organically grow our profit margins to expand for the Company and for the Company to return to positive cash flow generation in 2018. Additionally in 2018, we were more aggressively manage our overall liquidity including our billed and unbilled accounts receivable and inventories and as a result we have already began negotiating more liquidity feasible terms where we can contracts.
This focus on liquidity and cash flow willing certain instances delay some revenue or profit recognition timing as compared to our previous approach as for example we will not lien forward as much as we have historically on long lead program items like engines or electronics for our Unmanned Systems business. As doing so, increases on bill receivables ahead of receiving associated cash milestone payments. We believe our new approach will result in increased overall liquidity in cash flow for the Company which is an absolute top priority while not impacting ultimate revenue and profit generation over related contract for period of performance.
Also importantly and as Deanna will go through in detail the divest at Kratos' PSS business will be treated as a discontinued operation for financial reporting purposes going forward and accordingly the financial results of PSS will be reclassified for comparative purposes for all previous periods. As a result of this divestiture once the PSS transaction is closed and through approximately the end of 2018, we will be reducing cost at Kratos where we can and rightsizing our infrastructure to address the sale of approximately 150 million in revenue of PSS.
For instance approximately 2.5 million of corporate overhead costs were allocated to our PSS business in 2017 which going forward will now be required to be allocated to remaining company’s segments financial performance. Also similar to the past several years where we also hadn’t extended federal budget continual resolution and as I referred to earlier today we expect the second half of Kratos 2018 financial performance to be significantly stronger than the first half of the year once we have the 2018 budget in place primarily as a result of delays and increased production on existing programs like AFSAT and SSAT and new programs starts like our recent U.S. army UAS contract and related funding delays. We are assuming that the CRA will be resolved by the end of March in our initial 2018 financial guidance.
In closing I want to reemphasize that we expect the underlying strength of our core businesses to provide a long-time multi-year growth trajectory for the Company irrespective of temporary budgetary delays. Over the past few years including the last few months we have one multiple long-time program awards that are or will be entering or experiencing increased production and growth. Related to this I encourage you to look at the programs at Kratos Unmanned Systems, satellite communications, microwave electronics training and missile defense related business support or the programs or contracts we have received recently and the expected significant increase DoD funding related to these areas.
What I just went through is all included in what we referred to as Kratos base business model. In addition we are positioned for significantly greater potential growth above our base business model from Kratos unmanned tactical drone systems including LCASD, Mako, Gremlins and several others over the next few years. I’m more confident that even that Kratos unmanned tactical drone systems business is going to be very, very successful and we could start seeing the success accelerate further before 2018 is completed. At Kratos we have worked to bring together and create technologies, products systems and businesses that the DoD wants and they need. We are focused on bringing the government more for less and greater effectiveness at an affordable cost which I’m convinced is a winner. I think the Kratos shareholders our employees and all of our stakeholders are supporting us to build this incredible company. Deanna?
Thank you, Eric. Good afternoon. Kratos’ fourth quarter 2017 revenues of $202.2 million exceeded our expectations of $185 million to $195 million for the quarter, due primarily to strong execution and deliveries in our satellite communications and training systems businesses, and our Unmanned Systems business with certain deliveries and execution previously expected for the first quarter of '18, occurring in the fourth quarter.
Fourth quarter year-over-year consolidated organic revenue growth of 11% was driven by growth of 65.9% in our Unmanned Systems business driven by lower rate initial production of certain of our aerial targets in '17 and growth of 11.8% in our PSS business driven primarily by a security system deployment program for a mass transportation authority.
Revenues in our largest segment KGS declined slightly by 0.4% due to a reduction of over 15.3 million year-over-year in our legacy government services business, substantially offset by year-over-year increases in all other business units within our KGS segment. The growth in our KGS segment went approximately 12% year-over-year for the fourth quarter excluding the reduction in our legacy government services business.
Our Q4 adjusted EBITDA of $17.8 million slightly exceeded this high end of our expectation of $15.4 million to $17.4 million, due primarily to a favorable mix of higher margin work and shipments in our Satellite Communications Unmanned Systems and microwave products businesses, and improved performance in our PSS business.
