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Kratos Defense & Security Solutions (NASDAQ:KTOS)

Q4 2013 Earnings Call

March 11, 2014 5:00 pm ET

Executives

Deborah S. Butera - Chief Compliance Officer, Senior Vice President, General Counsel and Secretary

Eric M. DeMarco - Chief Executive Officer, President and Director

Deanna Hom Lund - Chief Financial Officer and Executive Vice President

Analysts

Michael Crawford - B. Riley Caris, Research Division

John Nelson

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

Tyler Hojo - Sidoti & Company, LLC

Sheila Kahyaoglu - Jefferies LLC, Research Division

Kevin Ciabattoni - KeyBanc Capital Markets Inc., Research Division

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Operator

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Fourth Quarter 2013 Earnings Conference Call. [Operator Instructions]

I would now like to turn the call over to Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary.

Deborah S. Butera

Thank you. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Fourth Quarter Conference Call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer.

Before we begin the substance of today's call, I'd like to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos' corporate website at www.kratosdefense.com. It is also available on the SEC's website.

Additionally, I'd like to remind our listeners that this conference call is open to the media, and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the company's website later today.

During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance and the potential impact of sequestration, federal government shutdowns and the constraints on the federal budget, could constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including those found in the Risk Factors section of our annual report on Form 10-K and our quarterly reports on Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including our annual report on Form 10-K and any of our other SEC filings, for a more complete description of these risks. All forward-looking statements are qualified in their entirety by this cautionary statement, and we undertake no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date hereof.

This conference call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Certain of the information discussed included adjusted EBITDA and the associated margin rates, pro forma EPS from continuing operations, excluding restructuring and acquisition-related items and other, unused office space and other, amortization of purchased intangibles, contract design retrofit costs using a cash tax rate and using a statutory tax rate of 40%, are considered non-GAAP financial measures.

Kratos believes this information is useful to investors because it provides a basis for measuring the company's available capital resources, the actual and forecasted operating performance of the company's business and the company's cash flow, excluding extraordinary items and noncash items that would normally be included in the most directly comparable measures calculated and presented in accordance with generally accepted accounting principles. The company's management uses these non-GAAP financial measures, along with the most directly comparable GAAP financial measures, in evaluating the company's actual and forecasted operating performance, capital resources and cash flow.

Non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information presented in compliance with GAAP and non-GAAP financial measures as reported by the company may not be comparable to similarly titled amounts reported by other companies. As appropriate, the most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the company's website.

In today's call, Mr. DeMarco will discuss our financial and operational results for the fourth quarter of 2013. He will then turn the call over to Ms. Lund to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business, and then we will open the call up to your questions.

With that said, it is my pleasure to turn the call over to Mr. DeMarco.

Eric M. DeMarco

Great. Thank you, Deborah, and good afternoon. A few months ago, the bipartisan Murray-Ryan budget agreement was approved, setting spending guidelines for fiscal '14 and fiscal '15. 2014 DoD Appropriations Bill has now been approved, and the Pentagon has recently submitted the fiscal year '15 budget request, and the Quadrennial Defense Review has been submitted.

In summary, as related to Kratos, there are some puts and takes in this recent information of missile defense, EW, cyber and directed energy, rail gun, ISR and other leading technology areas being solidly funded and supported and other programs like AEHF, P-8, LCS and EA-18G being cut, stretched out or reduced. As a result, though sequestration remains in effect, but the fiscal 2014 and '15 base defense budget now is about 100 -- excuse me, about $500 billion, down from approximately $530 billion in '12, and the U.S. federal contracting environment expected to remain challenging, we are now having some additional programmatic clarity and indications of priorities and funding.

Importantly, with the continuing federal industry challenges, Kratos' commercial and international business today represents nearly 35% of our revenues. Our critical infrastructure security business grew 14% in 2013 with continued organic growth expected in 2014. And our commercial satellite communications business, where we've seen a number of recent new contract awards the past few weeks, grew 30% in 2013, with similar growth forecast for '14.

Also, our PSS business backlog and bid and proposal pipeline remain at or near record levels, driven in part by increased threat awareness from security-conscious enterprises, including the education, energy, transportation, municipality and health care areas. The growth in our PSS business and our other commercial businesses and our international business has been and is expected to continue to help offset some of the reductions in our U.S. federal government business.

Over the past several months, several significant strategic and expected to be long-term national security programs have been awarded or have come out of protest situations, including SEWIP, AMDR and NGJ. The U.S. Navy is placing a priority on advancing electronic warfare, and Kratos must make the investments now in order to increase and secure Kratos' position on these new long-term program opportunities.

As a result, in the fourth quarter and to Q1 '14, we significantly increased our discretionary IR&D, in many cases, in conjunction with the customer. We are expecting this increased IR&D spend to be very high in Q1 of '14 and remain elevated throughout the first half of '14.

Since the end of Q3, we have made important progress with our strategic unmanned aerial systems initiatives, including having a number of successful flights with certain of our new high-performance aircraft and no flight failures. We have also just recently executed a contract modification, significantly increasing the contract value by several millions of dollars of an important new high-performance UAS development program we are under contract on. The total value of this program to Kratos with this new contract mod is now several tens of millions of dollars. We have a number of demonstration flights on this program scheduled throughout '14, and if we successfully execute on this contract and our milestones, this program could ultimately become the largest production program in the company.

