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

Kratos Defense & Security Solutions (KTOS +5.86%) and CACI International (CACI +3.28%) are two very different companies who rely on a common customer: The U.S. government. Kratos is a onetime wireless-infrastructure vendor who in recent years has focused on microwave electronics, satellite communications, and, most recently, drones. CACI meanwhile was founded in the 1960s by a pair of RAND Corp. alums interested initially in commercializing a software programming language.

Today they are both part of a middle-tier of government contractors who, while not as well known as defense primes like Lockheed Martin or General Dynamics, offer some of the same characteristics that make those primes attractive investments. The government is a reliable, albeit sometimes slow, bill payer with an insatiable appetite for additional goods and services. Both CACI and Kratos have established themselves as key suppliers in areas of government need.

A Kratos BQM-167 aerial target drone is moved into position. Image source: Kratos.

Both companies have also enjoyed a significant run-up in share price over the last few years, with CACI up 100% from three years ago and Kratos up 61% during the same time. Can that strong performance continue? Here's a close look at the two businesses to determine which, if either, is the better buy today.

Data source: Yahoo! Finance. Data as of June 26. TTM = Trailing Twelve Month. Forward earnings based on consensus estimate.

Drone pioneer

Kratos Defense in recent years has dabbled in a number of areas, but following the recent sale of its public safety & security division for $70.7 million in cash it is increasingly becoming a vendor of drones and other unmanned systems. Investors should note the company has an unsettling history of making promises about profitability and then failing to deliver, but Kratos seemingly is showing progress toward seeing its bet on unmanned systems pay off.

The majority of Kratos' current drone revenue comes from high-speed, jet-powered aircraft used for target practice by the military, but the company is in the process of developing high-tech platforms that it hopes will one day fly alongside crewed aircraft to provide additional firepower and to act as a decoy to confuse anti-aircraft systems.

Earlier this year Kratos won U.S. State Department approval to market one of those platforms, its Mako drone, internationally. In April, privately held Dynetics was selected by the Pentagon to develop a program that can launch and recover drones from military aircraft. Kratos is providing drones to the Dynetics bid and could generate hundreds of millions in revenue should the system eventually hit mass-production.

Kratos has its share of skeptics, with short-seller Spruce Point Capital in March accusing management of "tremendous value" destruction and predicting shares could fall by upwards of 70%. The fund reiterated its skepticism on May 15 after first quarter earnings, questioning Kratos' cash flow and calling it a "trust us" story. Kratos is not cheap by mid-tier defense standards and is going to need for its current projects to come good to justify its valuation and see it grow.

Spruce Point's characterizations are not without merit. A bet on Kratos today is a bet that this time will be different. While the drone business appears promising, and the government initial response encouraging, Kratos' history suggests investors would be wise not to get ahead of themselves.

Government services vendor looking to expand

CACI International is a provider of information and consulting services for the Pentagon, intelligence organizations, federal civilian, state, and local customers. Its IT business is focused on systems management and countering cyber threats, while also assisting with a range of intelligence support, logistics, litigation, and reconnaissance support tasks.

Shares of CACI got a boost earlier this month after upping estimates at its annual investor day. The company initiated fiscal year 2019 earnings guidance of $8.98 to $9.38 per share, above consensus $8.92, despite a slightly higher than expected tax rate, thanks to a robust outlook for future bookings. The company also raised earnings guidance for the remainder of 2018 thanks to federal discretionary spending expected to be up 6% in the current fiscal year and another 3% in fiscal 2019.

CACI is also on the prowl for acquisitions. It surprised the markets earlier this year with an ambitious, and ultimately unsuccessful, $10.1 billion attempt to outbid defense titan General Dynamics for CSRA.

That effort failed, but CACI has the resources to buy something. CACI is expecting free cash flow of "at least" $275 million in fiscal 2019, and given the company pays no dividend and doesn't tend to repurchase its own shares expect that capital to be used for acquisitions.

Scale is essential in the government services business, with federal and state customers looking to hand off increasingly large and complex systems to third parties. CACI is less than half the size of $10 billion-sales Leidos Holdings (LDOS +2.27%) and the newly combined General Dynamics/CSRA government business and is smaller than other rivals including Booz Allen Hamilton (BAH +1.91%) and arguably needs to be aggressive. CACI is an experienced acquirer, having done more than two dozen deals over the last 15 years, but any future purchase will add some integration risk.

Who's the better buy?

These companies offer two very different propositions to investors. Kratos is a rare boom/bust-type company in the defense market, with the potential for outsized returns should all go to plan but some lingering risk that your investment could be wiped out if new troubles arise or those drone programs don't progress as the company hopes. CACI meanwhile has a much more predictable business, but one that is much less likely to double overnight.

I'm optimistic about Kratos' chances to at least establish itself as a high-tech drone vendor and would recommend a small position in the stock to investors with a high tolerance for risk. For those more conservative, CACI is a stable company with some organic upside. But given the high probability of dealmaking, and the risk that comes with it, along with the attractiveness of some of its rivals, I'd put my money in Leidos or Booz Allen over CACI at least for now.

Given the expected growth in the federal budget it's a great time to be looking at second-tier contractors like Kratos and CACI. There are risks associated with both, but for those who can handle potential volatility there is also potential for reward.