On a year-over-year basis, our Q4 2017 adjusted EBITDA increased 32.8% or $4.4 million from $13.4 million in the fourth quarter of 2016 to $17.8 million in the fourth quarter of 2017. Our adjusted EBITDA for the fourth quarter is from continuing operations and excludes the non-cash goodwill impairment charge of 24.2 million and non-cash stock compensation cost of 1 million.
On a GAAP basis net loss for the fourth quarter was 22.2 million which includes the impairment of goodwill of 24.2 million mentioned earlier and a loss from extinguishment of debt of 15.2 million related to the refinancing that we completed in the fourth quarter. 2.7 million of expense related to amortization of intangible assets and capitalized contract cost and development cost non-cash stock compensation expense of 1 million and an 11.7 million of tax benefit.
The tax benefit was primarily related to the impact of the tax format which resulted from the net reduction of differed tax liability and differed tax assets due to the reduction of the corporate tax rates from 35% to 21%.
Moving to the balance sheet and liquidity. Our cash balance was $129.6 million at December 31st, plus $400,000 in restricted cash. Our outstanding long-term debt of $293.5 million reflects the refinance we completed during the fourth quarter to replace our existing remaining 369.7 million or 7% senior notes outstanding at the end of the third quarter with new 6.5% senior notes with the base value of 300 million with a new maturity date of November 2025.
We utilized approximately 90 million in cash to retire the 7% notes and issue the new 6.5% notes. We also refinanced our line of credit during the fourth quarter replacing our existing 110 million line with a new five years 90 million line. The borrowing rates and unused line fees were reduced by approximately 35 to 50 basis points. There are no maintenance financial covenants and a minimum fixed charge ratio of 1:1 that’s brings its borrowing availability to below a certain level.
At December 31, we had zero amounts outstanding on our bank line of credit and $9.5 million of letters of credit outstanding. Cash flow from continuing operations for the fourth quarter was a use of $1.5 million, which includes approximately $1.6 million of internal non-capital expense related development costs related to the LCASD program.
Capital expenditures of $7.5 million were primarily related to investments we are making in our satellite communications and Unmanned Systems businesses. Approximately $5.6 million of the CapEx was related to the Unmanned Systems business, which is primarily related to the two LCASD aircraft and related equipment we are building for our own use. We expect this capital effort to be substantially complete in the first half of ‘18.
DSOs increased from the 115 days at the end of the third quarter compared to a 121 days at the end of the fourth quarter. Our DSOs include the impact on milestone payments on long-term delivery projects where we are unable to contractually invoice for amount until the completion of certain milestones and/or the final delivery of products or the demonstration of certain flight parameters, specifically in our Unmanned Systems segment.
We currently expect certain of these milestones to be achieved in the first half of the ’18. In addition we have a number of billing milestone payments that are expected to be paid upon completion of the large critical infrastructure projects that are expected to be completed in the first and second quarters of 2018. As we are the prime contractor on sizable projects in our Unmanned Systems, and training systems businesses, our DSOs will continue to be lumpy as the payment terms will be based upon achievement of milestones rather than progress billings.
Our contract mix for the quarter was 91% on firm fixed price contract, 6% on cost plus and fixed fee contract in 3% on time and material. Revenues generated from contracts with the U.S. federal government during the quarter were approximately 63% including revenues generated from contracts with the DoD and non-DoD federal government agencies. We also generated 7% of our revenues from state and local governments, 17% from commercial customers and 13% from foreign customers with our aggregate non-DoD revenues comprising 37% of our total revenues.
Backlog at fourth quarter end was $730.4 million with $531.1 million funded and $199.3 million unfunded. Our book-to-bill ratio was 0.7 to 1 for the fourth quarter of ’17 and 0.8 to 1 for the 12 months ended 12/31/17. As Eric has previously mentioned we do not include the full value of contract awards in new booking or backlog until testing of our funding is received. Also importantly a number of our systems and products are designed in on and support long-time multi-year multi-decade programs.
