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The KEYW Holding (NASDAQ:KEYW)

Q2 2013 Earnings Call

July 31, 2013 5:00 pm ET

Executives

Leonard E. Moodispaw - Founder, Chairman, Chief Executive Officer, President and Chairman of Ethics Committee

John E. Krobath - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Chris Donaghey

Analysts

Mark C. Jordan - Noble Financial Group, Inc., Research Division

Stephen Cole

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Brian Kinstlinger - Sidoti & Company, LLC

Patrick J. McCarthy - FBR Capital Markets & Co., Research Division

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

Josh W. Sullivan - Sterne Agee & Leach Inc., Research Division

Operator

Good day, ladies and gentlemen, and thank you for your patience. You've joined KEYW's Second Quarter 2013 Financial Results Call. [Operator Instructions] As a reminder, this conference may be recorded. I would now like to turn the call over to your host, Chairman and CEO of KEYW Corporation, Mr. Len Moodispaw. Sir, you may begin.

Leonard E. Moodispaw

Well, thank you, and good afternoon, everybody. Before we get to the meet, of course, we have to do our disclaimer, so we're asking Jen [ph] to do that for us. So Jen [ph], would you read the disclaimer, please?

Unknown Executive

Under our Safe Harbor disclaimer, statements made in today's call that are not historical fact are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities laws. Actual results may differ. Please see today's press release and our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results.

Leonard E. Moodispaw

Thank you, kindly. As the press release about the quarter said, it's a period of exasperation and excitement. Despite that, we're pleased with the quarter. We had substantial growth. We made great progress on G. We had positive cash flow despite increased spending on G. So a number of very positive factors, but let's talk about the exasperation first and get that out of the way, and then we'll reach the government services. I don't believe there's anybody around who hasn't heard of sequestration. We told you at the last call that we expected a minimal impact in the second quarter, and we had that. A lot less than an impact in many other companies because of the nature of their work, but nonetheless, there was an impact. John will be giving more specifics about some of these things. Our RADIO program, for example, is flat from quarter-to-quarter, whereas we anticipated significant growth. We were able to have most of that impact felt by our subs, not us. You'll note that the labor -- the number of employees decreased. That's mainly a factor of the normal post-acquisition when people decide this is not the place for them or we decide it is not the place for them. Now John's going to talk about the impact of the sequestration on -- and reducing the number of subs on our margins, so I won't comment on that further.

Our cyber work is growing in the government circles. We support cyber exercises as both the military and civilian cyber workforce grows. We offer offensive and defensive training, and those courses are increasing. In fact, we're planning for expansion of facilities to accommodate those needs. We're still unable to predict what's going to happen in the rest of the government fiscal year because of sequestration. We spend a lot of time talking to our elected officials. And while our opinion is that the Senate is going to do their best to make things happen before the beginning of the fiscal year, I believe it's fairly obvious that nobody knows what the House of Representatives is going to do. So there will be a lot of anxiety, a lot of hand-wringing and a lot of going over cliffs, which we know [ph] on October 1. As a result of that, we can't predict what the rest of the year is going to look like. What we do know is, A, that we're still hiring. The impact on -- of sequestration is sort of program by program, so some programs continue to grow and others don't. And it's unrelated, really, to priorities. Hard to believe, but that's the way it is. And what is clear is that some very important national security programs are affected, and those things trickle down to us. We would hope that somebody will come up with good sense and realize that those programs must be funded. We see a lot of effort made towards that. So while we're exasperated, it's certainly shared by our customers.

We'll shift to the area of enthusiasm, where the level of enthusiasm in this company, as well as outside, on our products is ever increasing. In the first quarter call in late April, we said we would have 3, maybe 4 beta customers due in the second quarter. We had 4. All have gone active in the third quarter. Now to make that -- sense of that and to put it in context, after John does the financials, Chris Donaghey will detail the process of deploying Gs so that you're able to track the progress that we made. And we're satisfied with our progress. If you compare our progress to other companies with good products, not as comprehensive as G, but good products, any firewall and intrusion-detection systems, they've taken sometimes as many as 10 years or more to be successful. And we're just 18 months from what I call gleam in the eye to deployment of those systems. Today, we also announced the formation of our product subsidiary, Hexis, and the product family names, HawkEye G, which I will forever be calling G because I can't get anything else out of my mind. And Chris Fedde, as we've probably talked about before, is leading that. Chris had a long experience for us in industry running commercial encryption and authentication and other security kinds of functions.

So what we've done with G is combine all the necessary resources we need to support the technical team and to help our growth that we anticipate happening later in this year and thereon out. So we've got the purchase and the sales team and the leadership in the commercial products subsidiary that we have formed. If you look at that, in the press release, you will see links to our website, which has detailed product sheets for Project G and a white paper, which describes the threat landscape and for this kind of thing, the cybersecurity world and the G approach to that. Those documents and detailed presentations behind them were the basis of a 3-day sales force kickoff meeting last week, so we now turn the sales force team lose to generate even more orders for G, over and above those which we've told you about, which are backed up. And we hope to begin to get to those and open the doors for G in the fourth quarter, as we have said. We expect to begin doing new CAAS, the upfront assessments of networks in September to be ready for that growth in the fourth quarter.

