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The KEYW Holding (NASDAQ:KEYW)

Q3 2013 Earnings Call

October 30, 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 S. Fedde - Executive Vice President

Chris Donaghey

Analysts

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

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

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

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

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

Brian Kinstlinger - Sidoti & Company, LLC

Karl Oehlschlaeger - RBC Capital Markets, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the KEYW Third Quarter 2013 Financial Results Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to introduce your host for today's conference, Len Moodispaw, CEO and President of KEYW. Please go ahead, sir.

Leonard E. Moodispaw

Thank you and good afternoon, everybody. As usual, we'll start with a disclaimer read by Jen from our legal department. Jen?

Unknown Executive

Under our Safe Harbor disclaimer, statements made in today's call that are not historical facts 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, Jen. And once again, good afternoon, everybody. We will have on the call today John Krobath and Chris Fedde as speaking parts at the beginning. And then at the end when we take questions, Chris Donaghey will join us. So remember when you ask questions to specify which Chris you're talking about. I'll make a few brief comments and then turn it over to John. I want to start with a quote from my grandfather who once told me that, "The future is not what it used to be." And that's true for us in the short run. We're not going to see the growth we expected as a result of the government shutdown and sequestration and the ambiguity coming behind that. You'll get more details on that from John as we go on. But what we're seeing still after the government has gone back to work is our customers are hoarding money. They're concerned about the ambiguity about budgets. So until that gets straight, we will not know how the future is going to look, and we will continue to be flatter than we would like. However history shows us that when we come out of these situations, spending is robust. So we are encouraged by the growing list of opportunities and we're actually still hiring people. So the real question is when will Congress go back to drinking their usual Kool-Aid and stop gulping tea and get back -- and let us get back to work.

Couple of other comments as the Q reports, we settled the litigation with Exelis, primarily to reduce the risk for employees and satisfy our customers. It's a confidential settlement of the litigation, and there is no admission of liability by any party. The settlement was for slightly less than $5 million after taxes and includes all the legal fees.

It will be paid in several installments [indiscernible]. Some good things happened this quarter. We did win 2 of the largest prime contracts we have won in our 5 years for advanced cyber training and software development. And we launched our commercial product subsidiary Hexis and announced commercial availability of HawkEye G in early October as we said we would. And Chris Fedde will talk more about that when he talks about Hexis.

I do want to point out some several quotes, however, from an article in the Washington Post the other day, where 2 of our beta customers agreed to be reference customers and spoke highly of the product. And they talked about such things as the automatic remediation that they can't get elsewhere and the, as Chris pointed out, the awareness of the networks that they find -- don't find with any other products. So while it does lots of things, the awareness alone is really striking a chord with our beta customers and the other customers that we're approaching now that we've made it generally available.

So more on that to follow. And, John, over to you.

John E. Krobath

Thanks, Len. We had a good quarter, considering everything we were working on in the third quarter. Cash flow was about $10 million. Revenue came in for the total company at $73.8 million. The Services component of that revenue of $52.6 million came in about where we expected. We had a gross margin on that of about 26.9%. A little higher than what we've seen but consistent with what we've talked about in the past. The reduction in our subcontractors caused by sequestration in the second quarter and the lower margin that they run at has enabled us to get to a higher gross margin in Q3 of 26.9% on our Services.

For the Integrated Solutions, that's the one area where we had some revenue we were counting on in Q3 that got pushed out to Q4 and some into next year. There was just over $3 million of revenue along those lines that got pushed out.

So that's where, if you take a look in terms of the revenue number, that's where we expect to do a little better. The margin on the Integrated Solutions was 48.3%. We did not have a significant impact of software license sales in Q3 that would've bumped that margin up because of the higher gross margin they operate at. So overall, it was $21.2 million of Integrated Solutions revenue of 48.3%.

Our operating expenses from Q2 to Q3 decreased by $1.7 million. That's despite an increase of $1.8 million in what we're spending on the Hexis side to get the software up and running, reconfigure the sales team and have Hexis really ready to attack the market and start to generate significant revenue.

To give you an idea of what we're spending on Hexis. In Q3 we spent $5.5 million in operating expense. We spent $12.6 million year-to-date. Those numbers do not include roughly $2.6 million that we've capitalized related to the software development in the first half of the year.

So operating expenses were really down from Q2 to Q3 by about $3.5 million, if you take out the additional funds we've spent on Hexis. The big driver there is cost reductions that we made in conjunction with sequestration in the second quarter. And most of those were made late in the second quarter, so the impact that we got on them was reflected in Q3.

When we talk about our operations, we segregate for SEC purposes based on Services and ISP. But a question we often get is, well, what's going on with Hexis? So what we've done is I'll give you some color to the government services as opposed to the commercial services. Eventually, if Hexis grows like we believe it will, it will become a segment unto itself on the commercial side. But right now, it's a component of ISP.