Additionally and very importantly, we are now also working directly with the customer on a separate, new, high-performance, unmanned aerial system program initiative, which is very exciting for our company. In this new initiative, we will be producing 3 demonstration aircraft, and we are currently planning on flight tests with this customer in 2015. As you know, we are also making a significant discretionary internally funded investment in the UAS area, which we expect to continue throughout '14 with these investments impacting our near-term EBITDA.

We are truly fortunate that we have these opportunities, certain of which I believe are directly related to Vice Admiral Gerry Beaman joining Kratos last August and Vice Admiral Mike Malone. And if we are successful, these initiatives could truly change our company.

We are also under contract in the unmanned ground system and robotic area, where we are providing onboard command-and-control systems, communication systems, ground control systems and other UGS products. We see a large potential future opportunity in this area, with one example being the DoD-mandated conversion of tens of thousands of wheeled vehicles from manned to unmanned over the next few years. Kratos' total combined unmanned aerial, ground and robotics systems business across the company today is approximately $150 million in revenue.

In the cyber area, in 2013, Kratos was awarded a prime position on the DHS continuous monitoring MAC, IDIQ contract vehicle, affirming Kratos' position as one of the leading cyber security companies in the industry. Task orders have just recently started coming out under this MAC, with several expected over the next few months that we are tracking and we're planning on competing for.

We also entered into a strategic partnering agreement with Norse, whose significant shareholder is Oak, which is also Kratos' largest shareholder. Norse offers proactive, intelligence based cybersecurity solutions and continuously collects and analyzes real time, high-risk Internet traffic to identify the sources of cyber attacks. Norse is the only provider of live, actionable cyber threat intelligence that enables organizations to proactively defend against today's most advanced cyber threats, including 0 day and advanced persistent threats.

Kratos currently works with the health care organizations around the country to improve patient data security and privacy and to share compliance with HIPAA and HITECH, and our initial focus with Norse will be the delivery of live threat intelligence to help health care providers secure electronic protected health information or ePHI. I encourage you to take a look at Norse, as I believe you will understand why this new strategic relationship between Kratos and Norse is so exciting for our company. Similar to our UAS initiative, we are excited about the future possibilities of the Kratos-Norse partnership security offering, with 2015 potentially being an inflection point for Kratos in the cyber area as a result of this relationship. Kratos' cyber business is product focused; and including cyber work we are doing in the satellite communication area, total Kratos cyber-related revenue today is approximately $150 million.

We recently announced that we were awarded a prime contract position for all 7 zones in the SeaPort-e MAC, IDIQ contract vehicle. This is an incredibly important contract vehicle for Kratos, one where we have performed several hundreds of millions of dollars of work, including in the leading technology, directed energy, rail gun and weapon systems areas. And we are currently in pursuit of several hundreds of millions of dollars of new opportunities.

In the leading technology area, Kratos is also under contract, providing product and supporting the hypersonic vehicles, unmanned system and BMD programs, all of which remain priorities in the FY '15 budget request and the QDR. And for example, the U.S. Navy has just recently announced it will be deploying its first ship with a laser weapon this summer, the USS Ponce.

So in closing, the U.S. federal government contracting environment remains very challenging, and sequestration appears here to stay with the bipartisan spending agreement indicating that fiscal '14 and '15 will be the trough of the DoD budget. However, as I mentioned before, we have diversified nearly 35% of our business away from DoD funding. Our critical infrastructure, commercial satcom and international businesses are growing. We are working directly with customers on some large new program opportunities that the FY '15 budget requests and QDR indicate our priority areas, and we are continuing to make progress on our most important strategic focus area in unmanned systems. Deanna?

Deanna Hom Lund

Thank you, Eric. Good afternoon. Our fourth quarter revenues of $235.7 million came in below our expected range, primarily as a result of continued delays in bookings and shipments due to the continued challenging federal budgetary environment, including a continuing resolution lasting throughout the fourth quarter, impacting over 65% of our business.

Our revenues decreased year-over-year at 10.6% from $263.6 million in the fourth quarter of 2012, reflecting the impact of fiscal 2013s DoD budgetary situation, which caused certain delays in orders and awards, the related impact to timing and product shipments and the continued contraction of our legacy government services business, which continued to decline approximately 9.3% compared to the fourth quarter of 2012.

From an annual run rate perspective, our legacy services business is currently operating at approximately $85 million, down from approximately $100 million for 2012 or an annual 15% decline.

Our bookings were particularly strong in the latter part of the fourth quarter, especially in our electronic warfare and satellite communications, training and cybersecurity businesses, with an overall book-to-bill ratio of 1:1 for our entire Kratos government security solutions segment. However, as many of these bookings occurred in the latter part of the fourth quarter and due to the long lead time to produce and ship a number of these products, these shipments and deliveries are not expected to generate revenues until the latter half of 2014. As we have stated on prior calls, we expected our book-to-bill ratio to be stronger in the second half of 2013, which did occur, however, not quite at the level of our original expectations due to the budgetary environment impacting our industry, which we experienced throughout all of 2013.

Operationally, we continued to remain focused on cost reductions and efficiencies. And in the fourth quarter, we reduced our headcount by an additional 89 personnel or another 2.3% of our total workforce, down to a total headcount at year end of 3,815. This compares to a headcount of 4,317 at the end of 2012 or a total annual reduction for fiscal 2013 of 502 personnel or 11.6% of our total workforce.