We just presented at the Black Hat conference, which is a cybersecurity audience of innovators, investors and customers, at an event called the Disruption event. And there, we did a live demonstration of HawkEye G. And it was very well received. There were over 70 people there, very critical people, very smart, innovative people who understand this market. And it was received as the disruptive innovative technology that it is. So that's another part of the coming out of Project G. One of the things we want to talk about is some new relationships that we haven't talked about before. So when we talked about the beta customers, we have not talked about the specifics of any of them. One we do want to talk about is a leading high-tech security company, SafeNet, which is very well versed in encryption and authentication and cybersecurity. And so we have them as a beta site but also as a long-term partner. They have a CEO who's dedicated to protecting her own network with the best technologies available, so they're very familiar with the technologies out there and have selected G to partner with. We're pleased with the implementation process so far. We had network sensor collection, detection and remediation. Analytic updates have gone smoothly, and we've gone live with threat feeds and deep packing inspection. So G is out there working on beta sites just as we expected. One of the reasons to partner with them is because we want a long-term relationship with a company that has the history that they do, the commercial marketing that they do, the international communications and connections that they have. And we will continue to use them to help us test things before we roll them out because, as we said before, G is going to continually evolve and will be adding new capabilities, I'll say, forever as new advanced persistent [ph] threats come along.

The other relationship is with a company called IO Networks, and I draw your attention to their website, io.com. They are a company that provides modular data centers, particularly to large financial customers. And if you look at their website, you will see some of those. The combination of their technologically advanced data centers and HawkEye G provides the most advanced cyber defense system that can be found, so it's a natural fit for us to work with them. And we're working together on joint marketing, integration of G with their product lines. Their customers have asked them to have security added to their data centers, and we're providing that capability to them. So again, I encourage you to look at their website.

So despite the market impatience for G, we're not going to rush these products. As I've said before, G is a new way of handling advanced persistent threats. It takes a while for customers to integrate it in their networks. G interdicts threats in near real time. This utilizes subsystems which the commercial market has not yet experienced. And because it works automatically, it must be done with great care to avoid operational impact. There are many notable examples of rushing things out to market and ruining the reputation of the product, and there's many examples of installing products without the proper preparation, for example, installing a cyber product in a network and bringing down the trading floor for hours, which costs lots of money. We're avoiding all those things. I don't want to have a permanent reminder of a temporary feeling as we try and rush this out the door. More on G in a moment. But John, first, will you do the financial highlights?

John E. Krobath

Thanks, Len. Overall, the second quarter was a good quarter for us. We had $78.3 million in revenue. On a pro forma basis, that's about 11% growth over what was done in Q2 of 2012. Margins in the Services area improved. Len touched a little bit on that in the subcontractors. I'll get into a little more of that in a minute. We generated $9 million cash from operations in the second quarter. Typically, second quarter is a good cash flow quarter for us. It was again this year. We achieved an 8.2% EBITDA margin despite the fact that we increased our B&P and IR&D spending in Q2 by $1.1 million from where we were in Q1. So despite all that, we still held onto an 8.2% EBITDA margin.

In terms of our Services revenue, we were at $56 million. When we last talked on the earnings call 3 months ago, we had not taken a significant impact to sequestration. About 2 weeks after the earnings call, a couple of our programs came in and made some more significant cuts. Specifically, we impacted subcontractors there on a couple of our prime contracts, to the extent that we had 28,000 subcontractor hours in April. That decreased a little bit in May and was down to 20,000 hours in June. As a result of those specific cuts on those programs, it cost us about $3 million in Q2 revenue. And again, it was shared between us and the subs, but you can see the decrease in the sub hours. The improvement that we saw as a result of the reduced sub hours was a fact that our services margins went back up to 26.2%. Our sub work, we don't make a lot of margin on. We make most of our margin on our self-performed work. So we saw the impact of that increase in the margins we got on the Services side.

In Integrated Solutions, revenue was up. We had a good quarter for our hard legacy product orders. On the software side, we typically see a ramp from Q1 to Q2, and the ramp escalates from Q2 to Q3 and then again to Q4. We're seeing that again this year. We didn't have a lot of software revenue in Q2, so we didn't get the big margin bump on the gross margin in the ISP group. And again, there's 2 things that really come into that. How much software license revenue we have drives a lot of the margin in that group, as well as the maturity of the specific products that we sell. If a product is newer, it's got a lower margin. If it's a more mature product, we typically get better margin dollars in there.

Regarding operating expenses, they did increase from Q1, really, in 3 different areas. I talked about the increase in B&P and IR&D expense that we had in Q2. We also continued to invest, as we said we would, in the commercial infrastructure to get ready for the Hexis rollout and the Project G rollout to backfill specifically on the sales side and be able to handle all the work that's coming in so that we're ready and not chasing our tail by the time it gets here.

