Sep 21, 2008
Executives
Michael Baehr – VP of Corporate Communications Eric DeMarco – President & CEO Deanna Lund – SVP and CFO
Analysts
Mark Jordan – Noble & Finance Mike Crawford – Riley Investment Management
Operator
Good day everyone and welcome to the Kratos Defense & Security Solutions Second Quarter 2008 Earnings Conference Call. Today's call is being recorded.
At this time, all lines are in a listen-only mode. Following the speakers' remarks, we will announce the opportunity for questions, and instructions for asking a question will be given at that time.
As a special reminder to our media guests who are listening in, please remember that during the question-and-answer portion of this call, we are not taking questions – we are not taking questions. For opening remarks and introductions, I would like to turn the conference over to the Vice President of Investor Relations, Mr.
Michael Baehr, who will read the Company's warnings regarding forwarding-looking statements. Please go ahead, sir
Michael Baehr
Thank you. Good afternoon everyone and thank you for joining us for the Kratos Defense & Security Solutions second quarter 2008 earnings conference call.
With me today are Eric DeMarco, Kartos' President & Chief Executive Officer and Deanna Lund, Kratos' Senior 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 currently available on the Kratos corporate Web site at www.kratosdefense.com.
Additionally, I would 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 our Company's Web site later today.
During this call, we will discuss some factors that are likely to influence our business going forward. These forward-looking statements may include comments about our plans and expectations of future performance.
These plans and expectations are subject to risks and uncertainties, 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 most recent 10-Q and 10-K and any of our other SEC filings for a more complete description of these risks.
A partial list of important risk factors is included at the end of the press release we issued today. Our statements are made on this call today August 6, 2008 and the Company undertakes no obligation to revise or update publicly any of the forward-looking statements contained herein, whether as a result of new information, future events, changes in expectations or otherwise for any reason.
Also this call will include a discussion of non-GAAP financial measures as that term is defined in Regulation G. 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 Web site.
In today's call, Mr. DeMarco will discuss our financial and operational results for the second quarter of 2008.
He will then turn the call over to Ms. Lund to discuss the specifics related to our second quarter 2008 financial results.
Eric will then make some concluding remarks about the business and we will then open up the call to your questions. With that said, it's my pleasure to turn the call over to Mr.
Eric DeMarco.
Eric DeMarco
Thank you, Michael. I will start out today with an update in the status of Kartos' strategy and business plan and some specifics on the integration process of our two recent acquisitions.
And then I'll provide an operational review of the business. Coming out of our transformation at the end of last year, Kartos was a sub-scale, national and homeland security product solutions and services provider.
We were too small to credibly bid on and win large multi-year contracts in the prime contractual and not large enough to leverage off our fixed public Company, general administrative cost infrastructure to generate acceptable EBITDA margins. Over the past six months, we have made two strategic acquisitions, Haverstick Consulting and SYS Technologies.
These acquisitions have not only doubled our Company's size, but they have also provided Kratos with the resources, the contract vehicles, customers relationships, past performance qualifications and overall critical mass required to create a business development organization that has the capabilities to pursue and win large prime contract opportunities. Specifically, the acquisitions we have made have put Kratos in the position to bid on several major contract opportunities with major branches in the Department of Defense which this Company could not have bid on previously.
This business development organization is now being led by Cliff Cooke, SYS its former Chief Executive and now the Senior Vice President of Strategic Development for Kratos. This business development function and its success is absolutely critical to a Company like Kratos to generate and sustain organic growth.
This is a function that Kratos had not had previously, primarily due to our limited size and resources. As we move forward, this strategic business development function will be absolutely instrumental in Kratos achieving and sustaining its strategic organic growth objectives of up to 10%.
The successful integration of these acquisitions is also absolutely critical to Kratos achieving its EBITDA objectives. Immediately after the SYS merger closed, we executed a plan realignment in consolidation of three Kratos business units into a single division.
