Kratos Defense & Security Solutions (KTOS 0.68%) for years has been the rare defense stock that traded on potential and not on hard-and-fast revenue from billion-dollar contracts. Investors have endured management overpromising and underdelivering as the company, a collection of electronics, communications, and target drone assets, attempted to bring its more sophisticated UAVs to market.
It appears investor patience is beginning to pay off. Shares of Kratos jumped higher on May 9 after the company reported fine -- but by no means blockbuster -- first-quarter earnings. The excitement was likely generated by the conference call, in which Kratos management laid out in surprising detail the opportunity and potential timeline for its nascent drone business.
A lot still has to go right, but it appears Kratos is moving closer to making good on all that potential sooner rather than later.
Orders incoming?
Kratos passed an important milestone in early March when its Valkyrie "loyal wingman" drone completed a successful first flight. The Valkyrie is a high-powered aircraft designed to fly alongside crewed fighters to provide extra firepower and act as a decoy.
The Kratos XQ-58A Valkyrie in flight. Image source: Kratos Defense & Security.
Company CEO Eric DeMarco on a May 8 post-earnings call with investors said that since that test flight, conversations between Kratos and Washington have accelerated.
"Over the past several months, we have spent a significant amount of time on Capitol Hill including since the successful flight of the Valkyrie and we believe that there is considerable bipartisan support for this aircraft and Kratos' drone suite," DeMarco said. Since the successful flight, he added, several additional potential customers beyond the Air Force have been in touch to discuss possible applications for the drone.
But the Air Force remains the big target. DeMarco said that during a meeting on May 2 with a House Armed Services Committee subcommittee, the company discussed the Valkyrie and "its affordability, its offensive and defensive counter air measure capabilities, and its ability to soak up enemy fire and to take on enemy air defenses."
He said that the group also discussed fielding the drone as a wingman to both the F-35 and F-15 no later than calendar 2022. That could mean a potential large order not long after the Valkyrie completes its planned demonstration flights this year, as Kratos said it would take about 15 to 20 months from order to delivery as it ramps up production.
The company also believes it could book an order for the Gremlins project, in which it is a major subcontractor, either this year or in 2020. Gremlins is a project launched out of the Defense Advanced Research Projects Agency that calls for a swarm of small, reusable drones that can be launched midair from a C-130 air transport.
A meaningful head start
In early March, around the time the Valkyrie was making its maiden flight, Boeing (BA -0.20%) was unveiling its own wingman drone at an airshow in Australia.
The Boeing Airpower Teaming System (BATS), as the drone is called, was developed in consultation with the Australian government and not the U.S. With the first flight not scheduled until 2020, it is far behind the Valkyrie in terms of development, but given the company's extensive ties to the Pentagon and its massive resources, Boeing is a competitor that cannot be ignored.
Boeing's BATS drone on display. Image source: Boeing.
Some in the defense community have speculated that Boeing released information about the BATS when it did to at least make sure the Pentagon was aware it could soon have multiple platforms to choose between. While Kratos seems confident the military is moving toward the Valkyrie, DeMarco did seemingly take a shot at Boeing, without naming names, in expressing his confidence about Kratos' competitive position.
As you know, over the past several years, we have invested approximately $100 million in a suite of high-performance jet powered UAVs, some of which you were aware of and others we are prohibited by our customers from discussing. This investment along with our industry leading position in high performance targeted drone UAVs and the related customer relationships and credibility we have, have uniquely positioned Kratos as the industry leader and the expected to be multi-billion dollar tactical UAV market. The leadership position that Kratos has today with our tactical UAVs did not and cannot occur overnight for any company, no matter how large. It will take multiple years, hundreds of millions of dollars and unique qualifications. And we currently see no competitor even close to what Kratos is today.
Momentum is building
While things are certainly moving in the right direction, it is important that investors not get ahead of themselves. It does appear Kratos could be nearing actual contracts and revenue on its advanced drone platforms, but even if so, expect the dollar amounts to trickle in slowly.
An initial order of, say, two dozen Valkyries at upward of $4 million apiece would generate about $100 million, but that would be spread over the company's 20-month production timetable, or six quarters. Similarly, Gremlin drones are expected to cost less than $1 million apiece.
That's a step in the right direction but still a long way off from justifying the shares' current 56-times-forward-earnings multiple. Kratos does have other businesses with potential: Its space communications segment could be among the big winners from the government's Space Force push and efforts by Elon Musk's SpaceX and other commercial operators to provide internet connectivity from above.
Kratos, unlike most of the staid defense sector, remains a stock bought based on faith and hope and not, for now, massive, multiyear guaranteed contracts. The good news for investors is that based on the company's progress, buying in requires a lot less faith and hope today than it did a year ago.
Kratos, even at its elevated valuation, is an interesting speculative buy for an investor with a tolerance for risk. Just understand that however much progress the company has made, the drone wars are far from over.