On cash flow, $9 million in Q2. That includes the R&D spend that we put out. We spent, year-to-date, $6 million on R&D. That includes what we spent and capitalized on Project G. We spent specifically $3.2 million in Q2. All of that has building us up a backlog for what we're going to do in the future. Specifically, right now, we've got $4.3 million in capitalized software related to Project G. At the end of Q2, we're no longer capitalizing the Project G costs. So whatever cost that the developers are working on, will go ahead and hit the income statement going forward. In regards to amortization of that capitalized software, we're going to cap -- we're going to amortize that over the sales cycle. So as we recognize revenue, we'll recognize a certain percentage of that based on forecast, in terms of the expense that we're taking over a couple of years as we expense off everything we've capitalized.

As we look out for Q3, and Len touched on it, the uncertainty of sequestration makes it very difficult for us to see what our financials will look like for Q3. We believe revenue will be somewhere around flat, but that could be plus or minus 2% or 3%, depending on what happens. We don't expect a call like what we got in mid-May, but that happens. We also have the impact of the government fiscal year end. We don't know how many dollars will be available to add to revenue as that time rolls up. One of the things that we're hearing and seeing is not only are we seeing cuts on the direct side, but there's potential impact with contracting staff within the government to be able to issue the contracts and orders that could augment our revenue come September.

As we look at gross margin, we expect gross margin for Services in Q3 to improve. We've taken down the amount of subcontract labor and subcontract revenue as a percentage within our Services revenue. So we should see an increase in the Services gross margin, not back to where we were prior to the Poole acquisition but above the 26.2% that we saw in Q2.

We also expect the gross margin for the ISP group to increase as we increase the amount of our software license sales.

Operating expense, we've talked about it. We're going to have the G costs start coming in there in terms of their monthly cost that they were spending on capitalizable R&D. That now becomes an expense for us as we look out. While we do have the Exelis lawsuit that's out there, we don't anticipate long-term significant legal expenses. We will have some as we go through Q3, but we don't think it will be a significant amount.

And we have less bid and proposal activity as is normal in Q3, so there should be a slight reduction there. So as we look out, that's kind of the forecast in terms of where we see things as we sit here now at the end of Q2. Len?

Leonard E. Moodispaw

Thank you, John. And as I said earlier, I'll let Chris spend just a few moments explaining the G deployment process because I think that helps everybody understand the track we're on and the progress we've made. So Chris?

Chris Donaghey

Thanks, Len. So first of all, we're going to look a bit at the retrospective installations in the early adopters or beta customers. Obviously, the first step, as we've highlighted in many forms in the past, is you have to get an understanding and the context of the network that the G system is going to be installed in. And that can take a period of time depending on the complexity of the network. And in this particular case, because we're talking about our first 4 installations, some customers took a little bit longer than others. By the time we got to the fourth beta customer, however, that process started to smooth out very quickly. And in fact, by the time we got to the second step, which is the installation of the core G functionality itself, we were able to reduce the installation of the system down to only a few hours. So even for the first installation of a HawkEye G system in a customer network, it did not take a lot of time for the system. That's a very positive development. We're very happy with that aspect. So after you have the G then installed in the system, it has to sit in a listen-only mode. That is where there's still some question marks as to how long you have to have the system turned on before we can start to implement the more advanced techniques such as threat monitoring and then countermeasures on top of that. The basis for this is we have algorithms that are deployed in a series of groups. Some algorithms focus on user behaviors, some focus on networks, some focus on the actual machine-to-machine communications, and some focus on the log events that come in to the Sensage or HawkEye AP analytics platform data warehouse. So you have 4 different classes of algorithms, and some of those algorithms are designed to work on 2 weeks' worth of data, while other algorithms are designed to work on 6 months' worth of data. So at some period beyond that first 2-week time period, you will start to layer in the threat monitoring and the countermeasures associated with the G system. As it stands today, all 4 systems are live and active, with countermeasures for botnets and malware. One system is now active with more advanced threat types. And the other 3 beta systems will be going active with the more advanced threat monitoring in the not-too-distant future.

So some very good lessons learned out of these first 4 installations. Again, I would say the most positive development is that the actual installation of the G systems themselves has gone very smoothly. And for those of you who have been familiar with the tech industry and have been familiar with Sensage, you'd know that one of the complaints historically about the Sensage product was its difficulty to install. Because of how we've embedded the Sensage capability into the HawkEye G system, we were able to greatly simplify the installation of this pretty advanced data warehouse capability, and we think that that's going to enable us to be able to do some interesting things for the next round of customers as we start to bring those onboard in the fourth quarter, for sure, and if all goes well, in the final stages of the beta program, potentially even in the third quarter. With that, I'll turn it back to Len.

Leonard E. Moodispaw

Thank you, Chris and John. So we'll now open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Mark Jordan of Noble Financial.

Mark C. Jordan - Noble Financial Group, Inc., Research Division

A question for either Len or Chris. Specifically, there's been a lot of news recently about the Snowdens and Mannings of the world. How would and would G have identified these people garnering and extracting data? The second question, and I guess related to it, you've talked historically about this being focused on the commercial markets. With these events that have occurred, have you had some sort of contact with your historical NSA contacts about the capabilities of G, and is there interest on that side?