Although these expected Kratos deliveries are not reflected in our backlog, they do provide significant operational financial visibility to our company. Fourth instance we may not necessarily include in our bookings or backlog certain contract awards depending on current government funding on the awards. And this is an example we only included approximately 7 million in our bookings for the recent contract award for aerial targets from the U.S. Army of 93 million, which represents the executed delivery orders received today, although we expect to ultimately receive executed delivery orders for that 93 million.
Going forward as we adopt the new revenue standard on January 1, 2018 ASU 2014-09, our backlog will be calculated as the dollar value of the remaining performance obligations on executed contracts as defined into the new accounting standards. Backlog will not include our risk which neither partly has performed and which grants each party the unit lateral right to terminated wholly unperformed contract without compensating the other party.
As such backlog general lease will not include options for additional performance obligations which have not been executed unless you are considered within material right of the base agreement when contract. For IDI2 contracts only tasks have been approved should be included for backlog purposes. Based on the current expected impact to the transaction price that will occur upon adoption of this ASU on January 1st, we currently expect that our backlog balance that's going forward as well as many companies in our industry will be negatively impacted based upon the guidelines in the new accounting standards.
Today we also announced the pending divestiture of our PSS business. As Eric mentioned previously for all financials being it's going forward we will be recasting the operating performance of the PSS business as a discontinued operation with all prior periods re-class with comparative purposes. Accordingly today we are providing initial guidance for the first quarter and full-year 2018 reflecting PSS as a discontinued operation. Kratos' PSS business was forecast to achieve full-year 2018 revenues and adjusted EBITDA before corporate overhead of approximately 140 to 159 and 9 million to 12 million respectively.
PSS generated full-year 2017 revenues and adjusted EBITDA excluding the allocated corporate overhead cost of 149 million and 6.9 million respectively. As the result of the pending sale Kratos' Q1 2018 and full-year financial guidance provided today excludes PSS as those all other financial information covered.
As Eric had mentioned once the business is discontinued any corporate or public company cost that were previously allocated to that discontinued business are required to be allocated to the remainder of the continuing operations on a retroactive historical and go-forward basis. Specifically for 2017, approximately 2.5 million of corporate public company cost that were allocated previously to PSS will now be required to be allocated to our remaining businesses on a retroactive basis when historical financial payments are presented.
Our first quarter 2018 financial guidance it's the revenues of 140 to 150 million as compared to a 132 million for the first quarter of '17 and first quarter 2018 adjusted EBITDA guidance of 9 million to 11 million as compared to 10.2 million for the first quarter of '17. Kratos forecasted first quarter 2018 adjusted EBITDA of breakeven to $0.01. With that reflecting net income from continuing operations excluding non-cash amortization and stock compensation expense and you are utilizing estimated cash taxes.
Our full-year 2018 financial guidance for revenues is 640 to 650 million as compared to 603.2 for the full-year of '17 and full-year '18 adjusted EBITDA guidance of 55 million to 59 million as compare to 47.5 million for the full-year of '17. Kratos' forecasted full-year '18 adjusted EPS of $0.16 to $0.18 per share. We expected our total capital expenditures to be in the range of 23 million to 26 million for ’18, with approximately 14 million to 17 million related to our unmanned system business. The balance of the capital expenditures is expected on the satellite communications and training microwave products businesses to fund growth initiatives in both of these businesses.
We expect our operating cash flows will be impacted by the remaining estimated investments of $7 million to $10 million, we plan to make to develop the LCASD platform to maintain the intellectual property that are not included in capital expenditures. As a reminder, the total estimated investment that is not related to capital was accrued as a forward loss accrual in the third quarter of ‘16 when we were awarded the contract. Cumulative today through Q4 end we have funded approximately 12 million of non capital LCASD investments.
In summary, our estimated cash investment for the Unmanned Systems business for 2018 including the LCASD capital and other development costs is $21 million to $27 million. We expect that these cash investment for our unmanned tactical initiative will be substantially complete in the first half of ’18. We expect our estimated cash taxes to be approximately $3 million to $4 million for 2018. We expect the impact of tax reform to be fairly and significant to our estimated cash taxes due to our net operating loss position.
