Kratos Defense & Security Solutions (NASDAQ:KTOS) bills itself as "a leading National Security Solutions provider." It's also supposedly the lead contractor helping to build the U.S. Navy's Laser Weapon System, currently on patrol in the Persian Gulf. But if you've never heard of Kratos, that's still not surprising -- the whole company sells for a market capitalization of less than $300 million, making it one of the smallest publicly traded defense contractors in the United States.
Yet Kratos made headlines last week regardless, when it reported earnings, and saw its stock drop 2.6% in response.
What went wrong?
Releasing earnings for fiscal Q3 2015, Kratos reported a 15% decline in revenues compared to Q3 2014 -- just $161.7 million. It also noted improved gross margins -- but not improved enough to keep the operation profitable on a lower revenue base.
Pretax operating profits therefore dipped into the red, with losses of $11 million (about on par with last year). Yet somehow, Kratos emerged from the quarter with a net profit of $0.93 per share.
All together now: "How'd they do that?"
How they did that
The answer comes in two parts: First, Kratos booked a nice increase in tax benefits. At $15 million, this credit was more than enough to offset the quarter's operating loss. Additionally, Kratos booked a $51 million gain on the sale of its U.S. and U.K. Electronic Products business. It was this one-time gain that ended up producing essentially all of Kratos' profit for the quarter.
The downside to that, of course, is that now that it's been sold, that business can't produce any revenue (or profits) for Kratos in future quarters.
What's next for Kratos?
To replace those lost revenues, Kratos is diving headfirst into the wide, wonderful world of unmanned aerial vehicles. For a company of its (small) size, Kratos already has a hand in a surprising number of the Pentagon's most cutting-edge weapons systems -- from laser cannons to electromagnetic railguns. What Kratos seems most excited about, though, is its new UTAP-22 experimental unmanned tactical aircraft program.
Kratos already builds drone aircraft for the Navy and Air Force to use in target practice, but UTAP-22 is apparently a Pegasus of a different color. The company describes UTAP-22 as "a high performance" unmanned jet aircraft, capable of both remote-control and semi-autonomous operation, and "designed specifically for survivability in challenging and hostile environments." That's about all we really know about UTAP-22, though. Developed with Kratos' own funds, the project is very hush-hush, and Kratos has declined to provide "flight information or aircraft performance characteristics" on the drone.
Lasers and railguns and drones (oh my!) are all very high-tech and sexy projects, of course. But when you get right down to it, investors still want to see Kratos make some money off them -- else the stock really isn't worth owning. So what are the prospects for that?
Well, it could happen, I suppose. But honestly, and unfortunately, those prospects just don't look very great. Last quarter's subsidiary-sale windfall profit aside, Kratos hasn't earned a full-year GAAP profit at any time in the past four years.
The free cash flow picture is a bit better -- but even so, cash profits at Kratos have averaged just $10 million annually since 2010. Even on a sub-$300 million stock, that works out to a valuation of nearly 29 times FCF, which seems kind of steep given that most analysts who follow the company forecast earnings growth of about 3% annually over the next five years.
Long story short, despite all the whiz-bang technology, I'd still rather be short Kratos than long.