For Q3, we generated EBITDA of approximately $10.5 million in the government services side. I should say, the government side. That's about 14.6% of revenue. We did have some true-ups in the quarter related to some of our fixed-price contracts as we adjusted our estimates to complete. But for the year, for the first 9 months of the year, our EBITDA on the government work is about 12.4%. That's slightly less than where we were in 2012. The big impact there is we have more subcontractors at the lower margin rates, which pulled us down a little bit compared to where we were last year.

I can give you a percentage of the EBITDA on the commercial side, but with the spend we talked about before, we're running at a negative EBITDA. So if we're at 10.5% in Q3, that puts us somewhere around negative 3.8% in an EBITDA number for the commercial side in Q3 and a negative $7.1 million for the first 9 months on the commercial side. That gives you an idea of the investment that we're making to make sure we succeed in Hexis. We're not cutting corners to try and do it cheaply to get it out. We're trying to do it right, put the right people in the right places and the spend is reflective of that in the impact on our financials.

Len touched on the legal settlement. If you take a look at our nonoperating expense on the P&L, that's where that number is reflected, we also have interest expense and a couple other smaller things that are in there. But the big number you're going to see is the legal settlement in there and the tax effect is down on the tax line.

As we look out towards Q4, prior to the government shutdown on October 1, we would've expected revenue to be roughly flat from Q3 to Q4. The impact to us from a shutdown has been roughly 24,000 hours that were unbillable from the first 2 weeks of the period, as, at one point, we had almost 300 folks who were not able to go to work due to the government shutdown. That's been reduced. We still don't have quite everybody back, but the impact is there. And the impact just isn't on the people that aren't there. The impact is on contracting activities that need to occur, the fact that we're still working under a continuing resolution which delays funding, and one of our customers has put out the guidelines of how they're funding contracts when they start to run into issues because they're still spending FY '13 money.

So as we sit here and we look at it, we would've expected revenue to be flat. We have an impact of up to $3 million as it relates to the time lost from the government shutdown. Will we be able to recover any of that in Q4? We don't know. Normally in Q4, our Services revenue is down anywhere from 5% to 7% compared to the third quarter. As people take more holiday, there's shorter months because of the holidays that are in there and the PTO that people take.

The one thing, and we've done our best to go through and estimate this, is what will the impact be from our folks who had to take PTO during the time that they couldn't work, if they couldn't take comp time? How will that impact their PTO time come the end of the year? We've done our best to estimate that. But as we look at it, we've got the normal seasonality of the Services revenue plus the impact of a shutdown.

On the upside under Integrated Solutions, we expect that revenue to be up in Q4 from where it was in Q3. Some of what we had pushed out of Integrated Solutions in Q3, we're going to make back up in Q4. We've also got a couple of orders that have come in on the product side with some significant size that will help drive that number up as well, as well as license revenue from Hexis and legacy Sensage are normally better in Q4 than they are in any other quarters.

That being said, what we're looking for again is revenue roughly flat with where we were in Q3, minus the impact of the shutdown as we look out.

We don't expect a significant change in the gross margin. It would come down a little bit in Services due to the catch-up that we had on the firm fixed-price jobs that we won't see repeated in Q4 and the subcontractors we expect barring any activity from the government to increase or decrease to be the same. So I would expect gross margin to be in the mid-26% range.

On ISP, it's going to come down to how much software revenue we get in. We have an estimate there, but I would expect somewhere in the 51% gross margin range as we look out to Q4, pending the exact breakdown of the product orders that come in.

The EBITDA on the government side, I would still expect to be in the 12% to 13% range as a percentage of sales. The spend on Hexis is going to increase from where it was in Q3 slightly as we continue to build out the team there. And then again, it comes back to the software revenue. We still expect them to be in a negative EBITDA position in Q4.

There is a note in -- well, let me talk about operating expense first. We expect operating expense to decrease again in Q4, one of which is the fact that there is less hours during Q4 than there are in Q3, as we've talked about before. We're also continuing to focus on moving some of our what should be billable staff that has been on a small bench that we've had, move them to more billable positions, which will take labor out of the overhead labor. So that should continue to push down our operating expense as we move into Q4 on a straight dollars basis as compared to Q3.

There is a note in our filing under subsequent events within the financials. Len talked about the legal settlement. But more importantly, or as importantly, October 1 is also the valuation date for our goodwill impairment. Given the fact that on October 1, the government was in shutdown mode and 300 folks of ours, approximately 300, were not able to go [indiscernible], it complicates our goodwill impairment valuation. We don't know, given the circumstances out there, if we will have an impairment. There's a possibility. But there's also a possibility, as we work through the exercise with an external valuation firm, that there won't be. It's an annual event. We've got to do it to value our goodwill. We've never had an impairment before. We're hoping we don't now. But we wanted to let -- to put people on notice. We are looking at that and the convergence of dates of October 1 between our normal impairment review and the government shutdown is making it harder for us as we go through.

