In a week of strong earnings reports from American defense contractors, positively received by investors, the report filed by Kratos Defense & Security Solutions (NASDAQ:KTOS) stood out from the pack. On one hand, Kratos reported only a meager 5% gain in sales -- and lost money on those sales to boot. On the other hand, though, the company claimed to have earned a pro forma profit. And no sooner had it reported this profit than Kratos stock shot 22% higher -- and hasn't looked back since.
Was it the single penny per share in pro forma that Kratos reported that made all the difference, and sent its stock shooting to the moon? Or was there something even more significant that got investors all hot and bothered? To find out, we listened in on the company's conference call.
Here are five things they told us that we thought you'd like to know.
Thing 1: The more you know
"Major representative programs that we support in our satellite microwave and modular systems business include AEHF, WGS, Iron Dome, Sling of David, Arrow, BARAK, SPYDER, Patriot, DDG-1000 and a number of classified programs." -- CEO Eric DeMarco
Did you know that Kratos is involved in these programs? I didn't (at least, not in all of them). In particular, Iron Dome and David's Sling are well-known Israeli missile defense programs, on which Raytheon (NYSE:RTN) is known to be partnering -- in tandem with Raytheon's much better known Patriot program, of course. Knowing that Kratos, too, has a hand in their making shows that this company plays a valuable part in some very valuable and growing programs.
Thing 2: Everything's going great, except for maybe the most important thing
"Kratos' satellite business, along with every other Kratos business unit except unmanned systems where we're investing in a new growth market area, are all generating positive operating cash flow."
Kratos used $12.4 million in cash on its operations in the first half of this year, then invested a further $3.5 million in capital expenditures, resulting in free cash flow of negative $15.9 million for H1 2016. That was already a pretty steep decline from the $20.3 million in cash burnt in H1 2015. And now we learn that aside from the company's UAV (drones) division, Kratos would have actually generated cash from operations, and potentially free cash flow as well, but for the investments it's making in developing new drones for the military.
Thing 3: Tic-tac-toe, three drones in a row
"With the recent LCASD win, Kratos has in 2016 been awarded each of the three new tactical UCAVs opportunities that we have pursuing for the past year. LCASD, Gremlins and one additional contract."
Speaking of drones, when last we checked in on Kratos, the company had successfully landed two out of three important drone development contracts for the military, for which it had competed. As we now know, the missing third contract was "LCASD" -- and Kratos has won that one as well.
So far, none of these programs is a big money-maker for Kratos -- hence the negative cash flow from drones. The Gremlins contract, for example, brought Kratos only $3.9 million in funding. LCASD, while larger, is still only worth about $7.3 million to the company at this stage.
But that's not all ...
Thing 4: And one more (drone)
"We are confident today that Kratos' UTAP-22, tactical UAS will receive government funding either later this year or in 2017."
This is pretty big news. Up until now, Kratos has been funding the development of its UTAP-22 (dubbed "Tornado") internally. The fact that the government has not been paying for its development is directly responsible for all the cash drain that drones have inflicted upon Kratos in recent years.
If DeMarco is correct, however, and the government does award Kratos a contract to build (and sell?) UTAP-22 Tornado drones to the military this year, then that cash drain could immediately cease, and UTAP could begin producing cash for the company, instead of subtracting it. Granted, it's also possible that any UTAP contract Kratos receives could be a small dollar award along the lines of what it's won for Gremlins and LCASD -- but even a small contract would help to mitigate the cash drain.
And now, a bit more detail on UTAP.
Thing 5: Why UTAP is important
"The vast majority of UAV's and the DoD inventory today are propeller planes design to perform their mission primarily in uncontested airspace where the United States controls the sky. These aircraft are vulnerable to sophisticated adversaries as they're generally slow moving, easily identifiable and not very maneuverable... [In contrast,] Kratos unmanned aircraft are high performance jets, which have been specifically designed with jet strike fighter aircraft capability and performance in mind. Kratos' unmanned aircraft are designed to perform their mission in a contested environment in airspace against the potential adversary that is a near peer or peer in war fighting to us and technological capabilities to the United States. Our aircraft have systems, countermeasures, and the performance features needed to defeat missiles or other threats that maybe coming at them.
Other than Kratos' UAVs there are very few, if any high performance unmanned aerial systems addressing the anti-access area denied contested aerospace environment which the DoD has clearly identified as the U.S. capabilities gap. We believe that Kratos is the world leader in these types of high performance unmanned aircraft and we believe based on needs and requirements that the future market opportunity will potentially be up to thousands of these types of low-cost, high-performing systems."
That was a pretty long excerpt, but I think it's important to understand why -- at least from Kratos' perspective -- LCASD and UTAP are transformative products with the ability to transform Kratos itself into a profitable company.
Kratos expects to sell these planes for anywhere from $300,000 to $5 million each. LCASD, the larger drone, will probably be priced at $2 million or $3 million. This implies that UTAP will sell for less than $2 million per aircraft. But even so, multiplied by "hundreds or thousands of these aircraft being produced in the future," we're therefore talking about contracts potentially valued in the billions. And to put that in context, over the past four years, Kratos' UAV division has averaged sales of about $90 million annually.
Management believes that if LCASD "is successful, it could become the largest opportunity in Kratos' history," and investors are betting he's right. This, quite simply, is the reason that investors have bid up Kratos shares 35% from their pre-earnings price.