Similarly, we have continued to take actions on additional cost reductions in the first quarter of 2014, including in the personnel, excess capacity and facility areas. This cost rationalization will be a continuous process that we are focused on to enhance efficiencies and operating margins.

As a result, in the fourth quarter, we have recorded non-recurring charges and credits related to legacy acquired businesses, excess capacity caused in part by the delays in procurements and awards, changes in accruals for unused excess facilities, severance, legal settlements, refinancing costs and the contract design retrofit costs previously discussed in the third quarter.

For instance, certain of the more significant items include a charge of $1.5 million during the fourth quarter related to the cost of these personnel reductions, as well as due to the excess capacity and rate variances, a charge of $800,000 related to acquired businesses and $900,000 of costs primarily related to our refinancing efforts in November. These amounts were partially offset by a net $2.4 million credit, primarily related to a favorable legal settlement of a contract dispute with a former subcontractor on an acquired -- of an acquired business.

In addition, an adjustment in total estimated additional future costs related to the contract design retrofit, resulting from the aircraft flight test failure that occurred in October, was recorded of $2.4 million, along with an increase of $2.1 million to our excess office space accrual.

Similar to previous reports, we exclude such non-recurring or non-core business credits and charges from our adjusted EBITDA. Our adjusted EBITDA of $24.6 million for the fourth quarter is from continuing operations and excludes the charges and credits I highlighted.

From an operational segment perspective, our government solutions segment generated $180.1 million in revenues and $20.9 million in adjusted EBITDA or an 11.6% adjusted EBITDA margin.

Our public safety and security segment generated $55.6 million in revenues and $3.7 million in adjusted EBITDA or a 6.7% adjusted EBITDA margin. This is up sequentially from $51.8 million and $2.9 million or 5.6%, respectively, in the third quarter.

On a GAAP basis, net loss for the fourth quarter was $7.4 million, which included a loss from discontinued operations of $500,000, $8.9 million of expense related to amortization of intangible assets, as well as a $2.9 million income tax benefit.

We continue to believe it is also meaningful to provide our earnings per share excluding the amortization expenses and reflecting our cash pay income tax and excluding non-recurring items.

On a pro forma basis, EPS from continuing operations, excluding the amortization, restructuring and acquisition-related items, excluding the change in excess unused office space and excluding the change in future estimated contract design retrofit cost, utilizing the estimated average quarterly cash pay income tax provision of approximately $700,000, was $0.06 per share for the quarter.

Moving to the balance sheet and liquidity. Our cash balance was $55.7 million at December 29 plus $5 million in restricted cash.

For the fourth quarter, we generated $11.6 million in cash from operating activities after payment of the semiannual interest payments on our senior notes of $31.2 million in December.

The free cash flow generated for the fourth quarter was $7 million, after taking into consideration capital expenditures of $4.6 million. Our DSOs decreased 5 days from 108 days at the end of the third quarter to 103 days. For fiscal 2013, our DSOs have increased 9 days on a year-to-date basis when compared to the 94 days at the end of 2012. The increase in DSOs is a result of the current budgetary environment, as well as the shift of certain contractual billing milestones into 2014. The increase of 9 days is equivalent to approximately $23 million in impact to our cash flow, as each day's turn is equivalent to approximately $2.5 million in cash. We continue to target DSOs of approximately 90 days on a long-term basis, which we believe is achievable in a stable budgetary environment and as we expect that as the milestone-related contractual payment billing terms are met that we will be able to continue to reduce the overall DSOs and generate additional operating cash flow. As our revenue mix is more products focused now, our DSOs can tend to fluctuate due to the timing of shipment and satisfaction of billing and contractual milestones.

Our contract mix for the fourth quarter was 80% of revenues generated from fixed price contracts, 14% from cost plus fixed fee contracts and 6% from time and material contracts. Revenues generated from contracts with the federal government were approximately 64%, including revenues generated from contracts with the DoD of 60% and revenues generated from non-DoD federal government agencies of 4%. We also generated 7% of our revenues from state and local governments, 18% from commercial customers and 11% from foreign customers.

Backlog at quarter end was $1.1 billion with $540.7 million funded. Backlog at the end of Q3 was $1.1 billion as well.

Now moving on to our financial guidance. In January 2014, President Obama signed a $1.1 trillion spending bill to finance the U.S. government and DoD through September 30, 2014, after previously approving a U.S. federal funding deal that provides some clarity to expected defense spending for the next 2 years. As a result of the President signing the spending bill into law and the increased clarity the -- to the 2014 DoD budget, we recently provided and today are affirming the company's fiscal 2014 fiscal guidance.

The company currently expects full year fiscal 2014 revenues of $920 million to $980 million, adjusted EBITDA of $92 million to $106 million and adjusted free cash flow of $25 million to $40 million.

Kratos' fiscal 2014 financial guidance assumes approximately $18 million to $28 million in IR&D and other discretionary internally funded investments by the company with the first half and, in particular, the first quarter of 2014's currently forecasted IR&D spend expected to be significantly higher than the second half of 2014, as the company pursues large new opportunities in the UAS, electronic warfare, radar and signal processing and satellite communications areas.