Leonard E. Moodispaw

On the first part of the question, it is designed for commercial market and includes an insider threat use case. So it will find -- for example, if there was such a thing as a Wall Street employee who is siphoning off money or siphoning off data that he shouldn't, it would do that. Therefore, it could find such people as the names you've mentioned. So yes, they can do that. As to commercial and government, we are still focused on the commercial market. It would not be appropriate for me to comment as to whether we are working with any of our other customers on that kind of issue, so please bear with me on that.

Mark C. Jordan - Noble Financial Group, Inc., Research Division

Okay. John, a question relative to Hexis. Now that this is a separate subsidiary, are you going to be reporting this as a separate line item moving forward? And secondly, will you provide any historical data for Hexis?

John E. Krobath

Hexis will be -- continue to be functioning similar to how all of our other subsidiaries function now. As of right now, they'll continue to be in the Integrated Solutions segment line until such time that they get enough critical mass to qualify for segment reporting, at which point in time, we would go back and pull their piece out of our reported results, out of Integrated Solutions.

Mark C. Jordan - Noble Financial Group, Inc., Research Division

All right. And I guess a final question, really, a clarification of what your strategy is. As I understand it, you're saying that for a new customer, the first step would be the assessment period, where, I guess, policies, et cetera, would be written, established or whatever. You said that, I believe, that you will be starting that process with new customers in September. Is that correct? Which would therefore lead to [indiscernible] installations in the fourth quarter of the actual system.

Leonard E. Moodispaw

That's what I said, and that's the plan. We have said we don't want to actually have to -- not have to have, don't actually want to deploy Gs until we are satisfied with the progress in the beta sites. And we are satisfied with it, but we're not the way -- where we want to be yet. So we expect that to be in the fourth quarter. But we can start the CAAS before then. So now that we've had the sales force together and the training people, we'll be ready to start those, we expect, in September.

Mark C. Jordan - Noble Financial Group, Inc., Research Division

And could you give us a sense of, in September, how many targets or organizations would you start working on in that assessment mode?

Leonard E. Moodispaw

We won't be able to do them all at one time because there's too many out there that are asking for it. And I would be guessing if I said a number, but we ought to be able to start with doing at least 2 or 3. And again, as Chris said, it depends on the complexity of the networks to how long it takes. So we'll start working our way down the list then.

Chris Donaghey

Mark, this is Chris. I would just add to that as well that in the beta process, depending on how the customer wants the system installed and how small, first of all, understand that when we first install the system, it's going to be on a subset of a company's networks. So if they're very comfortable with the subsection of the network that the system is going to be installed, for example, if they have a very robust test network, then the assessment phase could go very quickly. One of the beta customers, in particular, went very, very quickly on the assessment side, less than half a day, whereas other assessments took several days. So again, it's going to be variable based on the relative complexity of the network and how prepared that network is or how prepared that customer is for a more advanced capability like this.

Operator

Our next question comes from Stephen Cole of Royal Bank of Canada.

Stephen Cole

Maybe just a question on the CAAS. I know that you talked about the gross margins on those are compatible with the rest of Integrated Solutions. But I wondered in the initial phase, particularly in 2013, as we start to see some of those come through, what you can say about how they'll impact the margin as you're sort of feeling your way through the CAA process with the initial customers.

Leonard E. Moodispaw

Stephen, before somebody else answers, I'll say, what time is it?

Stephen Cole

It's always afternoon in London.

John E. Krobath

This is John. I think when you're talking about the margins on the CAAS themselves, you're talking about margins closer to our Services margins than you are our fully integrated solutions margins. So I think as you go through the life cycle, the CAAS are, in a relative sense, the least profitable of the pieces as we go through. And as we get later in the product life, in other words, as we go through CAA to the installation to what we call the brain feed, the margins on that grow as we move through each of the 3 phases.

Stephen Cole

Okay. And maybe just a follow up with that, since we're now not going to capitalize the spend on G, do we -- can we then make the assumption that, at least from a technology perspective, you've got all the pieces that you need in the puzzle there and you're comfortable moving forward from a commercial expensing R&D basis?

John E. Krobath

That's correct, Steve.

Operator

Our next question comes from Tobey Sommer of SunTrust.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Len, you mentioned a couple of the beta customers and talked about kind of where they sit in the world and that they have -- are in touch with a lot of potential customers, essentially. Is there a discussion of -- with not only these companies, but others to be involved in the sales and distribution and marketing of what used to be called Project G?

Leonard E. Moodispaw

Yes. We'll have 2 pairs. One, our sales force will be out doing their thing. But SafeNet and other -- IO is not a beta customer, but we're working with them. And at least one of the other beta customers is very interested in being a reseller.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And given where you are with the beta customers -- and maybe try to move beyond that in September with additional assessments, is pricing squared away at this point, or is that something that's still under discussion internally and evolving?

Chris Donaghey

Tobey, this is Chris. The pricing models are pretty well fixed right now. Again, we won't commit to disclosing prices or anything like that until we get through the beta phase. But we're pretty solid at this point on what we think the pricing is going to look like.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And switching gears just a bit. Could you discuss trends in Flight Landata? I'm just curious what the update may be there?