This business consolidation in addition to enabling us to better focus our Company's resources on the customer resulted in a significant general, administrative and overhead cost reduction through the elimination of redundant employee functions and related items like travel, telecom, benefits, et cetera. Actions in cost reductions like this are an integral part of our acquisition strategy in process, and it is the key element to Kratos ultimately achieving our profitability expectations.
Kratos will realize the benefit of these cost reduction actions later this year in the fourth quarter and into 2009 as severance related costs wind down. Deanna will provide information on these cost reduction actions in her remarks.
We believe that it is continually important for us to communicate where we are in building Kratos, as this is clearly an ongoing process and we are aggressively executing the strategic business plan that we have previously described to you. Now that we have combined the three companies, Kratos, Haverstick and SYS, we are also looking in other areas to improve performance and profitability.
One of these areas relates to contract mix and increasing the relative portion of Kratos' direct labor in a contract as compared to lower or no fee bearing the sheet [ph] material in subcontractor costs. This can be difficult to achieve, as ideal contract characteristics for Kratos can sometimes be outside of our control.
Additionally, in certain geographic areas, cleared personnel may be difficult to obtain as we try and increase the direct labor base. However, successfully executing a transition like this to increase the direct labor mix and recruit these personnel can ultimately improve overall EBITDA margins and cash flow, and this is an area we are working.
We are also currently assessing the business rate structures across the entire business, including general and administrative, overhead, material and subcontract rates and fringe rates with the goal of optimizing consolidated structures as we move into 2009 with potential new forward pricing rates. This is an area that may allow us to increase our business development resources in 2009 with minimal ultimate EBITDA impact of the business as we realign our discretionary cost tools.
From a second quarter result standpoint, we achieved our stated revenue growth and EBITDA objectives in Q2. During the second quarter, Kratos continued to make progress against substantially all of the financial and operational metrics of our business plan, and our forward direction is in line with our stated strategic plan.
As we reported in our last earnings call, Kratos returned to profitability in the first quarter of '08 and in the second quarter just completed we improved on that profitability with expanded EBITDA margins, positive operating income and positive EPS. Through the first two quarters of 2008, Kratos is also tracking on the other elements of our business plan.
The key aspects of which are, to focus on the market scenarios where Kratos has critical mass, established relationships and key differentiators. These include command and control system, weapon systems life cycle extension and reset, Federal ITs and networking solutions and Public Safety & Security solutions.
We are also continuing to look at other market areas which we believe are very complimentary to our existing business and where we believe substantial opportunity exists. These include cyber security, modeling and simulation, military equipment and systems reset and certain intelligence, surveillance and reconnaissance areas.
Specifically we are organically growing, for example, a modeling and simulation capability in the Company and we were recently awarded our first prime contract in this area. The acquisitions of Haverstick and SYS have positioned Kratos to look towards these potential new markets and opportunity areas.
This is not something that Kratos could have credibly considered just 7 months ago. In the second quarter, Kratos' major customer mix and related percentage of business were as follows.
United States Navy, 33%; United States Army, 20%; Public Safety and Security customers, 18%; other Federal government agencies, just under 13%; United States Air Force, 5%; and other business with – other agencies and commercial customers, 10% to 11%. This mix will change somewhat for the third quarter when we include SYS' business base in these calculations.
From a business development standpoint, Kratos' qualified bid pipeline at the end of the second quarter was approximately $2.2 billion. Our book-to-bill ratio during the quarter was greater than one to one.
Over the past two quarters, Kratos has won approximately 25% of the new business awards we have pursued, and Kratos continues to win approximately 90% of our contract re-competes [ph]. Important contract wins for Kratos in the second quarter included $49 million award from the Naval Surface Warfare Center Crane to support Expeditionary Warfare Systems and IT and networking infrastructure contract with the Department – with the Defense Logistics Agency; $6.3 million networking and Information Technology contract win with the non-DoD government agency.
Additionally, during the second quarter, Kratos along with its team member SA-Tech won its major 2008 re-compete on an Aerial Targets Operations contract. This $59 million contract is for 5 years with work being performed at the Naval Air Weapons center at Pt.