We are also providing fiscal 2014 quarterly revenue and adjusted EBITDA guidance consistent with our previous guidance. Revenue and adjusted EBITDA are expected to increase and ramp throughout 2014 due primarily to the following: the effect that they're having been little U.S. federal or DoD budget clarity and extended continuing resolution authorizations throughout fiscal 2013, which significantly impacted and delayed the expected contract awards and orders.

We have just recently received previously delayed 2014 production orders on several of the company's largest programs, including Trident, EA-18G, a certain missile program, and a large confidential program with product deliveries and related revenue expected to ramp throughout 2014.

In November 2013, we announced that Kratos is a key member of a team, which received a $450 million single-award missile defense agency contract, which was subsequently protested by a losing bidder. The protest was just recently denied and the Kratos team award sustained. Kratos' work under this new large MDA contract award is expected to begin in the second quarter of 2014. KPSS, which has forecast in 2014 revenue growth of 5% to 10% based on current backlog and bid and proposal opportunities, is expecting revenue to decrease somewhat sequentially from Q4 '13 to Q1 of '14 and then increase throughout fiscal 2014, as certain large security system deployments conclude and new programs, many of which have recently been awarded, begin. The discretionary IR&D and strategic internal investments we previously discussed with a significant spend in Q1 and Q2 of 2014.

Our estimated adjusted free cash flow guidance is comprised of the $92 million to $106 million of adjusted -- estimated adjusted EBITDA, less cash interest of $62.5 million, less capital expenditures of $13 million to $16 million, less estimated cash taxes of $3 million to $4 million and assuming a reduction of DSOs of approximately 5 to 7 days or $12 million to $17 million. This is equivalent to estimated cash EPS used in an estimated annual cash tax pay of $3 million to $4 million, excluding annual amortization of $22 million of $0.01 to $0.15 for FY '14.

From a capital structure standpoint, we remain prepared to update the documents necessary for refinancing our senior notes once the no-call period expires after the 1st of June, at which time, there will be the stated 5% takeout premium or $31.5 million. But there will no longer be any make whole premium, which was a significant outlay of cash and costs when we pursued a refinancing effort in November.

As we have discussed on previous occasions, we continue to confer with our financial advisors to determine the appropriate timing of such a refinancing when the various upfront costs versus current market conditions and the benefits associated with the refinancing, with the expectation of reducing our interest expense and extending our debt maturity profile. If the refinancing is successful, this could significantly increase Kratos' free cash flow, and we plan to use the additional free cash flow to further delever our balance sheet with the goal of increasing Kratos' equity value.

With that, I'll turn it back over to Eric.

Eric M. DeMarco

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

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Mike Crawford from B. Riley & Company.

Michael Crawford - B. Riley Caris, Research Division

Can you share any further detail on the nature of the large UAS program you're now under contract for and also discuss whether the -- you have a working UCAS system today?

Eric M. DeMarco

On the large one, Mike, that we're currently working on, as I mentioned, we just recently received a contract modification. It's now at several tens of millions of dollars over the next couple of years. We have a number of significant, very important flights scheduled throughout this year. And as I said in the prepared remarks and in the release, if we're successful on this, achieving our goals and objectives and the milestones, this clearly would become the largest program in the company by far, potentially exponentially. It's that potentially significant to us. On the second one I mentioned, that is brand new. It has -- this initiative has just come together with this customer in the past several weeks. We are under a significant non-disclosed arrangement here, and I can't say anything other than I said that we are driving towards some demonstration or test flights with this aircraft, which would be a UCAS in '15.

Michael Crawford - B. Riley Caris, Research Division

We know that the DoD is pursuing this air-sea battle strategy and they have programs like Hydra, an integrated topside and such to help further strategic goals. Can you talk at all about how -- where you fit into any of these initiatives?

Eric M. DeMarco

Yes. We have submitted bids on Hydra. We have 2 outstanding on that one. We are involved with DARPA in certain other areas with some additional opportunities coming out. We are also involved with some other agencies with some similar unmanned -- next-generation unmanned system opportunities that we are working on. So we are right now directly related to what Admiral Beaman and his team are doing right in this -- the middle of what you talked about plus more.

Michael Crawford - B. Riley Caris, Research Division

And what about the existing or the preexisting CEI targets business with the Air Force and potentially others, including MALD and fire jet, et cetera?

Eric M. DeMarco

Yes. So the '14 budget, I believe, had $27 million in it for AFSAT. And then I believe in '15, the request has $33 million in it for AFSAT. MALD is moving right along at approximately 200 airframes a year. We are still under contract on MSST, and that contract is going to go for the next several years. I'm hesitating because we're under an NDA on that, but we're still working on that. And then there are the -- I'll use the word confidential programs that they are working on -- that we are still working on those. We are delivering aircraft on a number of international opportunities right now, producing and delivering them. Certain other international opportunities have been delayed for similar budgetary reasons that were experienced here in the United States, and we are currently negotiating on a very large several dozens of aircraft opportunity that, if timing comes together, we'll be able to talk about that in Q2 -- or Q3, excuse me.

Michael Crawford - B. Riley Caris, Research Division

And then final question, the -- you can call your notes at 105 on June 1 and if you had to pick a range of 50 basis points, where would -- if it was today, where do you think you'd get new debt in place?

Deanna Hom Lund

Mike, this is Deanna. I think it's in that probably 7-plus range. I don't really want to be too specific because it is a negotiation, so...