Chris Donaghey

Yes. So, Tobey, right now, we have 6 aircraft under contract. And as you're aware, we had 2 additional aircraft that were undergoing integration of new sensor capability as well as testing of the modifications to those aircraft. The larger aircraft has now begun to rotate in with those 6 aircraft. So we are flying the larger aircraft domestically for our customer. Mainly, it's proof of concept right -- kind of stuff right now for the longer-range missions that we might be flying in other parts of the world. But that aircraft is ready to go. And if we can get sequestration behind us, we have no reason to believe that there will not be at least 1 customer who is going to want access to that aircraft, hopefully, in the near future. But as it stands right now, all of our aircraft are still under contract with now discussions about getting the longer-range aircraft under more permanent structure as well.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And then, I'll ask one more about F -- about the former Project G, and then I'll get back in the queue. Chris, you mentioned a timeline for a couple of the processes and look-back periods that you would need, and one of them, I think, was 6 months. Is -- does that imply the -- kind of the full range of the use cases for a Project G, kind of, won't be -- cannot be realized until after 6 months at least have lapsed?

Chris Donaghey

Yes and no. So I'll -- without trying to get buried too much into technical detail. When an algorithm trips, whenever it sees an event that it believes is a particular kind of threat, it not only notifies you or notifies the system that it has indicated a type of threat, but it also assigns a rating or a grade to that threat. And in the optimum cases what you will have as multiple algorithms trip, that each essentially vote on how confident they are that this is indeed a real threat. So while there are some algorithms that require longer-term data to able to trip, it may be that there is another algorithm where you might get a more -- a lower grade or a smaller vote if it trips. So you're still going to get a lot of protection prior to that 6-months time period. But, yes, in some cases, there may be particular threat types that require that 6 months, but you're still going to be getting value out of -- a significant amount of value out of that system prior to the 6-month time period.

Operator

Our next question comes from Brian Kinstlinger of Sidoti & Company.

Brian Kinstlinger - Sidoti & Company, LLC

And the first question I have -- Len, you mentioned you have the ability to do 2 or 3 assessments. I'm wondering, is that per month? How long does an assessment take?

Leonard E. Moodispaw

Well, as Chris said, some of them have taken just a couple of days and some of them can take longer. And since I don't believe we prioritize which ones we're going to start with nor do we know how extensive they're all going to be, as I said, I'm guessing that 2 or 3 during the month of September is what I was thinking of. I hope we could do more, but I'm trying to be a little cautious.

Brian Kinstlinger - Sidoti & Company, LLC

Right. And I guess, something in terms of the long term goals of how many Gs -- or HawkEye Gs you need installed, you need to start ramping that up a lot more per month. Obviously, not now, but next year or so, will you need to hire more to do that? Or do you think when you get the gist of it, it can go much quicker? Just maybe give us a sense of do you have the people to meet the demand?

Leonard E. Moodispaw

I believe we have the people to meet the demand. However, I think, if you look out a year from now, when we expect the -- to be -- the growth to have really accelerated, we probably could use some more people. But we are trying to -- we're not trying to -- we're lining up partner companies, subcontractors, that can help with the surge because I don't want to have a bunch of people sitting around waiting for the next installation. I'd rather have that on the back of subs who are trained to do this and have the workforce.

Brian Kinstlinger - Sidoti & Company, LLC

And maybe could you explain the -- the relationship with SafeNet. So I think they are a customer, you said, and a partner. And so, when they go out and sell their products, will they be offering, as add-ons, your products? Will they be referring customers to you? Just explain how -- what they're doing to benefit you.

Leonard E. Moodispaw

Well, we think of it in 2 phases. One, what they're doing right now is being a very active testbed for now very likely [ph] people. But if you look beyond that, we would expect that when they're out doing their offerings around the world of their security products, since we complement them, that they would also be offering our products too.

Brian Kinstlinger - Sidoti & Company, LLC

And then, you would pay them royalty fees, so to speak? Is that how it would work?

Chris Donaghey

We'll have to wait and see how that part of the relationship develops, Brian. It could either be a commission or a pass-through or a royalty. That negotiation has -- is not complete.

Brian Kinstlinger - Sidoti & Company, LLC

Okay. One more on -- well, I have 2 more, actually on G. First, is there an update on -- I know you're not taking new customers or assessments right now, but is there an update on the AT&T relationship that I think you mentioned was on hold? And maybe, where they stand. Are they back in the queue? Or is that relationship no longer going to move forward?

Leonard E. Moodispaw

Oh, it will move forward. We've had another meeting with them recently. So they -- as I think I've said before, they slowed down because of reorganization and they're getting the right players back in the game. So it's back, active again. And what'll happen next remains to be seen because they're trying to figure it out, but the new players are involved. And so, yes, it will go forward.

Brian Kinstlinger - Sidoti & Company, LLC

In the press release, when you mentioned material revenue in the fourth quarter, I'm hoping, on this call, you could define what material means.

Leonard E. Moodispaw

You know better than that.

Brian Kinstlinger - Sidoti & Company, LLC

Yes, but some -- and so, that leaves a wide interpretation for a sell side analyst that -- we would like to get accurate as opposed to inaccurate.