Mugu, China Lake and at numerous deployed locations such as White Sands and the Pacific Missile Range in Hawaii. For this particular contract, Kratos' overall revenue going forward will be lower in the past as we are now the subcontractor on the program.
However, our margin rate is expected to increase as a result of workload mix and Kratos not having as much material pass throughs in previous years. Kratos has no other major DoD re-competes in '08.
We also now have most of our major Federal government re-competes secured through 2009. As I mentioned before, we are closely scrutinizing all of our programs and contracts in order to increase margins and EBITDA, increase Kartos' labor component and reduce low and no fee subcontractor material contract components.
As I mentioned before, that this may result in somewhat lower revenue, EBITDA margin rate and cash flow should be improved if we can successfully execute on this. From a weapons systems and other systems delivery perspective, the Company performed well in the second quarter especially as it relates to sequential Q2 '08 over Q1 '08 organic growth with our weapons systems solutions business having a strong quarter along with our Public Safety and Security business.
As we have previously, our weapons systems life cycle extension business is directly related to ongoing programs, and therefore this business is both delivery and milestone driven, which can drive some quarter-to-quarter variation. For example, looking ahead, certain Kratos weapon systems related deliveries and milestones are currently forecast for Q3 to be somewhat less than Q2 with Q4 being at least back to the second quarter levels.
With this in mind, and although our Q2 performance was relatively strong, we believe year-over-year growth is a more realistic matter to gauge the overall progression of the business. Additionally and related to this, we are currently expecting either later this year or in early 2009, a follow-on order from a customer for an additional 1400 surface to air missile systems.
This will position this business very well for 2009 and 2010 and would continue this business as growth trajectory. As a reference point, this weapon systems business grew organically nearly 10% last year on a year-over-year basis.
Equipment reset is an important part of Kratos' business and it is an area we believe can bring solid opportunity for us in the future. Our foreign military sales or FMS business related to weapon systems also continues to perform well.
This performance is being driven in part by the weak US dollar relative to certain friendly governments currencies which makes US-based systems less costly than non-US based systems. Additionally, this is an area where the quality of US weapon systems continues to show itself as being superior to former Soviet block and European systems.
Some of the other programs we were involved with during the second quarter and the first half of '08 include the following. A Naval Surface Warfare Center – Dahlgren work program are works related to gun range support, gun system support, test firings on the range and engineering support for test shots on the actual weapons range.
Naval operations are (inaudible) program where Kratos is performing work at the Pentagon and we are supporting the Surface Warfare Directorate for combat systems on onboard ships. Work at NAVSEA, this is work related to the acquisition of new weapon and C4ISR systems and support for the life cycle extension of existing systems.
Work at the cruise missile defense office and also work related to the SLAM RAM system at White Sands. On-site system reset work on thermal viewers, site kilometers and laser locator designators on units and systems returning from Iraq.
Work related to certain other surface-to-air weapons systems, various works on C4ISR programs and Public Safety and Security work on a major DoD and networking center in the United States. As we look ahead, some important second half 2008 operational activities for Kratos include, the delivery of 11 OL [ph] Rocket systems related to certain Ballistic missile and missile defense programs, the operation of tempo maintenance at various targets and weapons ranges and the installation of certain of C4ISR equipment and solutions.
We currently have visibility into each of these programs and they are each incorporated into our business plan for the balance of the year. From an overall industry or market standpoint, we would like to make some comments related to both '08 and '09 as we see it today.
Passage of the war supplemental spending bill is a significant event and we are hopeful that this would be a positive action for Kratos, as in certain areas of our business we have been adversely impacted by war requirements, which has resulted in certain of our Air Force projects being pushed out. On the Federal government IT side, we have recently seen a strong amount of new work opportunity and activity in this area, which we currently expect to continue particularly in some of the defense customer areas where we work.