Eric M. DeMarco

Mike, if we do part notes like we currently have in part-term debt, it will be less. If we do pure notes, again, it'll be a little higher upfront. But then again, it won't have amendment fees, et cetera, if we do anything moving forward relative to any of these programs. And so that's what we're studying.

Operator

The next question comes from John Nelson from State of Wisconsin Investment.

John Nelson

Eric and Deanna, it sounds like you've got a very promising opportunity set ahead of you, and I congratulate you for trying to develop that potential. My question's related to an item that we've talked about many times before. But with what just happened in the Crimea and the Ukraine, do you think there's much of a possibility that the land-based antimissile systems get reinvigorated for the eastern countries like -- Eastern European countries like Poland and Czechoslovakia again?

Eric M. DeMarco

Yes. So -- and first of all, John, thank you for your comments upfront. We -- we're very excited about the opportunity we have. We can see it. And the fact that we're under contract, and this isn't on a drawing board, it actually exists, is -- it's very reassuring. On your questions, yes, Aegis Ashore is moving forward. The recent -- there was just a recent contract award related to that, that's out there. We are involved with Aegis Ashore in many different aspects, ground-based midcourse defense now. When the president came in, he made the decision not to increase the number of interceptors at Vandenberg of Greely, Alaska. Now he has just recently changed and that they are going to be expanding the missile field. Just recently in the past couple 3 weeks, the decision by the DoD to redesign the Exoatmospheric Kill Vehicle, which we are also on, has come out. So I think it has to do with what's going on in Russia and Crimea and what North Korea is doing and what Iran is doing, and the world remains a dangerous place. So yes, sir, those are -- the ones you mentioned are all moving forward.

Operator

The next question comes from Mark Jordan from Noble Financial.

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

A question on the R&D. If you look back previous quarters up until the fourth quarter, you're running sort of -- certainly, at about a $4.5 million rate, plus or minus. Obviously, spiked up to $6.9 million this quarter. You talked about a higher rate in Q1 and then continued high in Q2. Is the higher rate up sequentially? And if so, how much? And do you see when it settles in the second half? Do you go back to that sort of $4.5 million quarterly run rate? Or does it settle at a higher level?

Deanna Hom Lund

Mark, it's Deanna. So as a rate of percentage of revenue, it will be slightly higher than the fourth quarter. But from a dollars perspective, we don't think it should be higher than what we just incurred for the fourth quarter. That will probably sustain for the first half and then we should see it drop back down, not at the levels that we have been at historically, probably just a little higher than where we have been at just because of the investments that we see being made throughout the year.

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

Okay. Eric, you -- following up on your comments relative to the potential debt structure you might have after you call the notes, either all notes or term and mix of term and notes. What if you are all notes, would you have the ability to pay down those notes as you generate free cash flow? Or would you have to wait some period of years until you have a non-call expires?

Deanna Hom Lund

Mark, as long as we understand, the -- if it were an all-note structure, if they're senior secured, then there is the ability to pay down. When we were in the market in November, what we understood was that we could pay down up to 10% per year at 103. So we foresee that, that should -- that would be the same structure if we were to go for on all-note capital structure.

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

Eric, you've mentioned a couple of major long-term naval programs, being the Next Generation Jammer, SEWIP and AMDR, all sort of breaking loose from protests and things. Could you say how much of the revenue do you expect to get from those types of contracts in 2014? And how do they ramp in '15 and '16?

Eric M. DeMarco

Okay. I expect SEWIP is going to be very strong for us this year, Block 2, and that is expected to ramp in 2015. Block 3 is expected currently to be awarded this year. If Block 3 is also awarded -- is awarded this year, then '15's ramp could be even more significant and beyond. On NGJ and AMDR, Mark, I don't want to get into details on that right now for competitive reasons, but we believe we are very, very well positioned on those. Those are a little bit behind the cycle relative to SEWIP, because SEWIP Block 1 was awarded a few years ago. SEWIP Block 2 was awarded most recently. AMDR and NGJ, both -- the development both just came out, and so production for those are a year off -- or a few years off. The initials on those would be design and development, which is one of the reasons we are spending. As you said, they broke free. We can't time these things, and we're working -- we are working to make sure we have important positions on these going forward.

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

Okay. Final question for me. You mentioned the Norse relationship. Looking at their material, so you seem to have some unique capabilities with regards to real time identification of bad IP sources. What do you -- what are you and Norse planning to do in terms of development -- or need to do in terms of development to have that "point of inflection" in 2015 that you've referred to?

Eric M. DeMarco

Right. Mark, what we're doing initially, we're going after the health care market because that's where we have a channel of distribution. And then very shortly thereafter, we will be going to the satellite communication market because we have a channel of distribution there also. What we are going to be working with Norse designing is going to be what I'll call the interface that is relevant to that direct customer set. In this case, we'll say the health care provider. Depending on the type of IP situation that we are going to be trying to proactively protect, whether it be customer-related -- excuse me, customer client, health care clients, so patient-related information, and those systems we're going to be protecting, Mark. But this can also include, as you know, everything -- virtually everything now has an IP address. So for example, a heart machine has an IP address or a CAT scan has an IP address. And those are literally being used as host by bad actors for things. We will have to -- we're developing a separate interface so the user, who is going to be wanting to protect those and identify proactively, prospectively, who's coming at them, can map out that system and identify where it is. So it's that interface relative to that network architecture and the specific IP items that we are going to be designing. But then we'll connect into Norse's information and Norse's system to identify the bad actors so people can see what's happening real time and make decisions on how to react.