Leonard E. Moodispaw

I understand that perfectly, but I -- because of all of the variables, I think all I would do is shoot myself on the foot if I gave you a number that's too small or too big. So I'd like to help you, and we'll try and give you better, if I may use the overused term, color on that. But it's certainly going to be significantly more than the 0 that we've had going on G alone, now we've had it from the Sensage and the other products or licensing revenue. But it will be, if I might use the word, significant, because we will be generating some good revenue. That's -- that's as good as I can tell you right now.

Brian Kinstlinger - Sidoti & Company, LLC

Okay. Maybe a few house items. The increase in OpEx per quarter, because you're no longer of capitalizing the costs, could you tell us about how much that is a quarter, and maybe I missed it, and how much is cash versus noncash?

John E. Krobath

In terms of -- are you talking about the G spend that we've got?

Brian Kinstlinger - Sidoti & Company, LLC

Correct. Right. You have an increased cost through the income statement, I thought you said. And so I'm curious how much is that in total per quarter maybe and how much is cash versus noncash?

John E. Krobath

You can assume it's all cash because most of it is employee salaries or necessary subcontractor expense in order to get us to where we need to be. In Q2, we spent about $1.4 million on that. But as we move into Q3, part of what you're going to see -- part of that is going to drop to operating expense. But part of it is also going to go to direct expenses. Some of these those folks roll off and start to do the CAAS that Len talked about, as we do install the work on that as well. So the number is $1.4 million in total, but where it ends up as we go through the quarter could vary depending on the workload that comes in.

Brian Kinstlinger - Sidoti & Company, LLC

That's very helpful. The -- maybe you can give us a headcount on RADIO and if the change in mix of revenue changed the revenue per person dynamics?

John E. Krobath

It did change the revenue per person dynamic. We're not going to give out how many people we have working on programs like that. But what -- the decision we made when we got some cuts in and that was one of the programs where we picked up some cuts is in order to preserve as many people under the project as possible, we addressed some of the more high-dollar positions, specifically, with the subs to make our cuts, so that we could preserve more people rather than less. That was a specific effort on our part in order to impact the least number of people as we went through some of that. And we did that on other programs as well. So while it would impact our -- in essence our revenue per person on that, it's not significant as we go forward.

Brian Kinstlinger - Sidoti & Company, LLC

In that line of thinking, what percentage of your total revenue in Services are you a sub where someone could say to you, on sequestration, what would you say to your subs?

Chris Donaghey

I think the mix right now -- I don't know that I can give you a precise answer on the engineering services, Brian. But I think, in general, our subcontracted work has been between 60% and 70% of our total work, while the prime work has been between 30% and 40%.

Leonard E. Moodispaw

But a footnote to that is that in much of that work, I'm going to say, we're a directed sub. So the prime can do their best if they want to act like a prime, but the customer wants us on the program, so we're somewhat protected.

Brian Kinstlinger - Sidoti & Company, LLC

Great. The last question I have because I had a bunch -- the awards [ph] pretty significantly in the first half of the year versus the first half of last year by a wide margin actually. And so, I guess, I'm wondering, where are those awards? Are they not in Services? Or are they being offset by Services cuts? And how will those transform into revenue the fact that you're booking so much more business in terms of revenue growth?

Chris Donaghey

Yes. First of all, Brian, I think a lot of the bookings relate to the RADIO contract, which will be recognized over a full year and over the Flight Landata business as well. Those 2 alone account for a relatively disproportionate percentage of the total bookings. So I don't want to say, exclude those, but I think if you excluded those, you would see a trend that's probably pretty close in line with the kind of pro forma organic revenue growth that you're seeing.

Operator

Our next question comes from Patrick McCarthy of FBR.

Patrick J. McCarthy - FBR Capital Markets & Co., Research Division

But I just -- on Project G, I was wondering if you could give us just an updated status on where you are on the use case development for the platform?

Chris Donaghey

Right now, Patrick, we have 4 use cases that are fully functional, and #5 is very, very close.

Patrick J. McCarthy - FBR Capital Markets & Co., Research Division

Okay. Great. You said that you set the sales force free on G last week. Would it possible to give us a number of how many salespeople you have on the program right now?

Chris Donaghey

I think the total number of salespeople in the organization is around 7, with 4 or 5 sales engineers added to that -- on top of that.

Patrick J. McCarthy - FBR Capital Markets & Co., Research Division

Okay. And then, I was wondering if you're seeing anything interesting from a competitor perspective that's similar to what you're up to. I know that the BAE Systems had an announcement not too long ago. And I was wondering if you looked at that and whether that was something that was competitive with what you're doing or just anything interesting you've seen in the competitive front?

Leonard E. Moodispaw

We see a lot of hype, Patrick. But -- and we do know about BAE and the other things. But when you examine them, they're not really doing it the way we do. So we still can't find anybody else approaching it the way we do. And when they come in and see us, they often walk in the door, thinking they are and they walk out the door saying they aren't.

Patrick J. McCarthy - FBR Capital Markets & Co., Research Division

What's the primary difference? Is it the analytics or the automated countermeasures or -- can you identify that?

Leonard E. Moodispaw

The automation and remediation are the 2 major things that everybody talks about. So you know that most people are looking at the outside. They're looking out of a network. Very few people looking inside despite what they say. But even if they are, they don't have the automatic countermeasures and the remediation.

