Michael Vi
A sad reality of the present is that, geopolitically speaking, we are living in challenging times. Therefore, nations have no choice but to strengthen their respective armed forces. That, in turn, creates opportunities for defense contractors. One of the smaller, but no less interesting, names in the sector is Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS). Kratos is a relative niche player focusing on unmanned solutions, military communication and electronic training systems. Those product categories are likely to continue to grow in relevance going forward. Consequently, Kratos stands to profit.
Strong Growth And A Healthy Balance Sheet
Kratos is displaying growth at a strong pace. Q1 revenue increased 19.6 percent YoY to $277.2 million. The unmanned systems business in particular is a driver of revenue growth (+21.8 percent YoY), but the as of yet larger government solutions segment still posted an impressive increase of 18.5 percent. Full year guidance projects 2024 revenue in the range of $1,125 to $1,150 million (FY2023: $1,037 million).
Kratos’ balance sheet is quite healthy, too. Cash and equivalents of $338.9 million make for ample liquidity, outweighing current liabilities of $288.2 million. Long-term debt is rather moderate, too, at $179.4 million, reduced by almost $40 million YoY. With a quarterly adjusted EBITDA of $26 million (FY2023: $95.4 million), that appears entirely manageable. Even more positive is that the company is consistently net profitable (Q1 net income: $1.3 million).
Potential Buyout Target
An additional benefit of Kratos from an investment point of view is that it may be a potential acquisition target for a larger competitor. I base my reasoning on two main factors: First, it is relatively small in absolute terms at a market capitalization of slightly below $3 billion. Also, it operates in a space that is poised for significant growth in coming years and decades. Obviously, owing to the nature of Kratos’ business, the circle of acceptable acquirers is somewhat narrow. I do, however, believe that there are still enough names for whom a takeover might be interesting. Access to the company’s know-how and technology would arguably even justify an additional premium on the share price
Valuation
Personally, I believe that within a few years, annual profits of around $50 million are not unrealistic, especially once the XQ-58 Valkyrie combat drone develops into a marketable product or product family. However, at the current market price, the company trades at a forward earnings multiple close to 60 based on the above assumption. Within the defense sector, earnings multiples of 20 or slightly below are the norm. Kratos, in my opinion, deserves a certain premium on account of its above average balance sheet, strong growth and the potential of becoming an acquisition target going forward. However, absent a catalyst, I do not see much immediate upside.
Risk
It should be noted that the relatively high valuation inherently contains a downside risk. Given a downside catalyst, there is significant room to fall. Also, as a defense contractor, Kratos caters to a fairly limited audience. At the end of the day, the US government as a customer and the sole arbiter of who else is to be allowed to buy but a single product the company offers is of existential importance. The nature of its business furthermore makes Kratos a logical target for state-sponsored cyberattacks. The fallout of such an attack, if successful, might be significant.
Conclusion
Kratos is certainly an interesting name to keep an eye on. The product portfolio is highly relevant for modern defense requirements, and they have built a technological moat that will not be easily conquered. The balance sheet is among the more healthy ones in the industry, too. However, the stock currently appears fairly valued, if not somewhat expensive. Consequently, I do rate it a hold for the time being. Yet, I will caveat that a price dip or a catalyst such as takeover interest might change that view in the future.