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

Your goals for the development of that interface are mid-year, fall, what time frame...

Eric M. DeMarco

Fall. Right now the plan is Q3.

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

Okay. Integral Systems, as you'd mentioned, had a real string of wins recently, talked about that, that was 30% growth last year, 30% growth expected for this year. Is that a function of an increase of a number of satellites coming -- going up? Or are you displacing already installed systems out there where your epic system is replacing some -- or legacy management system that's out there to upgrade the performance?

Eric M. DeMarco

Right. Mark, it includes all of the above. It includes new satellites that are going up, new services that are required by the operators. A demand for epic, which, as you know, is the gold standard on command-and-control space segment. And also, very, very importantly, it's what we're doing in the cyber area and the radio frequency interceptor jamming side relative to satellites, where we are working with these customers on identifying what's being jammed, who's jamming them, where precisely from geolocation it's coming from, so action can be taken. And that ties into KPIs and the KPIs the operators need to deliver.

Operator

The next question comes from Tyler Hojo from Sidoti & Company.

Tyler Hojo - Sidoti & Company, LLC

I guess, just firstly, to go back to the UAS development initiatives, I'm just kind of curious on a couple of different fronts. First would be -- when we should probably start thinking about moving from development into production? Curious what you have to say about that, Eric. And then I'm also curious just in regard to the internal R&D expense. I mean, it seems like interest from your customers continues to grow on this product line, and I'm just curious how we kind of size the risk of kind of a spending creep in terms of your internal spend.

Eric M. DeMarco

Yes, yes, very fair. If everything, Tyler, goes correctly and goes well, it is possible that in '15, we could go to LRIP. If it does not, it will be '16. Everything would have to go correctly to go to LRIP in '15, but more likely, '16. All right. So that's on that. On spending creep, that's a excellent question. We -- as I mentioned, we are -- we currently have an agreement with this customer who is in the second program now to do demonstration flights in 2015, and it's middle to Q3 of '15. We're -- if we're successful getting there, we're going to know a lot when we get there. I don't believe outside of the ranges that we gave today. I don't believe, unless something really unforeseen happens, that we would have spending creep outside of those bounds. I just don't -- we've identified the aircraft. We have the aircraft. It is not a brand-new aircraft. It is going to be a derivative of an existing aircraft. That's heavily modified, of course. And I think we have it scoped out.

Tyler Hojo - Sidoti & Company, LLC

Okay, that's certainly helpful. Okay, great. And I guess, maybe one for Deanna. I think you provided your cash EPS guidance. Was it $0.01 to $0.04? Did I hear that correctly?

Deanna Hom Lund

$0.01 to $0.16.

Tyler Hojo - Sidoti & Company, LLC

$0.01 to $0.16. And could you maybe just walk us through the restructuring and the amortization expense that's included in that range?

Deanna Hom Lund

Sure. So the amortization is about $22 million, and no restructuring is assumed in that guidance. And cash taxes are $3 million to $4 million.

Tyler Hojo - Sidoti & Company, LLC

$3 million to $4 million. Okay, great. And then, I guess, just lastly for me, I just want to talk -- I just want to touch briefly on the margin profile within the PS&S business. Certainly, it was nice to see the sequential improvement in Q4. How should we think about kind of profitability ramp in 2014?

Eric M. DeMarco

We spent a significant amount on sales and business development in Q4 in that business, Tyler. It was significant. And we have had a lot of wins recently. Most of them we're not allowed to disclose or we have -- we don't have approval to disclose them. So Q4, and thus far into Q1, has been very heavy sales commissions, wins and related business development. As these jobs come online and they ramp up, the revenue ramp against that spend will spread. We'll get leverage off of it, and we're expecting the margins to increase.

Operator

The next question comes from Sheila Kahyaoglu from Jefferies.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Just a quick follow-up on the CDM program. You mentioned task orders are in the upcoming weeks. When do you expect potential awards are awarded? And has been -- has that been pushed to the right at all?

Eric M. DeMarco

There have been -- I believe that there have been a couple 3 awards on the continuous monitoring, which went to some off-the-shelf software. The certain of the other prime holders have access to at discounts that we do not, and so we did not participate in those. Those were, I believe, straight from the -- those were DHS awards. The next several task orders that are coming are coming from civilian federal agencies. They're coming up instead of down. We're -- the requirements on these, on I think 3 of the 4, are right in our sweet spot. We're hopefully our -- now our advantage with Microsoft and Dell -- one of the other advantages was with, for example, HP will give us a favorable position. And so these are coming out in the next month or 2. These are ones that we are -- again, in our sweet spot. So we're going to bid on those. And so, as soon as they award them after that, so we'll get the next 3 or 4 months. We're going to know on this next slew of task orders, I believe.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Okay, got it. And then in terms of just sticking on in terms of your trajectory for upcoming orders for PSS, in the past, you've mentioned there are several big contract awards. Have they been awarded yet or is that part of the Q4 pipeline that you've been working through?

Eric M. DeMarco

It is part of the Q4 pipeline. And I was briefed just yesterday by the division president, who came in and saw me, that one of those large ones is slowly moving forward relative to procurement. So they're still there. They're coming. But it was part of Q4, as you mentioned.