Were there to be a charge, it would be a non-cash charge that runs through the nonoperating section of the income statement. We won't know the results of that work until we get to probably late November, mid-December as we continue to work through that number.

Chris, over to you.

Chris S. Fedde

Thank you, John. Several things within Hexis that you ought to be aware of. Let me start with HawkEye G, our active defense grid. Formally reported on as Project G, which was its developmental name. But now that it's a released product, as Len said, it's got its products name of HawkEye G. We did release that in the U.S. for general availability in the week of October 7. And then we released it globally the following week, and we released that through our EMEA channel partners. So we're really pleased that we released it on time. Len has reported for 2 quarterly calls in a row that we were targeting a third quarter release, and we were pleased that we got it out right on schedule. I understand, of course, October 7 isn't quite the third quarter. However, we did decide to delay it a little bit so we could take advantage of the CyberMaryland conference. We decided to use that as our venue for our GA. And that was very successful. It's a high visibility, well-attended conference here in Maryland, and we used that as our venue for our announcement.

When we had our EMEA channel meeting that following week, that also was very successful. We had over 60 of our partners and our customers there. It was a 3-day event. So we introduced HawkEye G at that point.

The other thing we did is we introduced our revitalized Sensage product, which we have renamed Hawkeye AP for Analytics Platform. So we introduced that to them too. I'll say something about Hawkeye AP in just a second here.

But back to HawkEye G, update for you on the betas. We were very pleased that Inmarsat came out and added their name to our named references. As you know, SafeNet had previously been a named reference for us. So you can understand how customers, whether they're betas or not, customers are a little bit hesitant to talk about breachability and particular problems they may be having within their own networks. Maybe a little counterintuitive that SafeNet, as a security company, was the first one to acknowledge it. But it really isn't. It's the security companies that don't pretend the threat can't get past the perimeter. The security companies know they can. The security companies have been dealing with it. SafeNet, as you know, I have a history with SafeNet. And SafeNet is one of those high-tech, very security-savvy companies that acknowledges the real threat, the real maliciousness of these mass threats. So we were pleased that both SafeNet and the government part of Inmarsat added their names to the HawkEye G acknowledgment. So we were pleased with that.

So what we're doing now is we are really queuing up HawkEye G customers that are ready to begin pilot installations. So by pilot installations, I mean these are customers that we believe are getting near their decision point. So it's not proof of concept. That's not something we think we'll be dealing with HawkEye G. Proofs of concepts are fairly early. That's really not something we expect we'll be doing. We'll really be talking with our customers, showing them what it can do. And when we think they're getting near their decision points, we'll start making installations in their networks. They can evaluate it. They can confirm what HawkEye G does. And we would expect then that we can move from there to a sale. So there's nothing unusual about that. Terminology may change, but if you were to talk to Sourcefire, talked to FireEye, you'll find that we're all doing approximately the same thing there. So I'll use an example. We had a name brand bank last week, early last week that heard about HawkEye G. They asked if they could have a presentation. The sales team, a few days later, made that presentation to them. And 2 days later, we heard back from that bank that said, okay, we're ready to roll up our sleeves and start talking about HawkEye G in our network. So that's exactly what we're looking for. Our customers that understand the value statement, understand the threat, the nature of the threat, and they want to get serious about how to address it.

So if you look at our pipeline, here again, it's pretty much what you would expect to see. We're seeing in our pipeline opportunities that generally range from $0.25 million to $1 million range. That's what we expected. That's what we're kind of seeing on our pipeline, and those customers are queuing up for pilots. So obviously, we're going to start running into holidays later in this quarter and fiscal year endings. But that's what we're seeing and that's going pretty much as we hoped.

As far as the analytics platform, the HawkEye AP that I mentioned earlier. So we've been investing in that product, too, because we can take advantage of the hot buttons in the market of big data, hot buttons in the market for analytics. And we believe we could reposition the former Sensage product to take advantage of that. And I don't want it to be lost. We're seeing that. We're seeing some very successful results there. We're seeing the pipeline trend turn around, it's positive. Last couple of quarters, we've had a couple of big name successes, not names that we can name. We don't have their permission to do that. But they are blue chippers. You would know them. We expect to get another one this month. So that's a real trend. You should keep in mind, that, that, we think, is going to be a solid product for Hexis and for KEYW.