Our NOLs as of 12/31/17 were approximately 319 million. Despite the high end level of continued investments in ’18 of approximately 30 million to 35 million between capital expenditures and the remaining non capital investments for LCASD. We expect to generate cash flow from operations of 35 million to 45 million and free cash flow of approximately 12 million to 19 million for 2018, as we expect any number of the building milestones which have impacted DSOs could be collective during the year.
Eric?
Great, Deanna. In closing I want to state that our public safety and security businesses management and our employees they just did outstanding job, supporting Kratos in the midst of the 2011 budget control act related sequestration and the significantly declining in reduced DoD budgets. I know the entire management team extremely well and I thank them all for everything they have done for this company.
To the PSS employees over the past several months I have gotten to know the key leadership is Kratos and I can assure that there is no better home for you other than this company. Their leadership team and their management team is outstanding. They have the absolute right strategy for their business and your business combined and the opportunities we all going to have personally and professionally of very candidly far greater than we could have given you because their focus is fully on your business. So I thank all of you as well.
With that I’ll turn it over to questions.
[Operator Instructions] Our first question comes from Mike Crawford with B. Riley FBR. Your line is now open.
How would you characterize your capacity utilization in the Unmanned Systems operation today in California and what room do you have to increase that before up and running in Oklahoma?
That is actually an excellent question. The business is ramping very, very rapidly. My most recent estimates we're going to generate well over a 100 maybe a 130 drones this year just in the current base plan and we expect some additional significant orders coming in. We believe that we are very well resourced and have the capacity to handle whatever practically comes through the end of this year. Our facility in Oklahoma progress there is moving rapidly now. It will be prepared to start manufacturing in the second half of this year.
However, we have also now have started having discussions with another mid-cap defense company that we know very-very well. We have an excellent relationship with them and it is possible that we may bring them into the partnership to help us with this production as well. So,, we are mapping it out Mike because things are accelerating rapidly and there are some big things we're not able to talk about that may come to fruition in the second half of this year and we've got to be ready.
Okay, and thank you. And then just two more quick ones, I'll just ask both now, so you said you are under contract for the 5 GAT and so I'm wondering if that is to be used as a target drone or is a tactical combat drone? And then the other one as you talked about recent information leading you to believe that Gremlins could be a game changer and I'm wondering what information would lead you to believe that there would be game changer versus prior expectations?
On the 5 GAT obviously 5 GAT stands for fifth-generation aerial target that's all I can say about that and on the Gremlins Mike I'm sorry I cannot comment on that there has been a number of pieces that have come out in the past three weeks relative to that program that might give you some additional information but I can't talk about that now it's a still competitive.
Our next question comes from Ken Herbert with Canaccord. Your line is now open.
Eric and Deanna, I really appreciate all the detail. I just wonder Deanna really I mean the guidance calls very significant improvement in cash from operations and free cash flow for the full-year. I know you went through some of this, but how will you characterize maybe the risk to that 40 million in cash from operations at the midpoint for 2018? And maybe just a little more detail on specifically, what you assume working capital and some of the other key pieces to provide?
So some of the rest are there is some flight milestones that need to occur on some of the Unmanned programs which just doing part arrange time to get on to certain ranges that Ken delayed that milestones so that's one of the risks some of the other ones we don’t really see as risky because they are just really hitting certain performance metrics that are in our control which obviously that the flights on range time those are not totally in our control.
From a working capital requirement prospective we do expect some use in working capital as we continue to grow the business but that some of that is offset in the cash flow guidance that we given with some of that milestone that we do expect and to collect. Some of these milestones are milestones we had expected in the second half of '17 and they have moved into '18 to some of them we do expect to see some in the first half of '18.
And Ken, let me touch on that also, it ties into my prepared remarks on the change in methodology, we’ve now implemented relative to liquidity to increase the liquidity and it's got a significantly drive it. Let’s say for example we have a 15 month production run and let's say based on the build plan, I will just talk about one subsystem. The turbo fans they can come in month eight and you can still deliver on your delivery schedules in months 10 through 15. Historically to be safe to build credibility with the customers to make sure our past performance qualification for bullet proof, we would place the orders because we would know. We would have an indication, we were going to get the order and we would receive those engines in my example in month one.