We are currently expecting there to be a continuing resolution situation later this year and possibly into '09 and we are in the process of addressing specifically what this could mean to Kratos. Preliminary we do not believe that a continuing resolution would materially adversely effect our weapon systems sustainment, reset, foreign military sales, or C4ISR business areas.
Additionally, we do not believe Kratos' Public Safety & Security business would be adversely impacted by a continuing resolution. The overall weak economic conditions in the US may suppress certain areas somewhat.
There are some new awards Kratos is expecting in the second half of this year that could potentially be adversely impacted or delayed by a continuing resolution, though we should have more clarity on this as we finish our assessment later on in Q3. Also as we know, we have a Presidential election coming up in a few months and both the perceived and real impact of a new administration is out there.
Potential result of administration a change, for example could be new regulations related to small business and other types of set aside mandates. Finally, there is Iraq and if when a drawdown occurs, this is an area where our weapons systems life cycle extension or reset business could benefit.
Obviously, these are all items we are closely tracking and accounting for in our actions and in positioning the business. Overall, we continue to believe the major focus areas of Kratos are well-positioned for our Company to achieve our business plan, grow the business and improve profitability.
I'll now call over to Deanna, who will provide more details related to the Company's financial performance in the second quarter.
Deanna Lund
Thank you, Eric. Good afternoon.
Today, we reported quarterly revenues at $72.3 million, a $24.5 million or 51% increase from comparable revenues of $47.8 million in the second quarter of 2007, which reflects a full quarter of operating results with Haverstick merger which occurred on December 31, 2007. Our operating results do not include the impact of the SYS transaction since the merger closed on June 28, the last day of our second quarter.
Our quarter end balance sheet includes SYS but the operating results at SYS will not be included in our operating performance until the third quarter. On a sequential basis, our second quarter revenues were up $4.1 million or 6% from first quarter revenues of $68.2 million.
Revenues in our government solutions sector were up sequentially $4.3 million or 7.8% from $54.9 million in the first quarter to $59.2 million in the second quarter. On a year-over-year basis, our government solutions revenues were at $23.7 million or 67%, up from $35.5 million in the second quarter of 2007 to $59.2 million in 2008.
This year-over-year growth includes the impact of the Haverstick acquisition which contributed $22.3 million thereby yielding an organic growth rate year over year of 3.9% in our government solutions segment. These sequential growth and year-over-year growth in our government solutions segments was the result of increases in certain C4ISR programs and weapons systems program.
Revenues in our Public Safety & Security segment were up year over year $800,000 or 6.5%, up from $12.3 million to $13.1 million driven primarily by growth in our Security, Access Control and Facility Automation businesses. On a sequential basis, our second quarter Public Safety & Security segment revenues were down slightly from $13.3 million to $13.1 million due to the completion of certain projects.
Our gross margin for the second quarter of 2008 was 17.8% or $12.9 million, up from 15.7% or $7.5 million in the comparable second quarter of 2007. The increase in gross margins is primarily a result of margin improvement in our PSS business.
SG&A as a percentage of revenues was down from 22.6% or $10.8 million in the second quarter of 2007 to 15.5% or $11.2 million in 2008. Sequentially, our SG&A decreased from $11.9 million or 17.4% of revenues in the second quarter – in the first quarter of 2008 to $11.2 million or 15.5% of revenues in the second quarter, primarily since a significant portion of our annual FY07 audit fees were included in the first quarter SG&A in the period in which the audit work was completed for a year end to audit.
Along that note, we are pleased to say that we have been successful in negotiating a sizeable reduction to our previous audit fees with our auditors Grant Thornton for our FY08 audit. Now that the complexities of the legacy matters associated with out wireless business are behind us, the audit fee that we have been able to negotiate is more in line with what our comparable government peer companies pay.
This audit fee reduction is part of our overall plan to reduce cost and fees throughout 2008 and to position Kratos to achieve its EBITDA objective. As we have stated previously, our ultimate objective is to achieve EBITDA margin consistent with our comparable peer group as we head into 2009.
