The question of whether Kratos Defense & Security (KTOS -0.79%) will be around in five years took on a fresh sense of urgency last month after short-seller Spruce Point Capital called the company a "strong sell," sending shares down 11%. Spruce Point warned they believe the stock will fall much further, saying the company has 40% to 70% downside risk.
Kratos shares in the weeks since have made back most of what was lost when Spruce Point went public with its criticism, but the longer-term question is still a relevant one. Kratos does indeed, as Spruce Point notes, have a checkered history. It also has a potentially lucrative drone business that, albeit still in the early stages, is providing investors with reason for optimism.
Ben Axler, Spruce Point Capital founder & CIO, told CNBC on March 16 that his firm was short shares of Kratos, and said he intended to hold the short expecting Kratos to fall by at least 40%. The firm has not provided a public update on its position in the weeks since.
Here's a look at the criticism of the company, as well as its potential, in an attempt to determine what the future might hold for Kratos.
A Kratos BQM-167 aerial target drone. Image source: Kratos.
A turbulent history
Kratos, a onetime wireless-infrastructure vendor that pivoted to become a government contractor last decade, has had its share of challenges over the years. As Spruce Point notes, the company has spent about $1 billion to assemble a hodge-podge of defense assets that in recent times has not been able to turn a profit.
Company CEO Eric DeMarco this time last year was forecasting profitability in the second half of 2017, but instead delivered losses. Kratos also burned through $53.5 million in free cash flow last year -- twice 2016's level of cash burn. The company now expects positive cash from operations of $35 million to $45 million this year, and should get a boost from milestone payments and less need to spend on research and development, though it is understandable if skeptics like Spruce Point remain unconvinced.
Kratos has done a good job of slicing in half the $650 million in total debt it had at the end of 2015, but it has done that in part by selling off some of the businesses it acquired in its effort to build its aerospace operations.
Despite the lack of profitability and Spruce Point's criticism, investors have largely been unfazed. Shares of Kratos are up more than 180% after hitting a 10-year low in July 2016, implying it is too late to get in on the bottom floor.
Drone warriors
Optimism about Kratos centers on the company's portfolio of jet-powered drones fast enough to simulate missiles in test runs and which could one day fly as wingmates to combat aircraft. The company today sells missile simulators, while working on its Valkyrie and Mako drone platforms that it hopes will one day fly alongside crewed aircraft providing additional firepower and acting as decoys to distract anti-aircraft systems.
The challenge for Kratos is to move those drones from development to a revenue-producing stage. The company became a huge step closer on April 18 when privately held Dynetics was selected for the demonstration phase of the Defense Advanced Research Projects Agency (DARPA) Gremlins program, a Pentagon effort to create drones that can be launched from and recovered by bombers or transport aircraft.
Kratos is providing the drones for Dynetics' bid, and could capture more than one-third of total contract value should the effort continue to advance. DARPA's goal is to be able to acquire more than 1,000 planes priced at less than $1 million apiece. That could mean more than half a billion worth of revenue to Kratos over the life of the program, should Gremlins be approved.
The real payoff for Kratos will be if its Valkyrie and Mako drone platforms are a success. The Mako has flown in a demonstration alongside U.S. Marine Corps Harrier jets, and in March Kratos won government approval to market the drone internationally. However, a steady revenue stream from these drones is still no sure bet, and will take some time even if it is to develop.
Kratos is a survivor
To be sure, there are a lot of ifs in the bull case for Kratos. And Spruce Point was correct in pointing out some of the past issues Kratos has had that should give long-term investors reason for caution. But Kratos' drones have significant potential upside, and the Gremlins win should be viewed as some confirmation of the company's strong position as a provider of unmanned systems.
The bet here is that Kratos either will still be around in five years or will have been acquired by a larger defense contractor at a premium to today's prices. There is enough uncertainty attached to the company that investors should view it as a speculative investment and not overcommit. But the odds are improving that Kratos ends up a winner.