We might not get the milestone for that until month seven or eight, so we would carry that either it in inventory or for what percent completed would be an un-build in revenue. So we been able to change that now with the improved capital structure and our past performance calls, we’re mapping everything in my example to come in month eight that’s when the milestone hits, so we get the engines and in my example we pay for them, there is no liquidity carry. Yes it has moved some of the revenue recognition out into months nine to 15 in my example, it also comes into the 15 month period of performance but it significantly improve liquidity and we’re doing that across the Company now, we've just begin.
And Eric, can you just it sounds great, can you just may be quantify or brackets sort of where you think, just through taking those kinds of steps and more focused on your efficiency. What that could contribute, say in '18 or may be in '19 on a full year basis?
Well this is a -- this is customer by customer, we're negotiating it, we been successful on some of that, that’s far which tighten to your initial question, your improved liquidity for '18. I'm not prepared to do that yet maybe later this year, once we get some of these negotiated, we will be in a better position but I think after all number out there will be unsuccessful with certain customers.
Got it and then just finally, I can appreciate that, it sounds like with the better source of budget visibility, I know we’re still operating under a CR and I think we all agree that at the end of March is realistic assumption of when we thing finalized for '18. What the pressure in your view and will there be things that might slip into fiscal '19 or your calendar '19 just because the ability of your customers to maybe put all this capital to work in a sort of truncated 6 months fiscal year? Is that a risk that you potentially see the good impact timing on something where you already starting to see may be things loosing up just with, with obviously the better visibility and sort of broader agreement on the budget numbers?
So we had a very similar situation in last year in 2017. And last year in 2017 assuming we get the 18 budget at the end of March, it's very similar to where we got to last year and we did not receive a number of our contracts starts or increase production until June, July, August and we didn’t get one of them until December of '17. Because of the CRA, we've taken those same assumptions and mapped that into our 2018 forecast where assuming we got a 2018 budget at the end of March we are not making the assumption we are going to get all this stuff in April and May. We are spreading it based on our historical experience which we just had last year.
So even though you are obviously guiding to a very strong second half and particularly very strong fourth quarter that already reflects a potential timing risk of some of these contracts?
Yes it does. Yes, our assumption in our guidance if we get at it, there is a budget in place by the end of March 23rd I think the end of March.
Thank you. Our next question comes from Mike Jordan with Noble Capital. Your line is now open.
Eric, a question relative to the SSAT contract, there are option exercise you announced yesterday the 24 million or the DoD announced. Was that a plus up to LRIP 1 and when do you expect LRIP 2 to be released?
Mark, I have to be very careful, on what I say here. The recapitalization of strategic weapon systems has not only begun, but it’s accelerating because of perceived nation state threats. And those weapon systems need to be exercised. So for example over the past couple of decades appropriately we have been addressing the terrorist threat and most recently ISIS and so I’ll use an example our fighter aircraft have been flying missions not against nation say peers in the air but against terrorists on the ground.
So, part of readiness now is the increased use of targets to prepare them in my example for taking one nation state weapon system, so things are pulling to the left and quantities are increasing. I don’t want to specifically answer your question and get ahead of the customer but I’ll say again at this level things are moving to the left, and things are accelerating and that’s one program that putting aside these tactical ones that is going to be the largest opportunity the largest program in the Company very soon -- very soon.
Is it correct that you have completed manufacturing of lot 13 of the offset in that ‘14 is expected to be awarded in the second quarter so you will have a gap here in the first half of the year pushing those revenues mainly to the second half?
Yes. So, we are almost substantially complete with lot 13, we are expected keeping in my our liquidity plan we are expected to get going on lot 14, I am going to say July, end of June, July, however we are working on I cannot name customers, certain international, opportunities that are in the line as well. So we should not have the significant break.
The LCASD you said is going to be -- it's first flight will be in Q3, do you have an idea when the decision point might be for the air force to look at procurement of potentially production units?
Yes we do.
Will you share it?
I’m sorry no sir, I’m sorry.
Last question from me, just quite a clarification, PSS is already in service revenue is that correct?
As far as service revenue that we report there is some other service revenue within CGS that has reported in services lines, because there are some services that are wrapped around product and they are actually classified as services.