Other areas where we are currently working to reduce cost include insurance, legal and outside consultants. Included in our second quarter operating expenses is a credit of $1.2 million for the recovery of unauthorized issuance of stock options from our insurance carrier and a reversal related to our access facility as well for unused office space.
Of this amount, approximately $600,000 is related to the insurance recovery from the access of stock options which occurred in 2002 and 2003 that we had discovered through our stock option review last year with the balance of $600,000 related to the reversal of the unoccupied facility accrual reserve due to our unused office space that we will now occupy as we continue to move the SYS personnel into our San Diego headquarters facility as part of our integration plan. As Eric mentioned, following the close of the SYS merger, we immediately took actions to execute a significant integration related business realignment and cost reduction action to reduce redundant cost to further increase our profitability and enhance our competitive position.
For the realignment actions that we took and plan to take to integrate the SYS operations into our operations, these costs will be included in our acquired liabilities of SYS, and will be included in our SYS purchase price allocation and associated goodwill. For the actions that we have taken in our existing Kratos businesses, these costs will be recorded as an operating expense in the period that the action was taken, which would be our third quarter.
Annual cash savings from these personnel reductions including fringe is approximately $2 million, the full benefit of which we will realize in FY09. We hope to have the integration of both Haverstick and SYS substantially completed by the end of 2008 or first quarter of 2009.
As we have previously discussed, certain of the integration actions cannot be completed until the first quarter of 2009 due to the timing and resources required to meet the year end financial reporting and Sarbanes-Oxley compliance requirement. Also as we have previously stated, we expect the restructuring and transformation actions and activities that we have taken to these substantial and completed in the first quarter of 2008 and to return to operating profitability by the first half of 2008.
As Eric mentioned, the first quarter of 2008 was the first quarter in which we returned to positive operating income since we exited our legacy wireless businesses and began our transformation activities in 2006. As we expected, we continue to improve our operating margins and EBITDA margins until the second quarter as we reduced certain of our SG&A expenses such as our external audit fees and other professional fees and we began to see the benefits of leveraging our SG&A.
Our operating income was $2.9 million for the second quarter of 2008, compared to an operating loss of $8.3 million for the comparable quarters last year. Included in our current quarter operating income is the $1.2 million credit related to the insurance recoveries on the stock option set and reversal of the unused facility accrual.
Excluding these credits, operating income was $1.7 million or 2.4%. As we have previously discussed, we continue to measure our progress and performance in terms of EBITDA or earnings before interest, taxes, depreciation and amortization.
We believe that EBITDA from our continuing operations is a meaningful measurement of financial performance due to our extensive acquisition activity especially since our entire federal business has been built through acquisitions that we have made since 2004 and our Public Safety & Security business was built through acquisitions that were made in 2003. Additionally, we currently have approximately $150 million in net operating loss carry forwards which were generated from our legacy wireless businesses and accordingly Kratos is not expected to be a material income tax payer in the foreseeable future.
Excluding the impact of the $1.2 million credit, I previously discussed, our EBITDA was $3.7 million or 5.1% EBITDA margin for the second quarter, up sequentially from first quarter EBITDA of $3 million or 4.4% EBITDA margin. For an any unforeseen surprises, we expect to continue to achieve increased GAAP EBITDA profitability in the future through revenue growth, leverage on our SG&A infrastructure and with the acquisition of SYS.
Income from continuing operations for the second quarter of 2008 includes $2.5 million of net interest expense primarily related to borrowings on our new credit facility which was used to fund the acquisition of Haverstick. In addition, included in our income from continuing operations is other income of $1.3 million related to the interest (inaudible) arrangement that we have mark-to-market which was favorable this quarter.
We then also excluded this gain from our EBITDA calculation, and it is specifically executed – excluded from our bank's measurement of our EBITDA as it is non-cash in nature. Our cash balance was approximately $17.4 million at June 29, which includes the SYS cash balances on hand at that time.
Our current cash balance as of August 4 is approximately $7.3 million which reflects the payment of SYS transaction expenses, scheduled, principal and interest payment and the funding of the 2007 securities litigation settlement, all of which were planned dispersion. The remaining funding of the 2004 securities litigation settlement have approximately $3 million is not expected to occur until mid-September.
