3 Reasons Boeing Should Buy Kratos Defense

By Markets Fool.com


Kratos Defense's UTAP-22 combat drone -- just one of three reasons Boeing should buy Kratos Defense & Security. IMAGE SOURCE:KRATOS DEFENSE.

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Down 6% in June, 21% in May, and 39% over the past 12 months, tiny Kratos Defense & Security stock is in real trouble. At the same time, much larger defense company Boeing isn't looking so hot either, having lost 12% of its market cap over the past 12 months.

But could these two stocks be a match made in heaven? Could it be that Boeing might want to take a look at buying Kratos stock, bringing the smaller company in-house?

I think it should. And now I'll tell you why.

Looking for Boeing's missing piece

We all know Boeing is the world's biggest producer of commercial airplanes. But in fact, Boeing makes nearly as much profit from its defense business as it does from selling commercial jetliners -- even though its defense business is less than half the size of its commercial business, in terms of revenue.

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Simply put, defense generates strong profit margins for Boeing -- but perhaps not for long.

Rumors have swirled for years about the imminent stoppage of Boeing's F/-15 and F/A-18 fighter jet production lines. For years, Boeing has bobbed and weaved and managed to keep production rolling, but ultimately, its luck must run out. In fact, last month, new Boeing Defense head Leanne Caret basically admitted to the Wall Street Journal that Boeing's days as a fighter-jet maker are numbered. But she also expressed hope that what revenues Boeing loses from no longer producing fighter jets, it will be able to make up by entering into new defense-related businesses.

Kratos could help with that.

A piece in search of an owner

For the past several quarters, Kratos Defense has invested "significant" sums (for a company of its size) in developing a new armed combat drone that it calls the UTAP-22 Tornado. Jet-powered, with a top speed of Mach 0.9, a ceiling altitude of 50,000 feet, and the ability to carry more than 500 pounds of ordnance internally and on wing-mounted hard points, UTAP may finally be the unmanned combat drone that the U.S. military has been looking for to take drones into the world of aerial dogfighting.

Problem is, Kratos has yet to persuade anyone to actually buy its combat drone. Meanwhile, as it searches for a buyer, development costs on the UTAP-22 have burned a big hole in its balance sheet, turning the former cash-profitable company into a cash-burner and contributing to Kratos' reporting its biggest quarterly loss last quarter in nearly two years.

But here's the thing: All the losses that Kratos has incurred in developing UTAP -- all the losses the company has incurred in the past 10 years in fact (according to data from S&P Global Market Intelligence) -- amount to less than half a billion dollars, or about as much profit as Boeing makes in just one month.

Continuing to develop and try (and fail) to find a buyer for UTAP could ultimately prove fatal to Kratos' business. But for a company of Boeing's financial heft, those losses would just be the initial cost of doing business, before ultimately succeeding in finding a market for the craft.

What's in it for Boeing?

And that's just if all Kratos had to offer Boeing was its combat drone. In fact, were Boeing to buy Kratos, it would acquire a $653 million annual revenue stream of new business -- revenues that would cost Boeing no more than 0.4 times sales to acquire at current valuations, a mere fraction of Boeing's own P/S ratio.

Were Boeing to acquire these revenues and succeed in applying its own 7.2% operating profit margin to them (instead of, say, Kratos's own negative 1% operating profit margin), it would quickly turn Kratos' money-losing business into nearly $50 million in annual profits for itself. That profit, it turn, would be enough to pay for the entire cost of an acquisition in about five years, even if Kratos' revenue stream grew not at all.

Now, will Boeing actually buy Kratos? I have no idea. I don't, in fact, know if Boeing is even considering the idea. But between UTAP, $650 million in new revenues, and potentially $50 million in extra profits, I see three strong reasons Boeing should buy Kratos Defense.

And I have to wonder if Boeing sees those, too.

The article 3 Reasons Boeing Should Buy Kratos Defense originally appeared on Fool.com.

Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 278 out of more than 75,000 rated members.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.