As far as the organizational readiness that John referred to, I'll add my vote of confidence there, too. I think the staffing is largely complete. We've got the critical element staff now. We've got experienced people in there, I think, and we're ready for an expanding commercial business. We will keep hiring on sales. There's some key hiring we'll still want to do on the developmental side. But by and large, I think we've got our staffing in place there. So we're ready there.

We're not spending sales and marketing, like some of the folks that you read about. We're not spending like FireEye or greater than 100% of revenues being spent on sales and marketing. We don't expect to. We don't think we need to. We think we're doing the right thing. We think that the team you're listening to on the phone here is managing just right as far as building up for success.

So in summary, I'd say things are on schedule. It's on the schedule that Len's been telling you to expect. We're getting the market reactions that we were hoping for, for both products, for HawkEye G as well as the HawkEye AP. And we're setting ourselves up for what we think will be a successful 2014.

That's the highlights within Hexis.

Leonard E. Moodispaw

All right, Chris, thank you kindly. And so I'll wrap up with just a couple of comments, then we'll take questions.

So on the Hexis side of things, I'm continually encouraged with the progress we're making and the team we have in place and I believe that has a huge future for us. When I think about the government side, I think about a story that was told about Noel Coward leaving the opera and when he said, "The problem with opera is not that it isn't what it used to be, it is the same as it used to be." And that's the way it is with the government business. We have these cycles. And when we come out of them, we come out of them robustly. And I continue to believe that we are in the best place for it by being in the intelligence business and, particularly, because of the kind of things we're doing in cyber and counterintelligence, which remain huge national priorities despite any of the press you might read.

So happy to take questions. Remember that you have 2 Chrises and John on the question -- on the answers also. So feel free.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Tobey Sommer from SunTrust.

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

I had a question for Chris Fedde right off the bat. In terms of the bank customer or potential customer for HawkEye G that you described, is a turnaround and response from an initial meeting of a few days, is that kind of an unusually fast one? Or is that the way that you've been experiencing customer responses and reactions to the meetings?

Chris S. Fedde

The initial customers are customers that are very aware of the threat. They've either been victims of the threat or know they could be, and they are very eager to find a solution for it. And so, we don't have a long history to base it on, so I can't give you any stats here. But finding people that want to move out quickly when they hear what HawkEye G can do is expected, and I think we'll probably concentrate on customers that fall in that kind of guideline here, customers that are really eager to find a solution and feel some sense of urgency. It's still going to be a long sales cycle, right? It's still going to require a technical level discussion and a pilot, like I mentioned. But I really think that the -- there's a lot of people out there that feel that sense of urgency. And I'm hoping that does become the norm.

Chris Donaghey

And, Tobey, this is Chris Donaghey. I would just reinforce that with some of the action that we saw in the beta customer environment, as well. For the guys who have experienced significant pain, particularly from an advanced threat and have had to bring in professional services companies to help them do the remediation, that's really the target audience because they felt a lot of pain as a result of that compromise. So one of the beta customers was in that same boat, and we saw them go from the first meeting with us to discuss then Project G to deploying the beta unit in about 3 weeks. So the ideal customer is the guy who has experienced a lot of pain and is very aware of the threat environment that's out there.

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

As a follow-up, I'm curious as to what your expectation is for the length of a pilot installation period?

Chris S. Fedde

Our history, so far, has been that it takes about 30 days before HawkEye G can really start demonstrating value. Now, there's no bright line threshold in here. But in a couple of weeks, it starts showing what it can do. In a month, it's really hitting its stride, and then it just continues to get better after that. So I would say that 3 to 4 weeks is kind of how we would target that. And part of that's dependent on the size of the networks that we have to integrate into also. But I would say that's a rule of thumb.

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

Okay. I had just kind of a numbers question that I didn't quite understand. You walked through some numbers to describe incremental spending associated with Hexis and R&D in the quarter. But I wrote down a number that I don't see in the press release. Can you just walk through the math on the impact of those investments in the quarter?

John E. Krobath

In just the quarter? I'll give you quarter and year-to-date if you want. In terms of operating expense, we spent $5.5 million on Hexis in Q3. That brings us to a total of $12.6 million year-to-date. And that $12.6 million does not include the $2.6 million that we capitalized during the first 2 quarters of the year related to the development of HawkEye G.

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

Okay, that's helpful. And adjusted EBITDA margin, if you were to exclude that operating expense, just of the base business?

John E. Krobath

Well, we kind of broke it up with the government business as opposed to where we were in the commercial business on an EBITDA number. So on the government side of the house, we -- in Q3, we did about $10.5 million, $10.6 million at 14.6%. And we had a negative EBITDA on the commercial side of $3.8 million. And year-to-date, those numbers are $27.6 million of EBITDA for the government side or about 12.4%. And on the commercial side, a negative $7.1 million in EBITDA.