Our cash flow generated from operations was approximately $3.9 million for the first six months of 2008 was approximately $1.9 million generated in the second quarter. With the SYS merger now closed, we expect Kratos' cash flow to improve going forward.
Other key balance sheet and capital structure elements at quarter end are as follows. Accounts receivable primarily from the US government and other agencies was $89.1 million.
Accounts receivable, day sales outstanding or DSOs excluding the SYS receivables were 95 days down from 106 days in the first quarter, reflecting our continued focus on improving our DSOs. Our receivables include amounts unbilled due to milestone achievement and shipped their requirement particularly on the Companies contract to provide Chaparral, Hawk and other weapons systems which are scheduled for collections later on in 2008, once these systems are delivered and accepted.
(inaudible) at June 29 was approximately $79.9 million, including $49 million on a five-year term note, $20.9 million underline of credit and $10 million in subordinated debt. Net paying [ph] debt, net of cash as of June 29 is $62.5 million.
Our debt-to-equity ratio at quarter end was 0.38 to 1. Additionally, from a cash perspective, once substantially all the SYS leaser agreement expire at the end of 2008 and early 2009, the combined Company should realize overall cash saving and leased payment of just under $1 million for a year going forward.
Lastly, as we have stated previously, part of our integration process includes establishing a consistent definition of backlog across our business units after evaluating and considering the various contract vehicles that we have. Since we are still in the process of integrating the recently closed Haverstick and SYS transaction, we anticipate that we will be in a condition to report our consolidated backlog, incorporating all of our recently acquired businesses and utilizing a consistent methodology, once we have a full quarter of operating performance including the SYS transaction.
As we have stated previously, we will continue to refine a consistent definition backlog across all of our business units. With that I would turn the call back over to Eric for his final remarks.
Eric DeMarco
Thank you, Deanna, very much. So, in summary, through the second quarter, the business is performing on track with business plan.
The SYS merger completed at the end of June, we are reiterating our annualized revenue run rate projection to be greater than $300 million for '08 and run rate of approximately $400 million for '09. This excludes any additional acquisitions and currently assumes no changes in contract labor material or ODC mix in the contract base.
The integration of Haverstick and SYS are substantially underway including the third quarter business realignment and G&A infrastructure cost reduction, a full benefit of which is ahead of us and will not be fully realized until Q4 and Q1 '09 due to the run off severance payment. This realignment action is directly related to our stated plan to integrate the businesses and they continue to improve Kratos' EBITDA margins and consolidating our current business position.
The key element of the integration plan for Haverstick and SYS relates to business development and winning new work. One of the primary reasons for bringing these businesses together and executing this acquisition strategy is to combine the resources, the past performance qualifications in order to go after new work in the prime contractor role.
This process has already begun with Cliff Cooke, Kratos' Senior Vice President of Strategic Business Development leading this absolutely critical initiative. That concludes my remarks.
Thank you for joining us today on this conference call. We'd now like to open the call up for any questions that you may have.
Operator
Thank you. (Operator instructions) Our first question this afternoon comes from Mark Jordan with Noble & Finance.
Mark Jordan – Noble & Finance
Afternoon Eric. Three questions, number one, given your service and product mix, where should – what should be a reasonable long-term target for you on DSOs?
Eric DeMarco
Very good, Mark. Assuming the mix stays the way that it is right now, long term 90 days, may be high 80s but that about is good as that can get assuming no changes in the delivery and milestone characteristics.
Mark Jordan – Noble & Finance
Okay. Secondly, with the addition of SYS obviously, being purchased for stock, what would you project to be your incremental borrowing capacity, again given the fact that you are larger – acquisition was done for equity?
Eric DeMarco
Right. Today's credit markets of course remain very challenging and tight.
