For defense contractors, all roads lead to and most revenues come from the Pentagon.
After broadly falling for five straight years, the U.S. defense budget finally ticked up a bit in fiscal 2016, rising to $585 billion. Now, Congress is contemplating an additional increase in 2017.
Military spending is already set to hit $602 billion based on the latest version of the 2017 National Defense Authorization Act, currently before the Senate. Sen. John McCain (R-Ariz.) has proposed bumping that number up by another $17 billion.
For military contractors like Kratos Defense & Security Solutions (NASDAQ: KTOS) and CACI International (CACI +1.09%), this is great news. But it still leaves us with the question: Which defense contractors will benefit most from increased defense spending? And most pertinently, which is the better stock to buy?
Let's take a look.
Kratos Defense & Security
Priced just under 18 times trailing earnings today, with negative free cash flow, no dividend, and a long-term earnings growth that analysts polled on S&P Global Market Intelligence put at no better than 3%, Kratos Defense stock doesn't look like much of a value at first glance. And the second glance isn't much better.
Analysts don't spend a lot of time focusing on Kratos, which at less than $250 million in market capitalization just gives them a lot less to look at compared to the giants of the defense industry -- the Lockheed Martins, Northrop Grummans, and the like. But what time they do spend predicting Kratos' fortunes seems to uncover nothing but misery. Projections for the next two years show Kratos' current GAAP profits evaporating, to be replaced by two years of losses -- much like the previous three years, in which Kratos also lost money.
CACI International
The situation at CACI, a much larger, IT-focused defense contractor, is night-and-day different. Nine times Kratos' size with its $2.3 billion market cap, CACI has proven itself capable of producing consistent profits -- $140 million last year and $145 million a year on average over the past five. Profits may not be growing, but at least they're consistent.
And profits may grow, at least, if analysts are to be believed. On average, analysts polled by S&P Global predict a 10% long-term earnings growth rate at CACI.
What's more, CACI's profits appear to be of the high-quality variety. Free cash flow for the past 12 months amounted to $204 million -- 45% ahead of reported net income. So while CACI's price-to-earnings ratio (18.7) is similar to Kratos' (17.8), CACI's price-to-free cash flow ratio is quite a bit better -- at just 11.1.
An open-and-shut case
Optimists may insist that at 0.38 times sales, there's still reason to prefer Kratos stock over CACI's, which sells for 0.65 times sales -- but I think that's grasping at straws. The mission of any business -- of any stock, more specifically -- is not just to simply rack up revenues but to transform those revenues into profits for the shareholders. Quite simply, CACI is better at earning profits than Kratos is.
Now, would I buy CACI stock myself? Honestly, probably not -- 11.1 times free cash flow isn't a terribly high price to pay for a stock growing at 10%, but it's not quite cheap enough for my taste. Also, CACI sports a relatively high debt load of $1.5 billion net of cash, and it pays no dividend whatsoever.
That being said, in a head-to-head with Kratos, there's simply no contest here: CACI is by far the better stock. Just because I think it's too expensive to buy today doesn't mean that, were the right price to emerge tomorrow, I wouldn't be ready and willing to buy.