Operator

And our next question comes from Patrick McCarthy from FBR.

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

I was wondering if -- just 2 quick ones on HawkEye G. One is, Chris, you had mentioned, Chris Fedde, you had mentioned that the pipeline was 20 -- $225,000 to $1 million. Could you give us a sense for how many companies are in that pipeline?

Chris S. Fedde

I don't have a number for you. We're kind of taking folks that had shown interest earlier and we kind of put them on hold until we felt we were ready. And so we're kind of building up that pipeline. So it's probably not a number I can really give you any accuracy to -- maybe until next quarter. But there's quite a few folks that we're moving from interest to pipeline. And we're trying to be very careful that our pipeline is a qualified pipeline here. So I would ask you to give us a quarter to get a better handle on that.

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

Is there any change to the number of customers you expect to convert in the fourth quarter? I think in the past, it's been 4 of the beta customers convert and then a potential 6 additional customers on top of that?

Chris S. Fedde

Yes, that would be -- to be candid, that would just be a guess. We've got -- like I say, it's not really a full quarter. We lose a lot of December. And you've got -- it's the end of the fiscal year for a lot of these folks. And this is not an insignificant expense. And so I think both those factors will play into it. So I'm just not going to hazard a guess as to how many of those we're going to convert this year versus convert after the 1st of January.

Operator

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

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

Chris Fedde, question relative to the size. You're talking about initial installations being more characterized as pilots. What would be the size range of a full installation for these customers if a pilot is in the $250,000 to $1 million range?

Chris S. Fedde

Well, that would be the ultimate sale would be in that range. Usually the pilots, what they do -- most networks, no matter how large they are, are built out of domains, right? And so normally, what people would do will identify their most critical domain and ask us to use that for their pilot. So the pilots are usually smaller than the network. It's where it's critical. It's where they can keep an eye on it, close eye on it, and use that for their evaluation purposes. When we ultimately field throughout their network, that's when you get into the $0.25 million to $1 million range that we expect these sales to be.

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

Okay. Relative to the distribution capability that you have for both HawkEye G and AP, could you talk about the number of people that you have currently in the sales function, where you want to be at year end, and sort of what your plans might be by the middle of next year?

Chris S. Fedde

I would say that in the sales group, we've got -- in the direct sales group, we've got about 15. And we're going to -- I would say, we're going to double that as quickly as we can. Can we do that this year? Maybe. But we're going to double that as quickly as we can. So that we've got a direct sales force that's twice that. We've got a good channel distribution through Europe, Mideast, Africa. So we've got quite a number of successful, proven channel partners there. I'd like to expand on that also because I think by adding -- by repositioning HawkEye AP and by adding HawkEye G, I think we've got a lot more relevance to more of the European market. And so we expect to be adding partners there. And so specifically, to answer your question, we're talking to some partners that are more plugged into the U.K. and some of the other Northern European countries where, I, personally, I think we're underrepresented. So that's kind of what our priority is there.

Operator

And our next question comes from Jim McIlree from Chardan Capital.

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

Can you talk about Flight Landata operations this quarter versus Q2?

Chris Donaghey

Yes. Hi, Jim, it's Chris Donaghey. They're essentially running at the exact same rate as they were in Q2. All 6 aircraft are fully functional. We are under contract through the end of the calendar year. We're in the very late and final stages of finalizing the contract that will take care of next year as well under, at the very least, the same scope of work that we have right now. So really, not much change there. If the 2014 budget were to be approved, as requested by the Army, it would provide us with a lot of ceiling to potentially expand the program to take advantage of the additional aircraft that we have.

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

And if the budget just goes CR, then you're just static for 2014, is that right?

Chris Donaghey

Correct.

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

Okay, great. That's good news. And then for the other Chris, have you encountered any reluctance on the buyers or unwillingness of the buyers to talk to you given that you're so closely identified with your major customer? Has there been some fear injected into them given your relationship?

Chris S. Fedde

Candidly, no. There hasn't been yet. And I'm not expecting that in the U.S. I was expecting to get some whiffs of that when we had our European kickoff. And quite honestly, we didn't get it there either. I'm not going to be naïve and say it's not there and won't play a role. But we haven't seen evidence of it so far.

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

Okay. And then, John, I just want to try to understand the expenses that are increasing in Q4 for Hexis. Do I -- am I to understand that you have an increase in just the Hexis infrastructure Q4 versus Q3? And I'm not sure you gave a number, but is it on the order of like a couple hundred thousand dollars, that increase? Or is it more or less than that?

John E. Krobath

Potentially, it could be more than that. I think you're probably in the right ballpark. There are a couple of things as we talked about. There's less days and people take holiday, which reduces our cost. But as Chris touched on, he's increasing the sales force, so that brings with it, on the salary portion of the sales force compensation, an increase. So you're not talking $1 million or $2 million increase, but you're probably talking $300,000, $400,000, $500,000, depending on how quickly we hire in those new sales force people.

