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Does Kratos' Big Contract Win Make It a Buy?

By Rich Smith - Sep 6, 2018 at 6:31AM

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No -- but it's a good start.

In an average year, defense contractor Kratos Defense & Security Solutions, Inc. (KTOS 6.22%) -- a tiny company with a very long name -- bills perhaps $700 million and change. Over the past 12 months, for example, Kratos' revenues were just over $766 million. Last year's full-year number was $752 million.

Last month, though, Kratos Defense won a single defense contract from the Pentagon that it values at nearly $109 million -- nearly two months' worth of sales, all won in a single day. Could this be the contract that lifts Kratos into the big time?

Drone aircraft silhouette

Kratos makes drones for other people to shoot at. Image source: Getty Images.

The lucrative business of letting people shoot at you for money

For a company of its size, Kratos operates a pretty diverse business.

"Government Solutions," which include the manufacture of electronic components and satellite systems, as well as the provision of training services, represents the company's flagship division, with $480 million in sales accounting for about 64% of Kratos's annual billings. Last month's contract win, on the other hand, went to Kratos' much ballyhooed "Unmanned Systems" division, which at $122 million in annual sales is just a quarter the size of Government Solutions -- but growing much faster, having nearly doubled over the past 18 months.

As Kratos explained in a July press release previewing the August award, the $109 million contract is for the production of "Air Force Subscale Aerial Target System (AFSAT) BQM-167A High Performance Unmanned Aerial Target Drone Systems" -- high tech rocket dummies for the Air Force to conduct air-to-air and surface-to-air target practice on.

As of July, Kratos was sure to receive at least $27 million for the production of 30 BQM-167As for the Air Force -- roughly $900,000 apiece -- with the option of building two additional production lots over the next couple of years. August's contract award, however, confirms that Kratos will be awarded the entire maximum value of the award, implying purchases of more than 120 target drones.

What it means for investors

As the maker of "the highest performance unmanned aerial systems in their class in the world," Kratos won its August contract "sole-source," meaning it didn't have to compete with anyone else to win it. And lacking competition in this area, Kratos says it expects sales of BQM-167A target drones "to be significant future revenue, profit and cash flow growth drivers for" Kratos. This should be true regardless of whether Kratos succeeds in its ultimate aim of becoming the Pentagon's go-to supplier for armed, offensive combat drones.

How "significant" will these revenues be? At $109 million in value over three years, August's target drone contract secures about one-third of Kratos' annual revenue stream for its Unmanned Systems division. This contract win also lends confidence that Kratos' revenues -- expected to decline 15% from 2017 levels this year, according to data from S&P Global Market Intelligence -- will quickly rebound back above the $700 million mark in 2019 and beyond.

Perhaps even more importantly for a company that's been promising to earn a GAAP profit for more than a year now -- but failing to do so -- securing a profitable contract for target drones could give Kratos a chance at finally returning to profitability in 2019 as Wall Street hopes.

Granted, even the most optimistic analysts only see Kratos earning $0.22 per share in 2019, and $0.24 per share in 2020, the two years that should see the bulk of Kratos's BQM-167A drones delivered. That's not a lot of profit to support Kratos's $13.55 share price. Even assuming Kratos succeeds in hitting Wall Street's profits target next year, that would work out to a forward P/E ratio of 61.

Still, it would be a whole lot better than watching Kratos lose money again for its third straight year.

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