Kratos Defense & Security Stock Surged After Earnings: Is This Bull Run for Real?

By Rich Smith Markets Fool.com

Kratos Defense & Security Solutions (NASDAQ: KTOS) is off to the races -- again.

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After Kratos reported earnings after close of trading on Thursday, its stock enjoyed a one-day, 18.4% bump on Friday as investors cheered the company's growing revenue stream and narrowed losses. Here's a quick rundown of how the numbers looked.

Artist's depiction of armed Kratos combat drones in flight. Image source: Kratos Defense.

Earnings day for Kratos

In fiscal first-quarter 2017, Kratos:

  • Booked sales of $167.8 million, up 9.7% from last year's $153 million
  • Earned gross margins of 26.9% on that revenue, up 340 basis points from last year's first quarter
  • Generated a positive operating profit margin -- 1% -- for the third time in the past four quarters

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Granted, by the time we reach the bottom line, we find that interest payments and other costs have eaten up that small operating profit and left Kratos with a net loss of $10 million, or $0.13 per share. Nonetheless, Kratos insists that the number investors should focus on is its adjusted EBITDA of $10.6 million.

Funny numbers

That last point probably requires some explanation, though, as adjusted EBITDA is not a financial metric you'll often find used by companies able to report actual GAAP profits.

With bottom-line profit still elusive, Kratos is emphasizing instead an extremely non-GAAP metric: Beginning with earnings before interest, taxes, depreciation, and amortization (i.e., most of the costs of doing business), it proceeds to "adjust" this number to exclude "losses and gains from discontinued operations, restructuring and transaction related items, investments in unmanned combat systems initiatives, stock compensation expense, unused office space expense, and foreign transaction gains and losses" (i.e., most of the other costs of doing business).

What's left is $10.6 million worth of something sort of, but not quite, profit -- and therefore not very useful in valuing the company. The good news is that, according to analysts cited on S&P Global Market Intelligence, Kratos is expected to finally turn profitable in 2018. With any luck, we may not have to put up with adjusted EBITDA metrics for too much longer. Presumably, once Kratos does turn profitable again, it will resume emphasizing real GAAP financials -- or so we hope.

But what reason is there to hope that Kratos will, in fact, be profitable next year?

Hope springs eternal

Well, there are a few things to look forward to. For one thing, Kratos raised $81.9 million in cash last quarter from a stock issuance, then used $64 million of that cash to retire debt. Presumably, this 14% reduction in debt will reduce Kratos' interest costs going forward, moving the company one step closer to profitability.

Businesswise, Kratos' flagship government solutions division -- the only one of its three main divisions that is already profitable -- "is seeing strength across virtually every capability area." The company is "forecasting ... strong performance" in this division's satellite communications business going forward.

Kratos' aerial drone target business is also performing well, with plans in place to begin production soon on the U.S. Navy's BQM-177 unmanned aerial target drone program and a contract received to produce more BQM-167 unmanned aerial targets for the Air Force.

At the same time, of the Kratos division that has everybody most excited -- its experimental combat drones division -- Kratos CEO Eric DeMarco says that the Gremlins program is on track, with Kratos as a key subcontractor; several UTAP-22 drones (now renamed "Mako") will make demonstration flights later this year; and the company's LCASD drone for the Air Force Research Lab should make its maiden flight in Q2 2018. At present, none of these programs are big revenue drivers -- but all three have the potential to drive revenue in the future if the Pentagon decides to expand their scope.

Whether they can deliver profits as early as 2018, as analysts hope, depends largely on how quickly the Pentagon decides to buy Kratos' combat drones in quantity. For now, that's the real X factor in deciding whether Kratos' stock price surge last week is the real deal or just a flash in the pan.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.