I’m dispensing with any pre-amble today and getting right down to business with the latest round of C.H.A.O.S.
You should be familiar with my C.H.A.O.S. tech stock screener by now, but if not, get the scoop on how it works here.
Headquartered in San Diego, Kratos Defense & Security Solutions (KTOS) specializes in national security and provides technology, engineering, manufacturing and system integration services to the U.S. government and related security agencies.
Today, however, Kratos’ defenses will be put to the ultimate test, as I run the company through C.H.A.O.S.
Let’s see if it survives…
While Kratos’ top-line numbers are strong, with sales and margins growing steadily in recent years, the company’s annual net income hasn’t risen above negative territory since 2010. Why?
In a word… debt.
In 2009, Kratos’ long-term debt was only $55 million. But by the end of fiscal 2013, it had ballooned to $670 million.
In the first quarter, Kratos lowered its debt burden to $642 million… but that still puts its debt-to-equity ratio at 225. Meaning, for every $1 in equity, Kratos has an ugly $225 worth of debt.
In other words, Kratos is highly leveraged and finances its growth through loans. And due to interest payments, this typically produces volatile earnings.
However, Kratos does have some bullish indicators, too.
For example, while the company fluctuates between profitable and non-profitable quarters, it’s recently shown greater consistency, beating earnings estimates in four of the last five quarters. And with an average upside surprise of 36%, too.
But Kratos’ assets are the company’s most bullish indicator…
One way to value a company is with a “net reproduction model.” It essentially helps to determine how much a company is worth, based on the amount that a rival would have to pay for its assets.
The model factors in cash and accounts receivable, fixed assets like land, buildings and machinery, plus intangible assets like patents. It also accounts for inventory (raw materials, finished goods and products in development), plus liabilities and asset depreciation.
Kratos’ net reproduction value is $17.62 – 108% higher than its current share price.
So while Kratos leverages much of its growth, the market isn’t judging the company on its full asset value… yet.
C.H.A.O.S. Meter: 16/20
Given Kratos’ various areas of expertise, it’s no surprise that the company’s technology has a very high impact within federal and state government agencies.
- Combat Systems (including missile defense and weapons testing).
- Infrastructure Security.
- Cyber Security and Cyber Warfare.
- Satellite Communications Systems.
- Unmanned Systems (including ground and aerial drones).
In addition, Kratos provides surveillance and reconnaissance through digital and closed-circuit security and surveillance, fire and life safety, and building access technology. It also offers solutions in design, engineering and control center operations.
Ultimately, Kratos provides essential, state-of-the-art technology to its clients. And it continues to rack up multi-million-dollar contracts at an impressive pace across a diverse range of areas. In a highly competitive space, such funding validates the success and importance of its technology and has made it a trusted, well-respected, leading player in the defense sector.
C.H.A.O.S. Meter: 15/20
When company insiders start piling into a beaten-down, oversold stock, it’s one of the most powerful bullish indicators you can get. And that’s happening right now with Kratos.
This month, insiders – including CEO, Eric DeMarco, and Deanna Lund, Kratos’ CFO – have bought a combined 212,000 shares. Company Director, William Hoglund, snapped up 200,000 of those alone at a cost of $1.4 million.
In addition, several large hedge funds have recently placed substantial “long” bets on Kratos – another very bullish sign. Two analysts have also raised their earnings guidance on Kratos by a hefty 40%.
And given the frequency with which Kratos racks up government contracts, major new deals should also fuel the near-term share price.
However, there is a potential roadblock for Kratos’ acceleration…
In an effort to reduce its debt burden, Kratos recently refinanced its $625-million note – from a 10% interest rate that was due in 2017, to a 7% interest rate due in 2019.
On the surface, this will save the company $18.75 million in interest in the coming years.
However (and this is why it’s always important to dig deeper), Kratos’ 8-K filing mentions that 35% of the note might get redeemed before May 15, 2016 from net proceeds of “certain equity offerings.” In other words… from diluted shares. That drops an anchor on momentum.
C.H.A.O.S. Meter: 14/20
A downward trend in orders led to a 21% first-quarter revenue drop, to $200 million, compared with Q1 2013.
And total annual revenue for 2013 also shrank by $18 million from 2012.
Blame it on the government.
As I noted, Kratos earns the bulk of its revenue from federal government contracts, as well as the U.S. military, where Kratos supplies missiles, helicopters, drones and fighter planes.
Over the last three years, government clients accounted for roughly 74% of Kratos’ revenue in 2011, 65% in 2012, and 64% in 2013.
The remainder of its business comes from local, state and foreign governments, along with domestic and international commercial customers.
For example, Kratos provides biometric access technologies for pipelines, electrical grids, port authorities, power plants and a host of other facilities.
It means Kratos works with industry giants like Lockheed Martin (LMT), Boeing (BA), Science Applications International Corporation (SAIC), ManTech International (MANT), Northrop Grumman (NOC), Raytheon (RTN) and iRobot (IRBT).
As you know, though, government orders can either come by the boatload, or fall by the wayside. And the last few years have seen the latter, with furloughs and sequestration affecting government budgets.
That’s negatively impacted firms like Kratos. For example, uncertainty over the Department of Defense budget delayed work and product shipments, which put a $28-million dent in Kratos’ Government Solutions stream.
What’s more, revenue here is expected to decrease even further going forward.
With constantly fickle government policy, it means Kratos’ order stream will continue to be unpredictable. However, for as small as it is ($485-million market cap), KTOS still pulls in annual revenue around the $1-billion range – on par (or better) than some of its bigger, more established peers.
C.H.A.O.S. Meter: 12/20
In order to boost its government-based business, KTOS needs to focus on two areas…
Acquisitions: Over the past three years, Kratos has stayed competitive by buying smaller firms that specialize in highly advanced warfare technologies. The downside is that this has come at a hefty cost, and given its debt burden, the company faces a delicate balancing act.
Lobbying: Kratos needs to ramp up its lobbying efforts to ensure that government funding falls its way. As it stands, business is up for grabs. In December, Congress passed the Bipartisan Budget Act – a two-year plan that sets spending for the Pentagon (and other federal agencies) at just over $1 trillion for 2014 and 2015. In addition, the U.S. debt ceiling was recently raised through March 2015, part of which offsets significant sequestration cuts. This should lead to more contracts for Kratos.
Given the whims of governments, however, Kratos needs to seek revenue in more reliable areas in order to scale its business higher.
In this regard, with its “government-grade” cyber-security and surveillance technology, Kratos should focus on the multi-billion-dollar mobile, Big Data and cloud-computing industries.
C.H.A.O.S. Meter: 14/20
Final Verdict: Kratos has been on my radar since its pre-$5 days. It’s a solid, yet under-the-radar company with tons of potential and incredible value, based on its total assets. And with Washington appearing to set the stage for an upward move in defense stocks, I’d consider buying shares on any dip under $8.
There are two things to note, though: First, government legislation has earmarked defense spending through 2015. And second, Kratos’ share dilution in 2016. So there’s upside potential for Kratos in the months ahead, but it gets murky beyond the end of 2015.
Your eyes in the Pipeline,