Kratos: Expensive Stock For Lower Tier Drone Company

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About: Kratos Defense & Security Solutions, Inc. (KTOS)
by: Strubel Investment Management
Summary

Kratos high growth drone business only makes up 20% of revenue.

The company's drone business is/was focused on relatively unsophisticated aerial target drones.

Stock trades at a premium to other larger, better-funded defense contractors.

Kratos Defense and Security (KTOS) is a small defense contractor focused on communications and support services as well as unmanned aerial platforms. The company's lack of a diversified in-production contract base and mixed financial results make the company a risky bet. However, that's not to say there isn't upside if everything goes right although the stock's recent share price gains may have already priced in a lot of the upside.

(Source: Yahoo Finance)

KTOS Overview

KTOS operates two different business segments. Its Unmanned Systems ("US") segment comprises unmanned aerial, ground, and seaborne systems business. While this is the growth business, it only accounts for about 20% of last fiscal year's revenue. Its Kratos Government Solutions ("KGS") segment operates as basically a catchall segment and comprises microwave electronics products, space and satellite communications, and defense and rocket support systems business.

The company has operated at a loss for the last several years; however, over the last year, the GAAP net loss has narrowed and the company is almost operating on a breakeven basis. Additionally, cash flow from operations was negative the previous two years but turned positive this year. However, free cash flow is still negative as capital expenses have exceeded cash from operations. Encouraging things look to continue to be headed in the right direction as the latest quarter saw the company post positive net income as well as positive free cash flow.

The biggest issue we see with KTOS is that its core growth products are relatively unsophisticated aerial target drones that it's trying to leverage into a fully combat capable drone product. It's competing against larger, better-funded companies like General Atomics, Northrop Grumman (NOC), Lockheed Martin (LMT), Boeing (BA), and others. Not only do these companies have deep pockets, but also they have significant experience in producing highly sophisticated aircraft.

Here's how KTOS describes their US segment in their latest 10-K.

Kratos is one of the industry leaders in high performance, jet powered, unmanned aerial target drone systems which are designed to replicate state of the art adversarial fighter aircraft, missiles and other threats. Kratos is the sole source or primary unmanned aerial target drone system provider to the U.S. Air Force, Navy, Army, and numerous allied foreign defense agencies. Leveraging off of this technology, for which Kratos owns the intellectual property, we made a significant investment over the past six years developing Kratos' first UCAS, our Unmanned Tactical Aerial Platform ("UTAP-22"), now formally called "Mako."

We're not sure what KTOS means by "sole source" given there are numerous aerial target drones in use produced by other contractors (one such system by NOC is here, others by LMT here). Perhaps, they mean they have contracts for aerial target drones in which, for that given contract, they are the sole contractor? In any case, the aerial target drone business is relatively unsophisticated compared to full scale combat and surveillance drones such as the MQ1-Predator, MQ-$ Global Hawk, or MQ-9 Reaper. KTOS does not appear to have any major combat platforms in service and a majority of its contracts outside the aerial target drone programs are for research and development work. This is a major risk for investors in KTOS compared to other defense contractors that have combat platforms in production, which all but guarantee them significant long-term revenue.

The largest business segment is Kratos Government Solutions. Here is the relevant information about that segment from their 10-K.

We are also an industry leader in ground-based command, control and communications systems for satellites, and a leader in related radio frequency interference identification, geolocation and mitigation. Our primary customers include the U.S. Air Force, Space Command and other agencies. Our microwave electronics business products have designed-in positions on critical combat system programs, including Barak, Gripen, Iron Dome, Sling of David, F-15, F-16, Gripen, and Arrow.

Again, the problem we see is the company has no significant presence on any next-generation platforms. The F-15 is set to end production in 2022. F-16 may end up being stopped in the near future. The Gripen is in production and sales are still being potentially made, but it's an older aircraft design whose days are numbered. The Israeli Iron Dome system is a current generation product and in production. Same with the Barak missile and the Sling of David (which is in development). Going forward, the company has no presence for its microwave electronics products on any major future platform.

Another potential area of concern about KTOS's business is a majority, 86%, of the company's contracts are fixed price. These types of contracts represent a double-edged sword versus "cost plus" type contracts which allow contractors to recoup their costs plus a guaranteed profit. If things go well and the company executes, fixed-price contracts can be immensely profitable (see LMT and the F-16). On the other hand, the company is assuming all of the risks if things go south.

These risks in conjunction with the company's current valuation compared to peers make the stock look relatively unattractive at present.

Summary

You'll see in our disclosure at the bottom that we own LMT, NOC, RTN, and BA. Our strategy is that we'd rather own a diversified basket of the largest defense contractors and not have to worry as much about specific management team execution and which company will win which contract.

Additionally, as we mentioned previously, it's worth wondering how much upside is priced into KTOS. The stock trades at an elevated forward P/E and PEG ratio compared to the other large defense contractors.

Ticker

Fwd. P/E

PEG

KTOS

47.5

4.3

BA

15.4

1.2

LMT

14.1

1.2

NOC

14.1

1.1

RTN

13.9

1.2

GD

13.0

1.7

HII

12.6

1.6

(Source: Yahoo Finance)

At the current price, with its current business, we don't find KTOS to be a compelling investment, especially for more conservative investors. If you are a high risk/high reward gambler, then the stock may warrant a closer look as there could be upside if the drone business matures and takes off.

Disclosure: I am/we are long BA, LMT, RTN, NOC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.