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Despite Promises Unfulfilled, This Analyst Still Loves Kratos Defense & Security Stock

By Rich Smith - Aug 16, 2017 at 9:32AM

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Kratos Defense surprised investors with poor earnings last quarter, but Drexel doesn't mind.

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

If nothing else, New York-based securities broker-dealer Drexel Hamilton deserves points for loyalty.

Five months ago, Drexel played a key role (as co-manager) in a stock offering that raised $75 million to fund Kratos Defense & Security Solutions' (KTOS -1.37%) continued development of jet-powered combat drones for the military. Three months ago, Kratos promised to use that money to help earn its first quarterly profit in nearly two years. Then last month, Kratos arguably broke that promise, informing investors that instead of turning a profit, it lost $0.07 per share in its fiscal second quarter.

Despite all this, Drexel Hamilton announced yesterday that it is initiating coverage of the stock it helped to sell to investors, rating Kratos stock a buy and assigning it a $14 price target.

Here are three things you need to know about that.

Kratos MAKO drone

Kratos Defense makes drones for the military -- but it doesn't yet make profits for itself. Image source: Getty Images.

1. What Kratos said about last quarter -- and next quarter

For those who missed the earnings announcement, here's a quick recap. Last month, military drone specialist Kratos reported 10% sales growth in its fiscal second quarter, combined with a reduction in losses -- but still no profit. After losing $0.17 per share in Q2 2016, the company shrank its per-share loss to just $0.07 per share in Q2 2017.

Citing a whole series of opportunities in the military drone space (some of them quite secret), Kratos management then went on to raise its guidance for full-year 2017 revenue. Management also predicted that its profit margins would improve, and profits would be "very, very strong," but failed to clearly predict a GAAP profit in Q3 or Q4 -- or indeed, to provide any GAAP earnings guidance whatsoever.

2. What Kratos said about next year

That being said, Kratos did reiterate one promise that it had made three months ago: After months of spending on its efforts to develop multiple armed, jet-powered unmanned aerial vehicles for military customers, Kratos would be wrapping up its capital spending for the most part this year. This, said Kratos CFO Deanna Lund, will pave the way for the company to "return to free cash flow generation in fiscal '18."

Precisely how much cash Kratos will generate next year remains unknown, and Kratos provided no details on that front. The final number will probably depend on how quickly the Pentagon adopts and begins ordering combat drones from Kratos -- and how many of them it buys. But management laid out a series of projects it has in the works -- projects numbering in the hundreds of units, and "$100 million plus" in value.

3. And what Drexel Hamilton said about that

All of the above seems to have Drexel Hamilton feeling optimistic about Kratos' future -- albeit, no one on the interwebs seems to have any details on precisely why Drexel has chosen to initiate coverage this week. All we know at this point is that 1. Drexel thinks investors should buy Kratos, and 2. it thinks the stock will hit $14 within a year.

But is that prediction reasonable? I'm honestly not sure it is. At a price-to-sales ratio of 1.6, Kratos stock is already trading well above my usual cut-off point of paying 1 times sales for a defense stock. Despite the expensive valuation, Kratos keeps promising to earn profits and generate cash, but remains both unprofitable and free-cash-flow negative.

Bonus thing: If not Kratos, then who?

Lacking detail on precisely why Drexel likes Kratos despite its earnings disappointment, investors may be inclined to seek out alternative investments. As it happens, Drexel may have some ideas on that score as well.

Earlier in the week, you see, Drexel analyst Peter Skibitski gave an interview to CNBC in which he divided defense spending into "pre-Korea" and "post-Korea." Arguing that North Korea's defense program presents a "palpable threat," the analyst predicted that President Trump's proposal to grow defense spending by 5.5% could nearly double, and morph into as much as a 10% increase in defense spending as Congress considers the Korean nuclear threat.

Curiously, Skibitski made no mention of Kratos in expanding on this theme. Instead, he named several larger defense stocks -- Raytheon (RTN) and Lockheed Martin (LMT 2.53%), for example, and Orbital ATK (OA) and Aerojet Rocketdyne (AJRD 2.11%) as well -- which could benefit from growth in defense spending in general, and from growth in spending on missile defense (i.e., defense against North Korean missiles) in particular.

Granted, like Kratos, none of these companies currently sports a price-to-sales ratio below 1. But unlike Kratos, all four of these named companies are already profitable, and Orbital ATK and Aerojet sell for significantly cheaper P/S ratios than does Kratos. Aerojet in particular, at 1.07 times sales, is just a rounding error away from 1 times sales.

If Drexel Hamilton's endorsement of Kratos stock doesn't appeal to you, it might be worth taking a look at some of these other defense companies.

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Stocks Mentioned

Kratos Defense & Security Solutions Stock Quote
Kratos Defense & Security Solutions
$13.71 (-1.37%) $0.19
Raytheon Company Stock Quote
Raytheon Company
Lockheed Martin Corporation Stock Quote
Lockheed Martin Corporation
$434.87 (2.53%) $10.72
Orbital ATK, Inc. Stock Quote
Orbital ATK, Inc.
Aerojet Rocketdyne Holdings, Inc. Stock Quote
Aerojet Rocketdyne Holdings, Inc.
$40.17 (2.11%) $0.83

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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