But a 100%, yes.
Yes, as Eric said, a 100% of PSS is service.
Okay so couldn’t crack that out of that prior services.
That’s correct, yes.
Our next question comes from Seth Seifman with JP Morgan. Your line is open.
This is actually Ben Bernstein on for Set. Just wanted to ask a couple of quick ones on the divestiture of PSS I mean why now, why is now the time to sale this business I think it has been all investors mind for a while as a non core aspect.
If you could see me I’m smiling because from our perspective the vast majority of Kratos is investor or potential investors have been encouraging us particularly in the last 12 months and it's been ramping up in the last six months as the other businesses were gaining traction. As why we don’t divest this and become a pure play systems and Product Company. And so we looked at it as we announced that this was a non core business.
I think at the end of ’16 and we have had a lot going on if you could imagine this process we use that very delicately with this took an extended period of time and we are where we are and I’m absolutely convinces with what we see coming in our satellite business, our training business our microwave electronics business at our unmanned business focus. We have got to focus on those because we have won some big stuff. We are going to win some other big stuff and we need to focus where the big growth opportunities are.
And I guess I mean not to read into the press release too much but you mentioned the rocket support being noncore and taking the charge there. Should we think about a similar path for that piece of the business?
We are routinely looking at the portfolio to see what makes best sense for the shareholders and that’s all I should say about that.
One last one on cash flow. How should we think about the timing of cash for 2018? Should we expect first half to be an outflow based on LCASD investments and the other drone programs? And then thinking about run rate is it wrong to think that beyond 2019 after these investments are made no cash flow will be significantly higher?
No, I think your thinking is in line with our expectations.
The investments they are going to wind down.
It’s a predominant investment is in LCASD and that flight is scheduled for Q3 so that investment will be complete by fairly end of Q2. The timing is a milestone that will drive what the cash flow is. I think you are actually – your comments on the cash flow generation or the second half being stronger that’s in line with our expectation.
And all other things being equal with the LCASD investment being done this year everything else being equal you would expect '18 by definition '19 would go up significantly.
Especially, if you take into consideration the CapEx that we were historically running at prior to 2017, when we launched this initiative so our CapEx in those years was anywhere from the 11 million to 15 million the last two years have been in the 25 plus range so we don’t foresee that heightened level of CapEx going forward past 2018.
Our next question comes from Noah Popanaki of Goldman Sachs. Your line is now open.
What percentage of the 2018 revenue outlook range that you've given us here is already in funded backlog and how does that are compared to how you've started the last few years on average?
So our total backlog is roughly typically total backlog what we see is converting the revenue in the next 12 months is typically about 50% of that. So and that's if that in line with what we how we've started each year in the past.
That's unfunded or on total?
It's actually more than that from the funded perspective so it's probably closer to over 70%.
Okay, and so it's 70% on the funded 50% on total?
Correct.
And so I should think of to call that 55% to 60% of the year is already in backlog?
Correct.
And is that a pretty normal starting point?
Yes, and as I had mentioned in my prepared remarks that's probably not be indicative of what's going to turn into revenues so for instance it's 93 million award that we received from the U.S. Army at the end of the year this is only 7 million that's included in backlog currently. But we fully expect to deliver on that this year and the next three years, so that would be not necessarily being the backlog but we have very good visibility on that revenue in 2018 and '19 and '20 and the three years as the performance.
So as how much of the remainder of the outlook that's not in funded backlog would you say fits in to that category of thing where it's a little bit of it little bit definitional and you do have visibility versus something that you have to go etcetera?
So a significant piece because we know the up tempo so for we know the Navy is op tempo for their targets in SM. We know the air force is up tempo for apps that in the 167 and right now we have nothing in there at all for loss 14, 15 and 16 we're going to get all three of them at once on the ballistic missile target launch schedule obviously we have that schedule. We know exactly what's coming on that with the U.S. Army on another drone. I can't get into the name on it. We know they are off tempo. None of this was in backlog, but it is very, very significant and these maps into our guidance. We give our guidance based on what I just went through.
