When Kratos Defense & Security Solutions (NASDAQ: KTOS) reported its fiscal Q2 earnings last week, investors rebelled. GAAP profits, promised three months ago, had failed to materialize. More promises of growth in profits were made -- but with no profits to begin with, investors were rightly skeptical of how Kratos intended to grow something that didn't exist.
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Kratos stock crashed 10% in response to the bad news, and it hasn't recovered since.
Will the stock recover? That may depend on the story that's unfolding behind the numbers at Kratos. And to give investors some insight into that big picture, Kratos laid out its vision for what the future holds in a post-earnings conference call.
Let's listen in, as Kratos lays out five key things it thinks investors need to know to understand why its future may look brighter than its recent past.
Drones are the future
For the second quarter's performance, Kratos' unmanned aerial drone systems business generated 42% sequential revenue growth over the first quarter's results. Since we last reported to you, it has become even clearer that our strategy that we laid out five years ago in the high-performance jet-powered unmanned aerial drone system area is working.
-- Kratos CEO Eric DeMarco
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Kratos does a lot of things for the military -- satellite communications, command and control, and RF signal interference identification. DeMarco calls Kratos' cybersecurity and training systems division "the operational star and the jewel of our company," responsible for generating 70% of the company's revenue and all of its operating profit.
In contrast, Kratos' unmanned-systems division, which produces drones for military target practice and is working to build a new generation of unmanned combat aerial vehicles, produced less than $76 million in sales over the past year -- just 11% of total revenue. But unmanned systems could be Kratos' biggest business in the future. Already, the division is working on LCASD, UTAP-22 Mako, and Gremlins combat drone projects for the Pentagon, the last one as a subcontractor.
Kratos also says it is pursuing "secret and restricted opportunities" in the drone space.
"Secret," you say?
A new program from a U.S. government agency [will yield] [b]y the end of this year ... a new multiyear order for up to a total of approximately 100 drone aircraft. ... If we receive this new program award later this year, this could represent up to an incremental $25 million to $35 million of revenue per year to Kratos, with deliveries beginning in the second half of '18.
One such secret program -- about which Kratos is keeping pretty mum -- is this unidentified drone, to be ordered by an unidentified agency. (Its initials are probably "D.o.D.") At $25 million or more per annum, this secret program has the potential, all on its own, to grow Kratos' drone business by nearly 50%.
This program won't be on its own, however. In fact, reviewing Kratos' post-earnings-call transcript, I found mentions of multiple multimillion-dollar contracts that Kratos expects to receive -- $15 million to $20 million from one production run on "a new confidential program," followed by "25% to 30% greater" revenue on a second production run, "$100 million or more" from "a new program award," and "$100 million plus" from a "training opportunity in an unmanned aerial drone system ... for approximately 90 aircraft."
That's all on top of the initial $25 million to $35 million mentioned. And these are only the projects with numbers attached to them. Kratos says it's also targeting "three brand-new opportunities with three new potential customers for tactical applications of our unmanned drone aircraft," and "a number of additional opportunities we have also not publicly disclosed."
But keep all this hush-hush, OK?
Certain events occurring most recently [are] requiring us to go into a stealth mode, with reduced specific disclosure and discussion on certain programs and initiatives that we are working on. This required restricted and reduced disclosure mode, it is for both national security-related and competitive reasons, including requirements from certain of our customers.
If a lot of what Kratos revealed in its conference call sounds like glowing generalities and wide ranges of numbers -- well, that's partly by design. Operating in the secretive world of defense contracting, Kratos is understandably hesitant to go into a lot of specifics on its most sensitive projects. Granted, this makes it harder for investors to get a handle on the company's prospects. But with Kratos stock up nearly 100% over the past year, this seems to be a risk that investors are happy to take. Still, they should at least be aware of the risk.
Not all of Kratos' work is tippity-top secret, of course. The Subsonic Aerial Target (SSAT) program, for example, is a bit better known.
Expect a big Q3, Q4, and more
In late June, which fell in Kratos' Q3 reporting period, we received the anticipated U.S. Navy SSAT program, low-rate initial production, year-one contract award for 40 unmanned aerial drone systems. ... [C]ontract value is $37 million, and is expected to be substantially earned over the next 12 to 18 months.
The Navy SSAT program ... is expected to drive the doubling of Kratos' Unmanned Systems business over the period from 2016 to 2018. ... ...
The second half of the year for unmanned business is going to be ... very powerful. Revenue and profit, very, very strong.
This SSAT contract could begin generating revenue as soon as this very quarter, and certainly by Q4. Kratos CFO Deanna Hom Lund echoed the CEO's assurance that Kratos' "fourth quarter is expected to be particularly strong, which includes the expected ramp for SSAT and the confidential LRIP programs."
Further out, DeMarco's promise of "doubling" drone revenue by 2018 suggests that SSAT sales will push drone revenue above $150 million in sales next year. Factor in sales from the "secret" combat drone programs, and sales should swell even more. The big question is how much profit will result from these sales.
Kratos hasn't ever come close to $150 million in drone sales before. The closest it got, in 2013, was just over $121 million in revenue -- and $17 million in losses. DeMarco's comments suggest the company will do better than that this year, but only time will tell.
Cash is coming
We are maintaining our free cash flow guidance for '17 of a use of $23 million to $28 million [after deducting] total capital expenditures. ...
We expect our total capital expenditures to be in the range of $28 million to $33 million for FY '17, with approximately $18 million to $23 million related to our Unmanned Aerial Systems business.
We expect that these cash investments for our unmanned tactical initiative will be substantially completed in '17 and that we will return to free cash flow generation in fiscal '18.
Meanwhile, Kratos continues to burn cash as it seeks to grow the drone business -- of this it seems certain. The hope, of course, is that as Kratos' combat drone development evolves into combat drone sales, cash will begin flowing into the company. Combined with a trailing off of spending on development, this could turn the company free-cash-flow positive (i.e., Kratos will begin generating cash profits) as early as six months from now.
After four long years of burning cash in its quest to become the military's preeminent supplier of combat drones, this will be a welcome change.
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