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Summary

  • Kratos has become a favorite for analysts and investors in the defense industry.
  • The recent demand for unmanned systems has given the company major opportunities to grow.
  • The massive amount of debt is still the company's biggest issue.

Kratos Defense and Security Systems (NASDAQ:KTOS) has received a lot of big news lately. From restructuring to big contract wins, this national security and civil technology company has many analysts and investors believing that this company is on the rise and is well situated to take advantage of the increased focus on high technology battlefield solutions. However, the company has had negative net income since 2010 and major debt, leaving me to wonder if I'm the only one missing something about this stock.

Why Do Investors Like This Stock?

Kratos has become well known in the Washington, D.C., beltway. Winning high publicity and exciting contracts, such as a $7.3 million contract for mass transit security and a $9 million contract for a new rail gun prototype in May. While these may not be large contracts compared to its competitors, the contracts have added up with yearly revenues for the company have risen from $334.5 Million in FY2009 to $950.6 Million in FY2013. With gross profit almost quadrupling from $63.6 Million in 2009 to $240 Million in 2013, Kratos has been successfully integrating itself across the Department of Defense, as well as the National Intelligence community. The company's customer base is heavily invested in defense, with 64% of the company's revenue derived from the Department of Defense, 12% international and 24% in the civilian sector. In their satellite division, Kratos has demonstrated its value, with their EPOCH command and control system used by 75% of commercial, Department of Defense and Intelligence satellites.

Additionally, Kratos has been made large strides in developing its unmanned system division. Recently winning a $35 million contract for land, air and sea unmanned systems, Kratos recently expanded Kratos Unmanned Combat Aerial Systems Division (or KUCASD) into Kratos Unmanned Systems Division (or KUSD), under the leadership of former KUCASD president Jerry Beaman. Through the company's subsidiary Micro Systems, the company manufactures unmanned systems command and control products to direct, identify and target enemy combatants. In the Unmanned Systems Integrated Roadmap, the Department of Defense has already planned to allocate $28 billion to unmanned systems through 2018, and cites a projection that the market for unmanned systems will double over the next 10 years to $89 billion. This number does not include the National Intelligence budget of $46.5 billion for agencies such as the Central Intelligence Agency, to whom Kratos is already delivering products and services.

While Kratos is already competing with the likes of AeroVironment (NASDAQ:AVAV) and Textron, Inc. (NYSE:TXT) for a piece of the unmanned systems budget, the scale and rapid expansion of this industry means that there will be many opportunities for Kratos. The company has already invested $5.9 million in R&D for FY 2014 Q2 alone, or 2.6% of revenues, above the usual 1.7% to 2.0% per quarter, showing the company has already started allocating R&D funds accordingly. Kratos currently derives 20% of its revenues from unmanned systems, and this looks to expand as the industry grows.

Why I'm Not Buying It

FY 2014 seemed to be average for the company. Revenues for Q2 fell 2.5% to $229 million from $235 million from Q2 2013 due to the loss of two satellite contracts as well as a decrease in the government services segment. The company reduced workforce by 2.7%, making it the 5th quarter that the company has reduced headcount by nearly 3% per quarter in reorganizations. Net loss for the company was $49.9 million, but management still confirmed their expectations of year end revenues of $920 to $960 million.

The real story here is Kratos' management of its debt. With a debt that has ballooned to $628.9 million, the company is extremely leveraged with a long term debt to equity ratio of 217.95. The company has repeatedly taken on debt to fund its acquisitions, such as its 2012 acquisition of Composite Engineering, Inc. and its 2011 acquisition of SecureInfo. From this debt, the company paid out a total of $62.6 million in interest in 2013 alone. In May, the company refinanced $625 million 10% notes due 2017 to %7 notes that will reach maturity in 2019, estimating that the refinance will save the company's annual interest by $18.75 million through 2017.

Additionally, the company's 8-K shows that the company can redeem 10% of the principal of the notes for 103% by 2016, giving the company a further plan to reduce its debt. However, even with the refinancing, this is a huge debt that will have to be repaid. While their high profile contracts look good, their inconsistent cash flows will have to not only stabilize, but grow immensely before the company can consider paying back the debt. The company's yearly cash flows have fluctuated; cash flows were $62 million in 2011, negative $21.9 million in 2012 and $7.9 million in 2013. The company has projected adjusted free cash flows of $40 million for FY 2014, but with their past inconsistencies, it remains to see if they can. The only other option is with new equity offerings, a possibility mentioned in the refinancing 8-K, which would dilute current investors shares.

Final Thoughts

While Kratos certainty seems to be capitalizing on new UAV and unmanned systems, and restructuring its divisions to provide greater support, the high debt load coupled with the inconsistent cash flows makes for a very risky investment. While management has restructured a majority of their debt, it still remains the greatest threat to their operations. Until management can prove they can provide stable cash flows to pay back the debt, this may be one stock to be "wrong" about.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.