Operator

And our next question comes from Josh Sullivan from Sterne.

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

Just on the government side, how should we think about the rollout of the prime contract wins you guys got, just given this flat outlook? I mean are they frozen here with the budget environment?

Leonard E. Moodispaw

No. It's Len, Josh. No. And that's an area where the money is there, and as fast as we can ramp it up, we're doing it. For example, the one contract is for cybertraining. And the government is committed to hiring a number -- not hiring, training a number of military folks in that area and they got to do it, and they're anxious to get it moving. So that's not slowing us down.

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

And what is the pipeline for other opportunities or other similar opportunities?

Leonard E. Moodispaw

Well, in the training area alone, both in the government as well as the commercial side, it is -- I'm trying not to be too bullish. The opportunities abound. We have unique background and therefore unique training, and we're finding a number of people who would like to have the -- what we're calling paraglabs [ph] in the commercial market in the U.S. as well as overseas. On the government side, just taking the training the military piece alone, that also has a significant upside because they need to train a lot of people very quickly.

Operator

And our next question comes from Brian Kinstlinger from Sidoti.

Brian Kinstlinger - Sidoti & Company, LLC

You said last quarter, you had 4 customers. Is that still your customer total today for HawkEye G?

Chris S. Fedde

The 4 were beta customers, and we didn't want any more than 4. And until we went GA, which we just did, we really opened for business. So yes, we had 4 beta customers. That was by our own choosing. Now that we're generally available, now we'll start adding customers to that.

Brian Kinstlinger - Sidoti & Company, LLC

And, Chris, I'm hoping you can help set an expectation here. I think that you have investors that have heard about conferences that there's been presentations of the product that there's a lot of demand. Customers are lining up it seemed over the last couple of calls, certainly it wasn't available for sale at the time. So then maybe help investors and sell-side analysts understand when you expect meaningful client additions? Is that a first quarter? Is that a second quarter event? Is it even a fourth quarter event? And I'm not talking 1 or 2 or 3, but when do you expect really the floodgates start to open where you are seeing customers weekly, for example?

Chris S. Fedde

Our priority is in Q4 making a very quality pipeline and to turn Q1 into the start of our revenue event. That doesn't mean we won't get revenue in Q4. But frankly, I'm all about making sure 2014 is successful, and the rest of the people on this phone call are like-minded. So we're really looking at Q1 to see revenue start lifting up. And we expect it just to continue to go up. And like anything, it's back-end loaded because it's a new product. Now you overlay the HawkEye AP on there, which like I say, I'm quite bullish on that also, as a good baseline product underneath that. So I think you'll see both products in Q1, and I think both products will just continue to increase during the course of the year. We're working on our 2014 budgets now and our projections now, and I'm sure Len will be sharing more of that at a future point.

Brian Kinstlinger - Sidoti & Company, LLC

I just want to -- Chris, I know you don't want to be held to anything, but I'd like -- the process is taking a while. You certainly are new to it, and we would like to be able to evaluate. I mean is the second quarter going to be numerous customer additions? Is that Q1? I mean it's just unclear to me how to evaluate when the sales process isn't meeting your expectations. And so while I understand revenue starts in Q1, when does -- when do you think investors will be able to see the evidence that the product is being well accepted in the marketplace?

Chris S. Fedde

I think the things you'll want to start asking us in Q1 -- I mean, you may ask now, but we'll start answering you Q1, is what the qualified pipeline looks like, what the deferred looks like. Because then you can see how not only the -- not only revenues but the service subscription that goes on top of that, how that's building up. I think the indicators in Q1 will tell you how the year is going to go, that's what I think. And like I say, we've got sales cycles that are anywhere from 3 months to a year. I can guarantee you there are sales cycle out there that are going to be a year long. But I think there's going to be enough that are 1 quarter sales cycle that in our first quarter you're going to see the trends that are going to be indicative for the year.

Brian Kinstlinger - Sidoti & Company, LLC

And then if you look at your beta customers. Last quarter, I think they were all generally in the gathering information stage. Have they all passed that? Are they all actively live looking for threats and evaluating networks?

Chris S. Fedde

Yes, they're all live. The only difference between the 4 now is to what extent are they automated? And some of them are very conservative and wanted to automate slowly, and some of them automated quickly, but that's the only difference. But even if they're not automated, they're still semi-automated, meaning HawkEye G is still stepping them through the process. If they want to put a human in the loop, they can put a human in the loop. They are still getting the advantage of fast detection, fast targeting and quick remediation as led by HawkEye G. So even if they're going about the automation in a slower manner, they're still getting almost all the advantages of HawkEye G. So yes, they're all live, and they are all -- the thing that benefits G and we're pulling kind of a consortium together to aggregate those, so people have a better visibility as to what they can expect from the 4 betas. Plus we've got it running on our own system for quite a while, too, so there's more history there. But these betas are now, what, 6 months, right? So there is very good history there. And that's why they're starting to agree to become named references. They like what they see, and they're willing to say so.