Patrick J. McCarthy - FBR Capital Markets & Co., Research Division

Okay. Great, great. And then just for Chris, real quick. You mentioned the larger aircraft, but I didn't hear any commentary on the smaller aircraft. Is there any status on that one that you could give to us?

Chris Donaghey

Yes. The smaller aircraft, Patrick, is really slated to be a spare aircraft in case something goes wrong with the 6 other aircraft that are in operation. What we have seen in the past is when we've had a spare aircraft, a customer has come along and acquired that capacity for program work. That is -- there's still that potential in this particular case. But right now, I think the idea is, for the near term, to hold that as a spare for the operational aircraft. But if the customer comes along with the requirement and the funding, we would certainly explore putting it under contract.

Operator

Our next question comes from James McIlree of Chardan Capital.

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

I think you guys, early in the call, said that RADIO was flat quarter-to-quarter. But then, I think, in follow-on comments, John was talking about cuts. Was RADIO flat quarter-to-quarter in terms of revenues?

John E. Krobath

RADIO was flat. We were building up back in the April timeframe and early May. And then, everything we built up, we lost in the second half of the quarter.

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

Okay. And then, the -- l see what you're saying, okay. So the quarter-to-quarter decline in Services, was that mostly in Virginia or mostly Maryland or some of both?

John E. Krobath

It's some above. If I had to weigh it, I would say it's more towards Maryland than towards Virginia. And the majority of it, like I said, the cuts that we are asked to take across several programs cost us roughly $3 million in Q2 revenue.

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

Right. Okay. And, Chris, when you were talking about the 2 weeks and the 6 months, is that part of the CAA, or is that after the CAA?

Chris Donaghey

No, Jim. That's after the system gets installed. So there is a collection of analytics that will get deployed with every G system. And in that portfolio of analytics are analytics that are designed to trip on 2 weeks' worth of data and others that are designed to trip on larger amounts of data. The assessment of the network really doesn't impact the structure of the analytics portfolio at all.

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

And the way you're contemplating deploying these things, customer buys the system, potentially buys different modules to look for different things and they would cut you the check right then even if they would have to sit there and listen for 2 weeks or 6 months. That's not your concern. Your concern -- you get the check when the module is installed. Am I thinking of that correctly?

Chris Donaghey

From a pure commercial technology company perspective, that's exactly the business model that we're targeting. The customer says they want one, then they write us a check and we go install it. In the early stages of how you do this, how you start these businesses, you have to be a little bit more flexible, mainly because there's not a whole lot of proven customers out there using the system. So we do have to be flexible in the initial stages of this effort. But at the end of the day, the objective is pure commercial technology business practice, which is, you want one, you pay us, we'll come install it.

Leonard E. Moodispaw

And, Jim, it's not additional modules, it's all 1 system. It's turning on the capability within the existing system.

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

Okay. Great. Yes, I see what you're saying. And, John, just once more on this R&D and the capitalization. So it looks like, in the past 2 quarters, you've capitalized about $1-million-plus of capitalized software each quarter. That is not going -- that cash is still going to be spent, but it's just going to be spent in the -- on the P&L rather than in the balance sheet. Is that correct?

John E. Krobath

That's correct.

James Patrick McIlree - Chardan Capital Markets, LLC, Research Division

Okay. So just for -- just to make it -- just to beat this horse to death, so we should expect our R&D expenses to increase by at least $1 million in Q3 versus Q2?

John E. Krobath

I think it depends on how much of -- how many of those folks get deployed to CAAS and system installs in -- call it, late August, early September. The more of those folks we have deployed there, the more of their cost you'll see up in cost of sales because they'll actually be doing some of that work. To the extent that they're not doing that, then, you're correct, the R&D expense will increase.

Operator

Our next question comes from Josh Sullivan of Sterne Agee.

Josh W. Sullivan - Sterne Agee & Leach Inc., Research Division

Just looking at the Sourcefire acquisition by Cisco -- and if there's any other consolidation to follow in the industry kind of as we saw with the Simms [ph] a couple of years ago. First off, is access to the tools -- or the subsystem Sourcefire provides now in anyway more limited? And then, two, if we see the large technology players bundle security with other services, how does G penetrate those customers? Or are you guys looking at that as just a larger customer set?

Chris Donaghey

So a lot of the technology that you're talking about in Cisco and Sourcefire, those would generally be viewed as part of a sensor network that HawkEye G ties into. So just because Cisco acquires an intrusion detection system company that could potentially be combined with their firewall business and any other security technology that they have doesn't mean that it's necessarily a direct competitor to G. I mean, again, the 3 major components that are differentiated in the markets base besides some of the additional features are a big data data warehouse, specifically designed for high volumes of security event data. Neither Cisco nor Sourcefire have that capability. The right analytics to mine that data, to find the digital exhaust that we know the advanced threats are leaving behind, neither of those 2 companies bring to bear that kind of capability. And then, finally, the countermeasures and the automated remediation, neither of which Cisco nor Sourcefire have that kind of capability as well. So it is a consolidation of perimeter defense companies, but does not represent a real competitive threat from a HawkEye G perspective.