If unmanned is doubling '18 versus '16 on the note or call it 115 million bucks, it would imply KGS is growing and your guidance is growing about 3%. Is that accurate? And could you talk about some of the moving pieces there what seems like it would have potential to be passing that given some of the businesses during there may be the government services pieces have drag again, if you could was us through that in a little bit more detail?
That is you’re absolutely correct. The government services piece is the drag.
Is it declining in 2018?
It is declining. It is as we deemphasized it and the bit pipeline is down, as I mentioned in the prepared remarks we lost a couple in Q4, one was like a $50 million we got triple across the board and we lost on price by couple of 100K, so that low price technically acceptable as you know was ruthless in services pace, it's terrible, it's terrible. So let me get another data point on that business for 2017, that RSS business, the book to bill ratio was zero. So think about what our book. Look at so you can reverse engineer what our book to bill ratio is excluding that and as Deanna said on the number of these big programs we don’t even put it in the backlog. So the problematic or contract award book to bill with the Company is extremely strong. But that is, that’s not a tailwind it’s a base wind.
Understood, I will ask one more just on margins, so you guys have this 10% EBITDA, adjusted EBITDA all in target for kind longer term, medium term long-term frame work. I guess that includes PSS, so for the front managing KGS combine that, I guess I implied 11 or 12, this year's kind of 9, is 11 or the 12 the right way to think about that behind 2018 and maybe just up there?
So the number one item to look at first is the $2.5 million number that the Deanna mentioned that was allocated. We're going to cost rationalize, there are there are things like licenses and things like that we have agreements on, but we have negotiate, you just can't fill them. We think we can negotiate ourselves out of the wind down by the year of the year. So our plan is just to reduce that by the end of the year, obviously other businesses are going to grow to make up for it and we're still looking for a normalized EBITDA margin for the Company. When we get to raid on these things is low teens.
Our next question comes from Michael Ciarmoli with SunTrust. Your line is open.
It's actually [indiscernible] for Michael. Just to go back on divesture of PSS and I guess that cash receivable of that coming in into queue, is that the way to look at it?
What we had mentioned was the in our press release announcing that transaction that with regulatory approval and customary closing conditions that we expected in 90 days.
I guess and then once that clears what will the capital structure for the Company look like and perhaps then interest expense outlook?
So, this is going to depend on what we -- on the proceeds. So, under our current bonds we have a year with the proceeds and if they are not redeployed into inventory or receivables or growth in the business there is the ability…
Or other investments.
Or other investments, thank you, there is the ability pro rata to bring some bonds back in that at par. We -- as Deanna and I went through in the prepared remarks, we have a lot of opportunities right now that we have won that production is going to get going as soon as we get god willing -- we are going to get the budget in the second half of the year it’s going to get going, I think we are looking real good on several other very large opportunities, I think we are going to win. And so our plan at least initially is to hold the cash initially. All things being equal and let’s see how we do won some of these, because if we do as and I am the CEO, I drink the Kool-Aid. If we run the table on them, we are going to watch a good part of not all that liquidity to execute on these programs.
I guess the last one then on how would -- I would just say Gichner fits strategically into the portfolio at this point?
Yes so that’s our modular systems division as you know, and right now we are in the middle of some very large production runs, one of them being Patriot. So, whenever you see Patriot like just recently you saw Patriot in Sweden, that’s Kratos, Raytheon is an extraordinary strategic partner of Kratos, as they are a wonderful company to work with. We are on a number of their missile and associated radar programs. We work very closely with Lockheed Martin, very closely with Northrup.
And the majority of what we are focused on there is ballistic missile defense systems, we are also on a number of Unmanned Systems, we built ground control stations, for Unmanned Systems, we are also involved Littoral combat ship, we are one of the providers of the mission modules with Littoral combat ship. We designed into electromagnetic rail gun. We designed into high power directed energy systems. This business fits into our focus on strategic systems and it’s in a number of areas we see the budget increasing significantly with the ’18, ’19 bipartisan spending that was signed assuming it gets approved.
Thank you. And our next question comes from Brian Ruttenbur with Drexel Hamilton. Your line is open.
A couple housekeeping adjusted EPS for ’18 should be down from 2017 is that how you are kind of looking at it going forward or you maybe have a negative in first quarter and then turn positive in the second half?
