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John Engle
John Engle
Articles (175) 

Can This God of War Scale Olympus?

One small defense company has been climbing, but its smooth ascent is getting tougher

November 13, 2017 | About:

Discussions of the defense industry usually center on the massive players dominating the sector, such as Lockheed Martin (NYSE:LMT), Raytheon (NYSE:RTN) and General Dynamics (NYSE:GD). Yet some of the most interesting action – and opportunities – can be found in the smaller and more niche players in the defense industry.

Kratos Defense & Security Solutions Inc. (NASDAQ:KTOS) is one such zippy, small-cap defense stock that should be on investors’ radars. Let’s take a look under the hood of this wee god of war.

Knowing the business

Kratos provides a range of defense-related products and services, but specializes in unmanned systems, satellite communication systems, microwave electronics, cybersecurity and warfare technology and solutions, missile defense systems and combat systems. As with most defense industry companies, Kratos’ principal customer is the government, specifically agencies dedicated to national security.

The company also works with state and local government agencies, as well as a range of private sector companies and international clients. In fact, Kratos is less dependent on the federal government than some of the big players, with only 57% of revenues coming from that source in 2016, compared to the 71% and 67% reported by Lockheed and Raytheon.

The U.S. government will play the most important role in any growth story, however. That is especially true as Kratos markets its low-cost combat drone models, the XQ-222 Valkyrie and UTAP-22 Mako. Orders for these drones are expected to rise and will reflect a growing piece of Kratos’ business. The unmanned systems segment already shows significant growth, reporting a year-over-year revenue increase of 127% in its third-quarter earnings statement.

As of the third quarter, unmanned systems makes up 21.2% of revenue; the other two revenue segments, Kratos government solutions and public safety and security, made up 58.8% and 20.0%. But these two segments have only grown by 2% and 14%, highlighting the scorching pace of growth within the company’s drone division.

Taking a look at recent financial performance

The past couple quarters have been a bit of a mixed bag. Second-quarter earnings disappointed, despite beating the consensus estimates on both revenue and earnings. Management raised guidance after its earnings call; it delivered on its promise, posting three cents per share in the third quarter on $196.2 million of revenue, which were in line with and a beat of estimates, respectively. Guidance for the fourth quarter was revised down, but kept in-line for the year.

As of the end of the third quarter, Kratos had a reported backlog of $798.9 million, a bid and proposal pipeline of $6.6 billion and cash on the books worth $239.2 million. That cash position has been expanded recently, when Kratos announced the issuance of a senior secured note on Nov. 8. The note raises $300 million in non-dilutive capital.

The market’s reaction to Kratos’ performance has been mixed as well. Shares are still up more than 35% year to date, but the stock has been tracking down since early October. In the past month, Kratos has shed more than 20% of its value. The reason for the drop is evidently the less-than-stellar guidance after the third quarter and concerns over the terms of the new debt.

Is there an opportunity here?

For serious value investors, Kratos shares still look a bit dear despite their recent pullback. A forward price-earnings ratio of nearly 36 and an EV/EBITDA of about 33 hardly screams a bargain. Yet for more aggressive investors, the pullback may represent a decent entry point.

There is no denying Kratos is well positioned to take advantage of many of the growth factors that will see expanding revenues for the defense sector during the Trump administration. The company has secured a central place in the Department of Defense’s Innovation Initiative, as well as its so-called Third Offset Strategy. That means Kratos will be well positioned to get a decent slice of the growing defense industry pie, especially as it continues to invest heavily in drone, information security and warfare technologies.

Kratos represents a solid play on the future of U.S. military development, but should be approached with some caution given its already high valuation.

Disclosure: I/We do not own any of the stocks mentioned in this article.

About the author:

John Engle
John Engle is President of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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