Wall Street loves a good story.
What Wall Street doesn't love, apparently, is when a story gets too confusing, with its numbers all mixed up and showing no clear direction. When a story gets as muddled as the one that Kratos Defense & Security (NASDAQ:KTOS) told last week, an investor's natural reaction may be to sell. And true to form, investors did sell off Kratos stock by nearly 3% on Friday.
Was that a mistake?
What Kratos said
To get an idea for just how much confusion Kratos caused investors last week, let's take a quick look at the company's Q4 earnings report, released after the close of trading on Thursday.
Quarterly revenue declined 1% to $164.4 million, with service revenue growing -- but not enough to offset declines in product sales. Gross profit declined as well. However, freed from a large charge to earnings for goodwill impairment that weighed down Q4 2017 results, operating profit turned positive in Q4 2018, coming in at $10.8 million, and Kratos reported a $4.7 million net profit for the quarter, or $0.04 per diluted share.
Thus, despite reporting sales 13% shy of Wall Street analyst estimates, Kratos reported profit greater than what analysts had forecast.
So far, so good.
Good news, bad views
Where things went wrong for Kratos was on guidance, with management forecasting that in Q1 2019 it will book revenue of only $147 million to $157 million. Assuming this is how things do, in fact, play out, those amounts would fall about 11% short of Wall Street's estimates for Q1 -- and it would mean Kratos will miss on sales for a second straight quarter. For a company that can't point to profits as a reason to own it, as it remains unprofitable, that's worrisome news.
That Kratos is promising to make up the difference later in the year, and book revenue of between $720 million and $760 million -- at the midpoint, 2% more revenue than Wall Street projects -- doesn't seem to have allayed investor concerns about the company's near-term performance.
Close, but no cigar
Yet consider that for fiscal 2018, Kratos came very close to reporting full-year profitability, cutting its net loss from $42.7 million a year ago to just $3.5 million in 2018. Free cash flow, a disheartening negative-$53 million in 2017, came within a whisker of fulfilling management's promise to deliver positive free cash flow in 2018. Operating free cash flow was $18.1 million. Minus $22.6 million in capital spending, free cash flow for 2018 was negative-$4.5 million.
There are of course two ways to view these numbers. On one hand, Kratos came very close to keeping its promise to earn a profit and generate free cash flow in 2018. On the other hand, "close" wasn't enough to win Kratos a cigar.
What comes next
Can Kratos do for investors what it promised but failed to do in 2018? Revenue, while not entirely as robust as Wall Street would like to have seen, do look primed to grow in the new year, with Q4 new backlog surging 19% in 2018, and Q4 bookings exceeding revenue by 30%, for a book-to-bill ratio of 1.3.
Furthermore, Kratos' unmanned aerial vehicles division is growing great guns, with sales up "approximately 75% over the past 24 months," and management promising "90% organic growth" in target drones in particular in 2019. Kratos' combat drone initiative, which the company calls its "tactical drone" program, now has six active development projects under way, "with several additional programs expected to be under contract by the end of" 2019.
With momentum on Kratos' side, I don't think it's unreasonable to believe that the company can follow through on its commitment to deliver $740 million in sales (plus or minus) in 2019. And if it does produce these sales, that would work out to 20% growth.
Most analysts at this point agree that 2019 will be the year Kratos finally returns to GAAP profitability and produces its first free cash flow-positive year since 2013, setting the stage for ever-higher earnings and free cash flow in the years to come. Whether this makes Kratos a bargain at $1.7 billion in market capitalization -- nearly 3 times sales -- remains to be seen.