Sheila Kahyaoglu - Jefferies LLC, Research Division

And just the size of them for scope is about $20 million. Am I recalling them correctly?

Eric M. DeMarco

$50 million to $100 million.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Over a few years, so...

Eric M. DeMarco

Yes.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Okay, got it. And then in terms of your cost-cutting efforts, you mentioned you're continuing a few reductions in Q1. How do you think about the appropriate size of the business, given that you think it sort of bottoms out in '14 and '15?

Eric M. DeMarco

Right. So the #1 thing that we've been doing is, as our facility leases have been coming up relative to the acquisitions we made over those number of years, we are doing everything we can to consolidate our footprint, where we have multiple facilities in a certain geographic region to get into one facility. And typically, it's a brand-new facility that's totally -- that's much less costly than what we have before. So that's continuing. That's part A. Part B, the mix of our business -- of certain areas of our business is changing significantly. Let me give you an example. In our modular systems business, we were previously building specialized tactical modules for the Humvee. This is when the -- it was more of an asymmetrical warfare position than a nation state. Now we are moving more towards modules for Patriot, modules for FAD [ph], modules for Aegis Ashore, the electronic module enclosure for DDG 1000. These are much larger and much more sophisticated, but there are a lot fewer of them. So we need fewer people to build them, but they're larger and higher value. So it's offsetting some of the revenue decline. So in that case right there, as that business continues to transition, for example, we are just going to continue to right size it through the product mix that we have, and that's both on the personnel side and on the facility side. I could see, over 2014, I'm speculating maybe another 100 headcount across the entire 3,700, 3,800.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Do you have to add headcount in PSS?

Eric M. DeMarco

Oh, yes. We do. But it's a mix. We do both. It's a rightsizing in certain areas but you add in others.

Sheila Kahyaoglu - Jefferies LLC, Research Division

Okay, got it. And then just the last one for me, please, if you don't mind. What's the risk to the low end of 2014 guidance on the revenue side?

Eric M. DeMarco

Well, I -- it's a lot different as we sit here this year than last year because we do have a budget. So we know we have a budget through September 30 of '14. In addition to that, we have a spending bill, the bipartisan spending bill that the President signed, that outlined spending for '14 and for '15. That's a good data point. So the risk I see, as we sit here today, is we get to October 1 of 2014. And even though we have a spending bill, Congress and the President don't come to an agreement on the defense budget, even though they know the spend is going to be -- supposed to be $496.6 billion. And we go into a continuing resolution into Q4. So that is the risk -- the one risk factor I see right now, as we sit here. We have...

Sheila Kahyaoglu - Jefferies LLC, Research Division

So it's more of a short-cycle business, not a program thing?

Eric M. DeMarco

Yes, yes. Yes, yes, well said. Yes.

Operator

The next question comes from Michael Ciarmoli from KeyBanc.

Kevin Ciabattoni - KeyBanc Capital Markets Inc., Research Division

It's actually Kevin on for Mike. Most of my questions have been answered, just a couple here. And Tyler started to go into this, but I was wondering if you could give us some color on the kind of bidding proposal environment in the PSS business, maybe kind of by -- I know you mentioned you couldn't talk about specific customers but maybe by kind of broader end market. And then an update on kind of the timing of task orders against the new SeaPort-e contract.

Eric M. DeMarco

Yes. In the PSS business right now, the bid and proposal pipeline is extremely strong in health care facilities, educational facilities and mass transportation. It is extremely strong, and procurements are moving very, very quickly. And where we have experience and where we're a known entity in some instances, we're getting plussed [ph] up or we're getting sole-sourced [ph] out because of speed of execution. And that's because of the threat perception right now in public venues in this country for the reasons we know, because of the stuff that continually happens. So those 3 areas are very, very strong. Also very solid is energy. And that's both in the transport area, the refinement area and the production areas. So those are the ones that are -- all areas are strong. Those are the ones that are the strongest right now.

Kevin Ciabattoni - KeyBanc Capital Markets Inc., Research Division

Okay, that's helpful. And then in terms of the SeaPort-e, any shift, I guess, from what you'd see on that versus the deals contract?

Eric M. DeMarco

They're a -- that is -- as I mentioned, that is an incredibly important vehicle for us where we do a significant amount of work, including in some of the areas I mentioned that are priorities coming out of the '15 request and the QDR in the directed energy area and in the rail gun area, for example. We have a fairly significant rail gun bid out right now. We're expecting to hear on over the next 30 days, for example. So that is -- it's very important. And as I said, we've got literally hundreds of millions out there with 1 or 2 big ones supposed to be awarded in the next month or 2.

Kevin Ciabattoni - KeyBanc Capital Markets Inc., Research Division

Okay. And then you talked about a lot of the positives from the budget release last week. And just kind of wondering, from your perspective, if there are any real big negative surprises. I mean, I assume LCS might fit into that category. Anything else out there that...

Eric M. DeMarco

Yes. So upfront when I -- in my prepared remarks, so the negatives AEHF. There are 2 satellites that are either being pushed or truncated, all right? Good news on P-8, which is a very important program for us. It's going into full rate production. Bad news on P-8, the quantity was basically -- has basically been cut in half for the next year or 2, all right? LCS, that's one I fully expected. It's actually turned out better than I expected. I thought that, that procurement would be cut in 20 shifts and I think it's cut in 32. I think. EA-18G, EA-18G plussed [ph] up in the '14 request -- in the '14 budget. Currently not in the '15 budget, though I saw this morning that it's going to be added on for congressional approval, so that has a question mark on it. So there were -- as I said, there were some puts and calls. We've had some good puts and those were some of the calls.