I guess when you made the comment that is down from 2017, our adjusted EPS for the year was $0.12 and what we just guided with 16 to 18 and then the first quarter of 2017 was at adjusted I think that was a loss of $0.01. So it's actually regarding to be up on the quarter and up on the year.
I missed that part. I didn’t miss so the next question that I have is can you name the top three big programs for us to watch? Is number Gremlin, can you just give us the top that we should be monitoring?
So number one, and we are still waiting for formal award, god willing, it's competitive is Gremlin. As I mentioned in the remarks that if we with our partner Dynetics are fortunate enough to be successful here based on most recent data points this is a game changer for the Company if it is the SSAT program. The SSAT is with the navy is replacing certain target drones to 34 and 74 and they are almost out of them and there is significant demand for those. You asked me about the three to watch I’m telling you three I can tell you about. The third one is LCASD. The LCASD program as I mentioned is on schedule on budget, I cannot talk about much of this anymore as I mentioned to everybody at Q2 of the last year but this is a big year as well.
Our next question comes from Greg Conger with Jefferies. Your line is open.
Just a couple of quick ones most of mine have been asked but in the prepared remarks you mentioned small SSAT and it didn’t seem like there is much you could say but I was just thinking just from the opportunities that near term longer-time and maybe just a little bit more color on the size of that opportunity?
So, it is happening right now, as far is getting designed into the constellations and getting designed into the operators. Now is the time to get designed on the ground side where we are. And this is an entire new suite or generation of ground command control and communication equipment for these LEOs versus the GEOs. As I’m sure, the small nano and cube sets, they are going to be far, far less capable, far, far less costly than the GEOs but there is going to be 1000s of them.
And so it’s a whole new generation of ground equipment smaller arguably less dynamic, but there is going to be a lot more of it. And so right now is the time to get -- we are getting designed and trying to pick the winners and because of our pedigree with epic, our industry leading command and control software our system. We -- this is a real opportunity for guys like us that we know the operators. There are customers and we took the fast performance qualities and credibility.
And then just staying on space I mean commercial space or I think you've had a really high market share I mean the industry itself is kind of been down it seems like it's starting to show on maybe where getting into the kind of recovery more there I mean it maybe any type of trends that you are seeing on the commercial side?
The primary trend is on the high throughput side and the spot being, and issue that we are seeing that we're addressing with our globally owned stepper monitoring business is monitoring interference related to those spot beings or jamming related to those spot being whether it would be on intended or intended identifying where it's coming from being able to geo-locate or use other means to identify where it's coming from so it can be mitigated or neutralized depending on what the customer wants that's a trend were seeing in that area.
And it's only going to grow this has been our opinion the potential for jamming or beams getting crossed or interfering with each other is more and more satellite going up it's only going to increase and being able because of KPIs being able to quickly indentify and remedy that is big business and big money and we are the industry leader in that and I believe we are the only company that has a globally owned and operated network that is were monitoring 100s beams and doing what I've said net it is growing rapidly I think we said in the prepared remarks it grew 35% year-over-year and that tides into directly what you are asking.
And our final question comes from follow-up from Noah Popanak with Goldman. Your line is now open.
I just wanted to ask about the NOL, one does U.S. tax reform change its value? And then two, does the divestiture change its values as a tax filter?
So, tax reform changes the value that is recorded on the balance sheet because it's just at a different rate. And so that's probably some of the movement on the tax benefit that was recorded this period it was change in rate from 35% to 21%. But as far as -- so going forward tax reform carry back is no longer allowed, but carry forward is unlimited. So we are under the current law or prior to the tax reform it was carry back 2 to carry forward 20, so that's not impacted as a NOLs that we have as nearly 390 .million but the go forward piece is what that would be impacted, but it's actually unlimited going forward. So and there is no change and no impact related to the divestiture on our NOLs.
Thank you. With no further questions in queue, I would like to turn the call back over to Mr. DeMarco for closing remarks.
Thank you all for joining us today, and our next scheduled chat will be when we report the first quarter unless something comes up between now and then. Thank you very much.
Thank you, ladies and gentlemen, this does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.