Kratos Security: Would You Buy a Defense Contractor With Negative Net Income?

With the rise of cyber-defense and unmanned drones, the national security technology business seems to be a growth industry. With more contracts being awarded for technology security, it seems like this could be Kratos Security & Defense Systems'  (NASDAQ: KTOS  )  time to shine.This defense contractor, with expertise in satellite communication systems, electronic warfare systems, unmanned systems, and cyber security seems to be well positioned, and it's winning government contracts left and right. Make no mistake, however, this stock is not for the skittish investor. With negative net income and negative profit margins, what is keeping Kratos from being a defense industry favorite?

The $628 million gorilla in the room
The rise in technology defense consulting has been good to Kratos. Since 2009, revenues for the company have risen from $334.5 million to $950.6 million, with gross profit almost quadrupling from $63.6 million to $240 million in the same time frame, driven primarily by Kratos' acquisitions in 2010 and 2011. . So why has Kratos not had a positive net income since 2010? For the same reason that ti has grown so quickly: The debt from its acquisitions has put a massive strain on the company. In 2009, Kratos had $51.6 million in long-term debt; it has since grown to $628.9 million. This ballooning debt has caused problems for the company -- it had to pay out $62.6 million in interest alone in 2013, and expects a pre-refinancing interest payment of $125.1 million in 2014 and 2015. With a long-term debt to equity ratio of 217.51, it is far more leveraged than its peers: Competitor CACI International (NYSE: CACI  ) has a ratio of 49.49 and Science Application International Corp.  (NYSE: SAIC  )  is at 133.16. However, it appears that Kratos' management has already started taking steps to address the issue, having refinanced its $625 million 10% notes due June 1 2017 to 7% notes due 2019 on May 15, 2014, reducing the annual interest paid by $18.75 million over the next three years. One key feature of the refinancing is the ability to redeem 10% of the principal at 103% in the first two years, which coupled with the growth of its new contracts, gives management the ability to start reducing its leverage and provides a long-term plan to address the debt. Unfortunately, according to its 8-K , it appears that Kratos has already indicated it may be willing to redeem 35% of the note by May 2016, with the proceeds from "net proceeds of certain equity offerings", meaning that investors should be prepared to have their shares diluted.

Is business really booming?
In its Q1 2014 earnings call on April 30, 2014, Kratos reported a result of negative $0.26 EPS. Overall revenues fell to $200.10 million, a $52.7 million decrease from Q1 2013, it should be remembered that many defense contractors suffered due to the effects, delays, and uncertainty of the government shutdown in late 2013. Kratos appears to have made up for it though, winning numerous high profile contracts in 2014, including $5 million for national security products for various agencies on May 13, a $4.2 million contract to support an "unspecified" government agency on May 30, a $9 million contract to develop a hypervelocity rail gun on May 20, and announced the successful customer acceptance flight test for its newest unmanned aerial drone program on May 14. While these high-profile contracts give the appearance of a healthy underlying business, analysis of its cash flows show that it is a little more complicated. Looking at Kratos' cash flow statements, it appears that its net cash flows fluctuate between positive and negative. While the company is projecting adjusted FCF to between $35 million and $40 million for FY 2014, a number significantly higher than the $6 million in 2013, any sign of growing free cash flow would help bolster investors' confidence. . As of December 2013, the company had a $1.1 billion backlog on its existing contracts, so the variable and inconsistent annual cash flow needs to be solidified if Kratos is going to make any headway in paying off its debt.

Kratos' management has already stated that the company will not pursue acquisition targets, so it appears that the company is going to need to grow organically. Management seems to be targeting areas outside its cores Department of Defense clients, citing the fact that 35% of business now comes from international security related or commercial security related contracts, and a 10% annual growth rate in its non-federal customer base. That still leaves 46% of its budget supported by the DOD, and in an age of spending cuts, Kratos will have to look to develop without acquiring another company.  

Is the valuation accurate?
The difficulty in trying to price defense contractors is that, with so many different lines of business, it becomes very difficult to figure out which metrics work best in determining a price point. With a price to sales ratio of 0.51 and a price to book ratio of 1.64, both on the low side among its peer group of general defense contractors, it might help to examine another metric. With a price to operating cash flow ratio of 0.39, Kratos underperforms its competitors CACI with 10.61, and SAIC with 3.82, showing that its underlying business may not be as healthy. However, Kratos' share price has received a relative bump in the recent weeks, after one of its directors purchased 200,000 shares for a total of $1.4 million on May 20, giving the stock a lot of momentum to. 

Their drones might be flying, but this company is stuck on the ground
With no positive net income since 2010 and a heavy debt burden, this potential portfolio addition looks to be an investment to stay clear of. Even with the refinancing of the majority of its debt, Kratos will have its work cut out for it trying to operate this extremely technical business and build its non-defense division to account for the cutbacks in defense budgets. Combined with the uncertain nature of its cash flows, this stock could be trouble. While the contract awards are a positive sign, the underlying instability is enough to make even the most risk tolerant investor think twice..

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