And we'd have to take into consideration any additional mark-to-markets of our credit facility, taking into consideration new market characteristics. But the way that we – one way that we look at it Mark is let's just say that we were looking at $50 million opportunity, whether it's generating 10% LTM EBITDA of $5 million, we take that, add that into our bank EBITDA and we would look at 3 or 3.5 times that total number.
Mark Jordan – Noble & Finance
Okay. Final question, you just allude your target this to achieve industry norms EBITDA margins over the longer term as once the inefficient cost drop off.
Could you define specifically what those EBITDA targets will be?
Eric DeMarco
If we can get into the range of 7 million to 9 million, 7.5 million to 9.5 million then 8 million to 10 million that would be fantastic for us.
Mark Jordan – Noble & Finance
Okay. Thank you.
Eric DeMarco
Thank you.
Operator
(Operator instructions) We move now Mike Crawford with Riley Investment Management.
Mike Crawford – Riley Investment Management
Thank you. So, I realize that we are probably not going to see adverse less numbers for the June period until I can say next quarter, but can give us just a rough indication was it around $19 million revenues, 7% EBITDA something like that?
Deanna Lund
Mike this is Deanna. It was little less than that $19 million, it was close to the $18 and the EBITDA was less than that due to some onetime transaction cost that – their performance that quarter.
Mike Crawford – Riley Investment Management
Right. Deanna, so you have backed up those onetime costs?
Eric DeMarco
I don't know if we give it. Mike, we haven't run that and looked at that way because we don't pick them up until Q3.
Mike Crawford – Riley Investment Management
Okay. And then further to that, I guess in another way of looking at the $2 million in expected annual savings as it's almost like adding 3 percentage points to the EBITDA margin?
Eric DeMarco
Yes, Mike. Let me clarify that.
That $2 million is not for SYS alone. That $2 million is from the combination of Haverstick's Navy business, Kratos' Navy business and SYS' Navy business.
And putting together three Navy businesses into one division if you will and the duplicas – the duplicity and the redundancy in G&A functions and overhead functions in both rate pools.
Mike Crawford – Riley Investment Management
Okay.
Eric DeMarco
Okay. So, it's a combination.
Mike Crawford – Riley Investment Management
Okay. Eric, just on the guidance, can you just flush out what you mean by $400 million run rate for next year?
Do you mean you are entering – do you expect to enter the year at that level or that is about what you expect for next year or is that what you expect to end out in the Q4 of next year?
Eric DeMarco
We are expecting to do somewhere around $400 million in revenue for 2009
Mike Crawford – Riley Investment Management
Okay. Great.
And in that expectation, I think it's my expectation that there's room for upside related to a missile test shot work. Do you have much in the way at that for in those numbers?
Eric DeMarco
Right. They are probably depending on the operational tempo at some of the bases and some of the program work under that $100 million TSA [ph] contract we won a few months ago.
There very well may be some room for some upside. However, as I mentioned we are actively right now looking across the entire contract portfolio at material and subcontractor pass through revenue.
And so over the next 18 months, if we are talking about now through the end of '09, if we can eliminate some of that to get out of our operational numbers lower or no fee business, our ultimate objective would be to increase the margins and that could offset some of that upside on deliveries.
Mike Crawford – Riley Investment Management
Okay and that makes sense. And one final question, as you would like to – SYS stays in pursuing some public security contracts where they set some inroads in Pennsylvania and some other local markets, has there been any more progress on that?
Eric DeMarco
Q3, the quarter that we are in right now and maybe the first month or so of Q4 are going to be very telling on these opportunities for us.
Mike Crawford – Riley Investment Management
Okay.
Eric DeMarco
Thank you, sir.
Mike Crawford – Riley Investment Management
Thank you.
Operator
That would conclude our question-and-answer session. At this time, I would like to turn the program back to our speakers' for any additional or closing comments.
Michael Baehr
Thank you. We would like to thank everyone for joining us for our second quarter earnings conference call.
We'll be back in touch with you the third quarter. Thank you.
Operator
Thank you everyone for your participation on today's conference and you may disconnect at this time.