Kevin Ciabattoni - KeyBanc Capital Markets Inc., Research Division

Okay, that's helpful color. And then last one for me, you mentioned a couple of areas where that kind of increased R&D spend was targeted, UAS obviously, EW satellite. Just kind of wondering if you could maybe be a bit more granular in terms of how that actual total amount of R&D is split up, maybe looking at it by a percentage towards UAS versus EW.

Eric M. DeMarco

No. No. No, sir.

Operator

[Operator Instructions] The next question comes from David Olkovetsky from Jefferies.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

First, on a lighter note, I was in the subway in Manhattan at 51st and Lex the other day and there's a Kratos sign. I was just wondering if that's you guys.

Eric M. DeMarco

Absolutely, it is, sir. A very important account for us, the MTA.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

What are you guys doing down there?

Eric M. DeMarco

We are deploying some very interesting security assets down there.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Okay, fair enough. Good, so you're keeping me safe. I appreciate it. All right. And I was going to ask about the sign but it sounds like we just went over that. Can we go over the backlog a little bit and just remind us approximately what percentage of that you're designed in on, so to speak?

Eric M. DeMarco

Right. I would -- okay, take our -- the midpoint of our range of 950, take out our critical infrastructure security business of, say, 220 or 230, take that piece, the remaining piece, we are designed in on that piece, I'm going to say 60% to 70%.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

60% to 70%, okay. So in other words, and correct me if I'm wrong, that business is not going away essentially, correct?

Eric M. DeMarco

Unless something else happens with the budget or the program gets terminated or canceled, that business is not going anywhere.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Great, okay. And then I'm not familiar with Norse. Did you mention how big they are? Are they a possible acquisition or merger target?

Eric M. DeMarco

No. No. No, sir. No, no, no. They are one of those companies -- first of all, they're private and so I can't get into their size. But this is one of those companies that is or is going to be worth hundreds and hundreds of millions of dollars, based on valuations for what these guys are doing right now. This is like a Mandiant kind of a thing. That's kind of what this is. And so, no, there's not a chance for us to acquire something like that. We are very fortunate that their principal shareholder is our largest shareholder, and it's given us the ability to team with them on some interesting -- very interesting opportunities like -- that I said could be very beneficial for us if we're successful next year.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Okay. I guess, I'm just wondering if there would be any synergistic benefit between the combination of the 2 businesses. I don't know if [indiscernible].

Eric M. DeMarco

There would be. But I'm not talking about an acquisition type of combination but a combination like we're doing strategically. It's the channels of distribution that we bring in certain areas, where we have significant cyber footprints and customer relationships and credibility already, and that's where we're starting out in health care because that's a big cyber area for us and satellite communications.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Got it. So it's a -- like revenue synergies is essentially what we're talking about here, right?

Eric M. DeMarco

Yes. It's revenue. But it's also, and this is no slight to them at all, they're a technology company. But we have been working with these customers for years and years and years, so its credibility and critical mass, if you're going to do a large multimillion-dollar deployment.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Okay. And then, Deanna, I think you said that there was a $900,000 charge for the attempted refi in November?

Deanna Hom Lund

That's correct.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

The -- so I guess the question is -- I mean, what was that -- I mean, it didn't get done, right? So what does the bank make you pay for exactly?

Deanna Hom Lund

So it's comprised of a couple of things. It's -- a portion of that is related to the bank. There was some deposits that they required us to provide for estimated fees. There's a fee related to one of the rating agencies because they did rate the company, albeit it was -- the opinion was pulled after a day when we had pulled the transaction. The good news is we should be able to use that fee when we do go back out in the market, so it's not lost. But from an accounting perspective, we're required to expense it. And then the remainder of the fees which related to legal and accounting fees.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Okay, great. And then also, you went through your free cash flow bridge. I thought it was a little bit quick for me. Would you mind doing that one more time?

Deanna Hom Lund

Sure. No problem. No problem. So if you use the adjusted EBITDA of $92 million to $106 million, subtract cash taxes of $3 million to $4 million, interest -- cash interests of $62.5 million, so this assumes no refi, and CapEx of $13 million to $16 million, that comes to about $13.5 million to $23.5 million before any types of working capital changes. So we're assuming we will be able to reduce our DSOs from 5 to 7 days, which would generate $12 million to $17 million to achieve that $25 million to $40 million of free cash flow range, assuming no refi at this point.

David J. Olkovetsky - Jefferies LLC, Fixed Income Research

Okay, perfect. Right. But we are assuming there will be a refi, right?

Deanna Hom Lund

Correct. It's like -- it's when it will happen. And obviously, we don't want to get ahead of ourselves. So that is our focus, and we continue to discuss with financial advisors to determine when that -- when the right time is.

Operator

At this time, I am showing no further question. I would now like to turn the call back over to Eric DeMarco.

Eric M. DeMarco

Very good. Thank you for joining us this afternoon, and our next scheduled update will be related to our Q1 announcement. Have a good afternoon.

Operator

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.

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