Josh W. Sullivan - Sterne Agee & Leach Inc., Research Division

Okay, okay. Good. And then, I just have one last one. Just -- I know the sequestration has obviously caused a lot of problems here. But I mean, are there any material changes to your long-term targets or how those targets maybe are composed?

Leonard E. Moodispaw

Yes. No, not at all. The cyber war -- the counterterrorism war, unfortunately, as citizens will predominate -- will dominate the -- they're our customers for quite some time. So, no, we don't see it as anything other than a blip. We hope it's a short blip.

Operator

Our next question comes from Brian Crown [ph] of LS Capital [ph].

Unknown Analyst

Quick question for you -- FLD, what was the revenue for FLD this quarter?

John E. Krobath

We generally don't give out individual performance of the subsidiaries that we have out there. I think we've given out information in the past that our revenue per plane runs somewhere in the $7 million to $8 million per year range, but that's as much detail as we give out on individual unit performance.

Unknown Analyst

Okay. And then, when does that contract expire? Isn't it September?

Chris Donaghey

So the contract that was awarded to us at the end of December, early January, provides fully funded operations through the end of the government's fiscal year, but also included an option to take us through the end of the calendar year as well. This is not different from how the previous 3 years have been because this program has been funded out of supplemental appropriations specifically designed for overseas contingency operations. The government is not really allowed to fund this program beyond 1 year at a time. So we've gone through this exercise each of the last 2 years, at the end of 2011 and in 2012, where the government has the money to spend, but it takes some time for them to find the contract vehicles to be able to put that money into to fund the aircraft operation. So for better or worse, at the end of this year, it's kind of business as usual. They're in the process of establishing the contract vehicle for those operations going forward.

Unknown Analyst

Okay. Regarding Project G, I know you guys won't give us any revenue or even any hopes of getting any revenue there. But in a different sense, when you guys book revenue, it would, number one, it would be helpful if you guys could break it out, even if it's not 10%. Obviously, I would say most people are owning the stock because of that. The second thing would be to ask, is it going to be in a sense, sort of, some software and some maintenance? I mean, are you going to input it -- some of it in embedded and some of it in Services? Or how should I think about how revenue will be disclosed?

John E. Krobath

Well, I think the revenue process for us starts with the CAA, which is services-based. So whether it's fixed price or hour-related [ph], there's going to be a number there, and we're going to recognize that as we incur it. Then when we go through the license sale and with the various accounting rules that are out there, we'll take a portion of the license revenue immediately. There will be a, what we call, a feed or a maintenance revenue stream. As we go forward, that we'll recognize on a ratable basis over the period. Normally, I think, it's going to be in the neighborhood of 12 months. So there will be a portion of that initial license sale that relates to the ongoing data and threat feed that we'll recognize on a monthly basis going out. That will then recur in out years, as we go forward, in terms of what you're referring to as a maintenance revenue stream with the ongoing feed revenue that we'll get. We only intend on having 1 version of the software out there. There's no upgrade fees or anything like that. Everything is continuously upgraded through that key revenue.

Chris Donaghey

And, Brian, this is Chris. I would just add to that, that our objective and hope, obviously, is to be able to get to the point where we are disclosing this as a separate segment as quickly as we possibly can.

John E. Krobath

And one of the things you should see, as we go forward and we've seen it this year, is you should see an increase in our deferred revenue balance on the balance sheet because that's representative of that maintenance revenue, for lack of a better term, growing that we've got to recognize out in the future.

Unknown Analyst

Okay. That's good. At least we can start to track something there. And then, finally, I just -- I thought I'd make sure I'm clear on this. You guys -- the name of the company you guys named was SafeNet, correct?

Leonard E. Moodispaw

Yes. The company we named as one of our beta clients, beta sites, as well as a long term relationship. Yes, SafeNet.

Unknown Analyst

Okay. Chris, what were you the former President and CEO of?

Leonard E. Moodispaw

Well, Chris Fedde was...

Unknown Analyst

SafeNet, right?

Leonard E. Moodispaw

Yes.

Unknown Analyst

So, Chris -- Right. Okay. I just want to make sure those were the 2. So Chris where he was President and CEO that's your partner and now beta?

Leonard E. Moodispaw

That's correct.

Operator

Our final question comes from Mark Jordan of Noble Financial.

Mark C. Jordan - Noble Financial Group, Inc., Research Division

A question relative to the 4 betas. It was my understanding that they were -- those betas were to be, over time, converted to traditional commercial/revenue units. Is that still correct? And when do you expect that event to occur?

Leonard E. Moodispaw

I certainly hope all of them convert, and we have no indication that they won't. But as to when, it's likely to be sort of around the same time we open the doors to other customers. So fourth quarter.

Operator

Thank you. At this time, I'd like to turn the call back over to Mr. Moodispaw for any closing remarks.

Leonard E. Moodispaw

And my closing remark is thanks, everybody, for your attention, and we'll see you next quarter. Goodbye. Good night.

Operator

Thank you, sir, and thank you, ladies and gentlemen, for your participation. That does conclude your program. You may disconnect your line at this time.

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