Brian Kinstlinger - Sidoti & Company, LLC

And then I'm just trying to understand the partnership structure. Clearly, we all know you -- SafeNet's a partner. What I didn't understand in your comments are do you actually have other partners signed up already? And is SafeNet -- and if you have other partners actively selling HawkEye or is that not happening yet?

Chris S. Fedde

Well, there's 4 betas. SafeNet's a beta customer.

Brian Kinstlinger - Sidoti & Company, LLC

Right. I'm talking about partnerships.

Chris S. Fedde

When I was talking about partners, I'm talking about our go-to market partners. So these are channel sales partners. And most of those are in EMEA. We have one in the U.S. I take that back. We have 2 in the U.S. We have one major one in the U.S. But we have several in Europe and they -- like I say, we will sell indirectly into EMEA. We will sell virtually exclusively through those channels. And that's why I said earlier, we are actually going to build out the channel structure, too, because there's certain parts of Europe that I think we can now penetrate with the new products.

Brian Kinstlinger - Sidoti & Company, LLC

Okay. And then I guess, Chris or Len, the other Chris or Len, with your new 2 contracts that we just talked about, when do you expect services is going to stabilize? Obviously not in the fourth quarter. And then maybe when do you expect it'll return to growth?

Leonard E. Moodispaw

Well, this is Len, Brian. You'll know as soon as we will, which is when you read the news that they reached a budget and they're moving on with 2014 budget. That's the thing that's holding everybody back.

Brian Kinstlinger - Sidoti & Company, LLC

Okay. And then I guess in your Analyst Day, I wanted to go back to that a little bit. You laid out a path for core services revenue as well as RADIO. I just wanted to understand, given the current environment, if that's still achievable from a revenue and profitability standpoint? Or will that piece of the outlook, probably, look a little bit differently given what's going on?

Leonard E. Moodispaw

For 2015, which is what we talked about at the Cyberitaville [ph], those numbers are still achievable.

Brian Kinstlinger - Sidoti & Company, LLC

Okay. And then I sort want to ask the same question on the commercial side. Do you -- it sounds like the first half of the year may be not -- or the first quarter, as robust in terms of sales as maybe I thought it would've been. That doesn't mean anything because what I know is small. But is the target for revenue in 2015 the same? Is it less or equally achievable or more achievable than maybe you would've thought back then?

Leonard E. Moodispaw

I think I followed the question. But -- so the answer, yes, it's still achievable.

Chris Donaghey

Yes, this is Chris Donaghey. I would just say that based on the preliminary business plan for 2014, if we hit the business plan for 2014, then the expectation for 2015 really shouldn't be too much of a stretch from that.

Operator

And our next question comes from Karl Oehlschlaeger from RBC Capital Markets.

Karl Oehlschlaeger - RBC Capital Markets, LLC, Research Division

Just a question on G. In the past, you talked about sort of 3 different types of revenue streams, the assessment and installation fee and kind of the recurring stream. How does the pilot installations figure into that?

Chris S. Fedde

Pilot installations are not part of the revenue stream. They're part of the sales process. So what we would expect to do is go from a pilot system to a purchase order. And our revenue streams will be -- the big revenue stream will be perpetual licenses. And right behind that will be the subscription service that supports the product. That's the 2 big revenue streams for HawkEye G.

Karl Oehlschlaeger - RBC Capital Markets, LLC, Research Division

Yes, so the cyber analytics assessment is probably a fairly small piece?

Chris S. Fedde

Well, yes, we're in a products business. Everything we're doing is to get products sold and implemented. I expect we will absolutely run into more customers that need those analytics. And by all means, we'll make sure they get those. But if you're asking where our priorities are, it is placing the product and getting the subscription services lined up.

Chris Donaghey

And this is Chris Donaghey, Karl. I'll just say that, that has been a little bit of a shift versus where we thought we were going to be this time, say this time last year. We did think that there was going to be a heavier upfront services capability. But as we engaged with the beta customers, we kind of realized that -- and somewhat of a positive surprise, that it was going to be a lot easier to install a G system into a network than what we had anticipated with a canned set of policies, essentially preprogrammed into the device. So rather than going in and doing a larger scale policy definition exercise, we can install the system in a network pre-configured with certain policies, put the system in learning mode, so it's gathering information about the network that it's installed in, and then we can tweak the policy environment over the next few weeks as the system is in learning mode using far fewer resources and not quite as significant a professional services upfront commitment as we had expected.

