What happens when a tiny company -- less than $800 million in market capitalization -- promises to disrupt the entire way America wages war? What happens to its stock when this company says it can replace manned fighter jets, which have dominated the battlefield airspace for decades, with a new generation of armed combat "drones" that do everything a jet fighter can at a fraction of the cost?

Answer that question, and you'll understand why Kratos Defense & Security Solutions (NASDAQ:KTOS) has become perhaps the most exciting "story stock" in the defense industry today.

Last week, Kratos reported its financial results for Q1 2017 -- and at first glance, they weren't much to look at. Despite growing sales nearly 10%, Kratos lost money on the bottom line. That hardly seems like the kind of news to ignite a stock rally. And yet, that's exactly what happened last week when Kratos stock exploded 18% higher in a single day.

An artist's depiction of drone fighter jets.

Kratos sees squadrons of combat drones in its future. Image source: Kratos Defense.

So what's the real story at Kratos? Let's listen in on the company's post-earnings conference call, as Kratos management reveals a few things going on behind the scenes at this remarkable company.

1. Drones, drones, and more drones

We recently met with our U.S. Navy customer on our SSAT unmanned target drone system program, our BQM-177 aircraft, and we are ready to begin production once the 2017 [Department of Defense] budget is formalized. We expect first full-year incremental revenue for production option 1 and related ancillaries to be approximately $30 million to $40 million.
-- CEO Eric DeMarco

Kratos referred to this contract in its actual earnings release, but did not mention the size of the contract there. At $30 million to $40 million per batch of BQM-177s, this is a sizable deal. It's also worth pointing out here that Kratos' combat drones -- which are capturing all the headlines lately -- are actually an outgrowth of the company's legacy business building remotely operated targets for the military to practice shooting at.

Last year, that target business yielded revenue of less than $76 million for Kratos, but business is apparently booming, and target drones could be a big revenue driver for Kratos going forward.

2. But Kratos is more than just drones

In Q1, Kratos' satellite communications, cybersecurity, technology, and training division once again was the operational, financial, and execution performance jewel of the company, which we expect to continue throughout 2017. ... The DoD continues to expend considerable resources ... to prepare for a potential war in space, which is now being militarized by Russia and China. ... Kratos'-owned and -operated global satellite demonitoring business ... continues a strong growth trajectory, with approximate 61% growth in Q1 '17 revenues over Q1 '16 from both existing and new customers.
-- DeMarco

Of more importance to Kratos is this "jewel" -- Kratos Government Solutions -- which, at $466 million in revenue last year, is actually the company's flagship business. According to data from S&P Global Market Intelligence, it's also the company's only profitable division, earning operating profit margins of 3.7%.

And suffice it to say that, when your biggest revenue producer is growing at 61%, that's good news for the company as a whole.

3. Kratos inside

[In Q1...] India announc[ed] a $1.6 billion deal with Israel Aerospace Industries for Barak-8 missile systems ... [that] will include 600 Barak-8 missiles, and Kratos' content per missile is approximately $35,000. ...

Also in our Microwave Electronics business, we expect to receive an order later on this year on the Gripen fighter program, where we support the electronic warfare system. Kratos' content per Gripen aircraft is approximately $200,000 to $250,000 per plane, with initial quantities currently being estimated at approximately 100.
-- DeMarco

In addition to its own "name" programs, Kratos also supplies high-tech innards for many weapons produced by other companies. The Barak program should produce $21 million in incremental missile revenue for Kratos. Gripen will be another $20 million to $25 million -- and now we know that whenever Saab sells a Gripen, Kratos collects at least a $200,000 check.

4. But seriously -- tell us more about the drones!

On Kratos' contract with the Defense Innovation Unit Experimental, or DIUx, we remain on schedule and on budget for a number of Kratos UTAP-22 UCASs now formally named "Mako" to participate in a major military exercise in the second half of this year. ...

We remain on track on our Air Force Research Lab LCASD contract, being both on schedule and on budget ... We are tracking toward a Q2, Q3 2018 demonstration flight for this large tactical unmanned combat aerial system. 

And finally, we have ... a new low-cost, high-performance, jet unmanned aerial system Kratos has developed, what I will call our secret, special programs group. We have had several successful demonstration flights with a government agency with this new UAV, which, in my opinion, is our most capable aircraft developed to date.
-- DeMarco

Keeping track of all the different combat drone programs Kratos has in the works is no easy task -- but these post-earnings conference calls do help. After making a few remarks concerning Kratos' subcontractor role (under Dynetics) on the DARPA Gremlins program, for example, DeMarco segued into this discussion of Kratos' other combat drone programs.

By my count, after losing some competitions and winning others, Kratos' active combat drone programs now include:

  • Gremlins (as subcontractor)
  • DIUx / UTAP-22 / Mako -- the drone formerly known as "Tornado"
  • LCASD -- the " Low-Cost Attritable Strike unmanned aerial system Demonstration" program, which could yield hundreds of drone sales, and hundreds of millions of dollars of revenue
  • a "secret, special program," yet to be revealed
  • "a brand-new airplane," also somewhat mysterious, for which Kratos has already "got the initial contract" for $1.6 million

So all together, that's at least five rolls of the dice Kratos has in hand with which to try to make it big in combat drones. But it still leaves us with one big question:

5. When will Kratos start making money?

[E]very Kratos business unit is expected to be operating cash flow positive in 2017 except Unmanned Systems... We expect the majority of our tactical unmanned investments to be complete by the end of 2017, and we expect every Kratos business unit to be cash flow positive in 2018....

[W]e are expecting significant revenue, profitability, and free cash flow increases in 2018. ...

[In response to an analyst's question later:] I am fully expecting a return to profitability in Q2 [2017], and I'm expecting that profitability to increase significantly [in the] second half of ... '17...
 -- DeMarco

We are updating our free cash flow guidance for '17 ... to a use of $23 million to $28 million ...

[W]e expect our total capex to be in the range of $28 million to $33 million for '17, with approximately $18 million to $23 million related to our Unmanned Aerial Systems business ...

[Ou] estimated cash investment for the Unmanned Systems business in 2017, including the LCASD capital and other development costs, is $25 million to $33 million or substantially all the free cash flow use we are estimating for the corporation for the year. We expect that these investments for our unmanned tactical initiative will be substantially complete in 2017 and that we will return to free cash flow generation in 2018.
-- CFO Deanna Hom Lund

That's a lot of numbers to parse, so let's break this down for you. Kratos is saying that in 2017 -- this very year -- it will:

  • Generate positive operating cash flow of about $5 million, spend between $28 million and $33 million on capital investments (mostly related to combat drones), and thus end the year with negative free cash flow of between $23 million and $28 million.
  • But begin reporting GAAP net profits as early as this current Q2, and grow more GAAP profitable as the year progresses.

That alone is very good news, given that Kratos has only reported a full-year GAAP net profit once so far this decade (in 2015). Kratos also hasn't generated positive operating cash flow since 2014 -- but this year, it expects to repeat that feat.

The news gets even better next year, with Kratos promising 2018 will show:

  • Positive free cash flow -- perhaps as much as $33 million with no further capital investments in the drones program required.
  • And growth in (and so, by definition, positive) net profits as well.

At last report, analysts who follow the stock agreed that free cash flow would probably turn profitable next year, but the revelation that GAAP profits might turn positive this year -- that must have taken Wall Street by surprise. It helps to explain why investors had such a strong reaction to Kratos' report of another money-losing quarter last week -- and why investors continued to bid the stock up this week as the news sank in.

Now, to keep the bull run running, all Kratos must do is deliver on its promises.

Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.