Better Buy: Kratos Defense & Security Solutions, Inc. vs. CSRA

Kratos Defense & Security Solutions (KTOS -0.28%) and CSRA (CSRA) are two very different businesses, but they are both reliant on the U.S. government -- specifically the Pentagon -- for the bulk of their revenue. While Kratos is focused on high-tech military hardware, CSRA's expertise is in software and running large IT networks.

Though neither is as well known as the prime defense giants, both are in areas that have attracted considerable attention from investors in recent years. The military still needs tanks, planes, and ships, but increasingly it also needs sophisticated technology -- which contractors such as Kratos and CSRA can develop, manufacture, or keep in service.

Let's take a look at the two companies and try to figure out which is a better fit for your portfolio.

Data source: Yahoo! Finance, as of Jan. 18.  TTM = trailing-12-month.

Drone warrior

Kratos is a onetime wireless infrastructure provider that pivoted to become a government contractor in the last decade. After dabbling in a number of businesses, today it focuses on unmanned systems, satellite communications, microwave electronics, and training systems. It's the drone business that deservedly gets the most attention.

A Kratos BQM-167 aerial target drone. Image source: Kratos.

The company hopes its jet-powered drones, used to simulate missiles in training, will one day serve as wingmen to combat aircraft. Kratos envisions a world where a handful of its drones fly alongside each manned aircraft, increasing available total firepower and acting as decoys to overwhelm and distract anti-aircraft missiles.

That vision is still a long way from becoming a reality. Kratos introduced its next-generation drone platforms just last summer, and is still building a mockup of one of the two models. Kratos is not yet profitable on a GAAP basis, though it does believe it can become cash flow positive in 2018 thanks to expected milestone payments of more than $22 million and a wind-down in capital spending as programs enter initial production.

The company has done a good job keeping its debt under control, bringing down total borrowings from about $650 million at the end of 2015 to $369.7 million at the end of its most recent quarter. There's more to come, with management saying it sees opportunities to restructure and refinance some of its remaining debt and in turn revamp its balance sheet in the coming months. 

A number of contract wins late in the year have given reason for optimism. Investment company Canaccord Genuity in early January reiterated its buy rating on the stock, saying a healthy backlog should deliver revenue growth going into 2018. The firm said that as visibility improves in terms of free cash flow and profitability, investors should gain confidence in the stock. It's worth noting, though, that investor confidence doesn't seem to be an issue for Kratos: Shares of the company are up 52.57% since the start of 2017 and up 128.5% over the past three years.

Military-grade IT

CSRA is a government-focused IT company created in November 2015 via the alphabet-soup merger of SRA International and the public sector business of CSC. The company provides tech services to the Departments of Defense and Homeland Security, as well as to various intelligence agencies and some civil branches.

The company has kept making acquisitions since the merger, spending a combined $340 million last year on two deals to expand its offerings, and has grown to nearly $5 billion in annual sales.

Government IT was a hot growth area as the Cold War ended, amid the expected slowdown in weaponry sales and the need by the public sector to quickly and efficiently modernize its technology. But as numerous competitors rushed into the market, margins dropped. In recent years, as new military threats have emerged, many of the traditional contractors have divested their IT businesses to specialists.

CSRA believes it has the scale to be one of the winners in the business. The company has a backlog of more than $17 billion, including $2.7 billion fully funded, and late last year won a recompete for its largest contract: a 10-year, $2.4 billion program to provide enterprise IT services for a Pentagon agency.

In its fiscal second quarter, which ended last September, the company recorded a year-over-year increase in quarterly revenue for the first time since the merger, and said it expects sales growth to accelerate through the second half of the fiscal year "to and perhaps beyond" its long-term target of 2% to 3%.

"Our market should support continued organic growth over the long term," CSRA CEO Lawrence Prior told investors during the second-quarter earnings call.

Which is the better buy?

It is difficult to compare these two companies. CSRA has about seven times more revenue than Kratos, is consistently profitable, and pays a modest dividend. Kratos is a bet for the future -- perhaps a distant future -- but could pay off big, eventually.

Nevertheless, I'd steer most investors away from these two companies. Drones are interesting and have tremendous potential, but given how far away Kratos' really exciting products are from deployment, I'd rather get my exposure to drones through more well-rounded defense contractors like Boeing or Northrop Grumman. Government IT is a relatively stable business, but it relies on scale, and I like the size and potential upside of Leidos Holdings over CSRA.

Speculative investors might do well opening a small position in Kratos and hoping for the best. But for most, there are better buys elsewhere.