Karl Oehlschlaeger - RBC Capital Markets, LLC, Research Division

Got you. And then one other question on Cyberitaville [ph], you think you're going to have another one in 2014?

Chris Donaghey

I didn't call it the first annual Cyberitaville [ph] for no reason.

Leonard E. Moodispaw

And we're going to try and improve the weather this time.

Operator

[Operator Instructions] And our next question comes from Tobey Sommer from SunTrust.

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

I had a question about the individuals who couldn't go to work kind of during the shutdown. Is there any unifying ways to describe them? Or do they work on-site and therefore weren't allowed to go because the office is closed? Any kind of color you could give would be helpful. Thanks.

Leonard E. Moodispaw

With that said, you're right on, Tobey. The hardest problem or the biggest problem we had was when the government shut down, they shut the doors. And so the government employees weren't allowed to go in and our people weren't allowed to go in. That was the biggest push initially. And then you noticed that the many government people and the DoD people were allowed to go back to work, and that's when our people went back to work. So that's the biggest chunk right there.

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

And the way this unfolded, if we were to have another one in January, have you learned something that would allow it to be less impactful on your people next go-around?

Leonard E. Moodispaw

That leads to so many straight lines about what we learned about this, but I'm going to let them all pass. We took a number of steps this time and we were different than many other companies in how we treated it. We wanted to be fair. And so everybody in the company participated, if you will, to help lessen the burden and to show that we were all one company. So that worked and I don't know that we would do anything differently, but it's going to depend so much on which people are allowed to go to work and which aren't.

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

And then just one thing I wanted to double check with Chris Fedde. I think you said that the direct sales force was 15 people? And that you'd like to double it maybe even this year? Was that a 2014 comment or is that the next 2 months?

Chris S. Fedde

No. In the next few months. That's the total direct sales with their SE supports, and a couple of others direct support in there. But we've got offers out that -- and again, we're going after experienced people. We're not -- we are going after people that know how to sell this and appreciate what they have here. So we're being very selective. But we've got a number of really quality people in the pipeline. We've got -- accepted offers for people that haven't started yet. So no, we're not going to double it by the end of this year, but that's what we -- that's kind of what we set for ourselves, but it will probably take a little bit into next year. But that's -- it's still that close in, I think.

Operator

And our next question comes from Brian Kinstlinger from Sidoti.

Brian Kinstlinger - Sidoti & Company, LLC

Great. Just one follow-up, and maybe you could either give us the revenue, given it's a sizable contract, or the number of people in the RADIO contract in the third quarter?

Chris Donaghey

Brian, I don't have that number at my fingertips. We're not going to -- I'm not going to give you the exact revenue breakout of the contract, but I'll see if I can track down the number of people.

Brian Kinstlinger - Sidoti & Company, LLC

Is that declining? I mean you're talking about subcontractors being less of a mix and that's why the margin isn't better. Is that where we're seeing more of the decline in the core engineering business that you have?

John E. Krobath

I think we -- as you talk about the tunable -- the RADIO contract, and we sit here and go through, we took the cuts back in -- midway through the second quarter, we didn't see any additional cuts in the third quarter from where we were. But we did have the subcontractors there for part of Q2. Once they dropped off, we've been relatively flat in terms of subcontractor piece as we went through Q3.

Operator

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

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

Yes. A follow-up for Chris Fedde. Relative to the AP, HawkEye AP introduction. Historically, at least, Sensage's SIM business peaked in the fourth quarter. With the release of AP coming fairly close to the fourth quarter, would that push out normal fourth quarter strength into 2014? Or is that not affected by the recent release of the upgrade?

Chris S. Fedde

If I understand the question right, the positioning of AP now really just adds new dimensions to the sale. So it shouldn't have any effect on in-process sale. There was some SIM business and call data record business, things like that. It's a better product for those markets than it was. But this is really all about getting it positioned for what's a much more dynamic and a much more opportunity-rich area of Big Data and analytics beyond those markets. So this is really about opening the aperture up, so we can take it to the broader markets.

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

Okay. So its introduction would not have delayed any sales that would've been in the pipeline?

Chris S. Fedde

No. It makes -- it advantages those sales. I mean they get the advantage of some of the things invested in, but it shouldn't have any delay. And the AP's available now, right? So it's not something anybody would have to wait for anyway.

Leonard E. Moodispaw

All right. Thanks, everybody.

Operator

And I'm not showing any further questions. I would now like to turn the call back to CEO Len Moodispaw for any further remarks.

Leonard E. Moodispaw

I have no further remarks other than to say good night and thank you, everybody.

Operator

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

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