What happened
Shares of Kratos Defense & Security Solutions Inc. (KTOS 2.82%) plunged 15% in March, according to data from S&P Global Market Intelligence.
In addition to the company's release of its fourth-quarter and full-year earnings, investors responded unfavorably to a critical research report on the company from Spruce Point Capital Management, which identifies 40% to 70% downside risk to Kratos' stock.
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So what
Despite bright spots in the company's earnings report -- revenue growth, and gross and operating margin expansion -- investors found causes for concern with the company's cash flow. For the third consecutive year, Kratos reported negative annual operating cash flow. In 2017, the company reported cash from operations of negative $27 million -- coming after the negative $26 million and negative $12 million that it reported in 2015 and 2016 respectively, according to Morningstar. Management, in the company's 10-K, attributed the challenges in generating cash flow to "contract development costs on new platforms in our U.S. segment" in addition to greater expenses related to "business capture pursuits in the tactical unmanned aircraft systems initiatives."
Besides the earnings report, investors were moved to sell off shares as a result of the pessimism in the stock shared by Spruce Capital. In addition to questioning the integrity of Kratos' management, Spruce Capital expressed skepticism about the company's ability to reach management's annual revenue target of $800 million and an EBITDA margin of 10%.
Although it didn't mention Spruce Capital by name, Kratos presumably had the investment manager's report in mind when it published a statement on its website in response to "a report on the Company that has recently been published in the market place." Supporting its claim that the critical report "includes statements that are factually incorrect and makes misleading assertions related to Kratos and its leadership," management identified that the company's qualified bid and proposal pipeline at the end of 2017 was approximately $6.8 billion; moreover, it estimates that insiders own approximately 15% of the company, speaking to management's vested interest in Kratos' future success.
Now what
The fall in Kratos' stock last month shouldn't come as a surprise. When the bears on Wall Street announce their concerns about a stock, investors on Main Street often become frightened. But it's crucial to note that the critical report comes with an important caveat: Spruce Capital would benefit from the stock's decline.
Moving forward, investors should monitor the company's success in bringing orders through its pipeline to actual sales, and whether the company is able to return to generating positive operational cash flow -- two things that would speak louder than Spruce Point's concerning words.
