One day, Kratos could become a combat drone powerhouse. But can investors afford the wait? Image source: Getty Images.
Last month, news that Kratos Defense & Security Solutions (KTOS 2.88%) had landed all three of the military drone contracts it had been aiming for (and had a lead on another big one) helped to drive Kratos stock up nearly 60%. Today, we're going to tell you a bit more about one of the contracts that fueled that rally.
Low-Cost Attritable Strike unmanned aerial system Demonstration
Kratos actually won the Low-Cost Attritable Strike unmanned aerial system Demonstration (LCASD) contract a month before reporting earnings, on July 11, 2016. LCASD is a new project sponsored by the Air Force Research Laboratory to develop "a high-speed, long-range, low-cost, limited life-strike UAS."
Let's break down those elements for you.
"They were expendable"
In many ways, LCASD appears to be an Air Force equivalent of the old Navy "PT boat" fleet.
"Low-cost" is key, as the U.S. Air Force is working on a tight budget brought about, in part, by the high cost of the thousands of manned Lockheed Martin F-35 stealth fighter jets it's buying to replace its legacy piloted aircraft. Even after cost reductions, those birds cost $100 million or more to buy, so for its unmanned programs, the Air Force is looking to spend considerably less per drone unit put in the field.
"Attritable," or as Kratos puts it, "limited life" is in part a function of the low cost objective. Lockheed's F-35 program, for example, is supposed to have a 60-year shelf life. Once built, each $100 million F-35 should keep on flying for decades before needing to be replaced. Because LCASD drones will be cheaper, however, it's permissible to make them disposable over shorter periods of time.
And finally, "unmanned." Contributing to the LCASD's "attritability" is the fact that these drones will be unmanned. If an F-35 gets shot down, a pilot's life is at risk. If an LCASD drone gets shot down, at least no pilot dies. Hence, these drones don't need to be as survivable as an F-35.
What's in the box
According to Kratos, the Air Force is looking for the following from LCASD:
- A flight range of 1,500 nautical miles, at speeds up to Mach 0.9.
- "Runway Independent Take-off and Landing" capability (perhaps similar to the TERN UAV that Northrop Grumman (NOC 0.76%) is building for DARPA).
- A 500-pound payload (sufficient to carry four Hellfire missiles or two GBU-39 small diameter bombs).
- And the ability to store weapons internally (for stealth).
Furthermore, all of this must come in at a price tag under $3 million during low-rate initial production, falling below $2 million as production ramps up.
M-I-C-K-E-Y...LCASD
This is admittedly a tall order that Kratos has been tapped to fill, but the Air Force clearly believes Kratos is the company to do it. According to the company, it beat out six other competitors to win the LCASD contract. (We don't know which ones, but off the top of my head I can name six much larger defense companies known to have drone programs.) And yet, the reward that Kratos will win for beating out all this competition seems kind of Mickey Mouse.
As Kratos explains, the LCASD program has a base cost of $40.8 million, "with potential additional government funded technology spirals of approximately $100 million." Not all of this money will be going to Kratos, however, or at least not right away.
To the contrary, it turns out that the Air Force is actually only handing Kratos $7.3 million to start up its project, and will be expecting the company to come up with the remaining $33.5 million on its own. As for the "approximately $100 million" to follow, Kratos doesn't clarify who will be footing that development bill. But if funded proportionally to the initial award, Kratos could continue bearing in excess of 80% of the cost of developing this project, and for a period of 30 months or more.
The upshot for investors
So what does all this mean for owners of Kratos stock? There are really two ways of looking at it. On the one hand, there's a big pot of gold at the end of Kratos's rainbow if it should receive orders for "up to 99 units" of LCASD at $3 million a pop, followed by $2 million purchases for LCASDs ordered in lots of 100 units or more. With Kratos currently clocking annual revenue of just $661 million, a 300-unit LCASD order could potentially more than double the company's business, and perhaps at a nice profit margin.
On the other hand, the near-term picture is less promising. At last report, Kratos' investments in drone development had the company burning through cash at the rate of more than $37 million a year (per S&P Global Market Intelligence data). And now it seems the Air Force is quite content to let Kratos continue developing combat drones on its own dime, dangling the prospect of a big payday in front of the company in lieu of cash payment up front.
Long story short: Over the 30 months that Kratos will be working to develop LCASD initially, and perhaps for years thereafter, I see little prospect of the company's cash crunch lightening up. Cash levels will fall, debt will rise, and there's even the prospect that Kratos will need to issue new shares (diluting existing shareholders in the process) in order to cover its costs.
Investors in Kratos may ultimately be proven right -- but success may be a long time coming.
