Is Kratos Defense & Security Solutions a Buy?

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Kratos Defense & Security (NASDAQ: KTOS), despite some ups and downs, has rewarded investors in recent years, with shares up 55% in the past year and almost 140% over the past three years. It is a company full of potential, but which has so far had trouble turning that potential into profits.

Is it too late to jump on board? Let's take a deep dive into the company and see if Kratos is a buy.

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A bet on unmanned air power

Kratos, a onetime wireless infrastructure vendor that pivoted to become a government contractor last decade, is today focused on unmanned systems, satellite communications, microwave electronics, and training systems. It is that unmanned systems business that has generated the most excitement.

The company makes jet-powered drones able to simulate missiles in test runs today, and which will one day hopefully fly as wingmen to combat aircraft, increasing each manned-aircraft's total available firepower and acting as decoys to overwhelm and distract anti-aircraft missiles.

The drone business has largely been in development mode in recent years, but that R&D effort is beginning to show results. Third-quarter revenue at Kratos jumped 19% to $196.2 million, fueled largely by a 127% jump from the unmanned systems division. That unit contributed $41.6 million in revenue and accounted for more than three-quarters of the company's overall growth. Management said it expects the business to "double in revenues" from 2016 to 2018.

For now, most of that revenue comes from lower-margin targeting drones, but the company hopes to soon roll out its Valkyrie and Mako drone platforms, which would sell for about $3 million apiece and have the abilities to augment $100-million-plus fighter jets. The company imagines a future where dozens of drones would act in tandem with only a few manned aircraft.

It's a cool vision, and Kratos is at the forefront, but it is still a ways off from becoming reality. Kratos introduced the Valkyrie and Mako at the Paris Air Show this summer, but the Valkyrie mock-up will not be built until early 2018. The smaller Mako, meanwhile, has reportedly made test flights, but that highly classified project does not appear close to becoming available for more widespread use.

The company expects to get continued funding to develop the programs, but the real payoff will come if and when the drones are deployed. That date appears to still be some time off.

Financials stabilizing

Kratos failed to turn a GAAP profit in its most recent quarter, and said it expects negative cash flow of about $55 million for the full year. The company believes it can get to cash flow positive in 2018 thanks to upwards of $22 million in milestone payments it expects to receive and a wind down in some capex spending as programs enter initial production.

Be warned, though, that Kratos does have a recent history of falling short of expectations. In early 2017, the company said it expected to earn a profit in the second quarter, but failed to deliver and saw its shares temporarily fall 9% as a result.

Kratos has done a good job bringing down its total debt from about $650 million at the end of 2015 to $369.7 million as of the end of the most recent quarter, thanks to secondary stock sales and the sale of part of its electronic products division in 2015. The company has said it sees opportunities to restructure and refinance some of its remaining debt, with hopes of implementing a balance sheet revamp early in 2018.

Is Kratos a buy?

Kratos has a portfolio of interesting products with the potential to generate considerable top-line and hopefully bottom-line growth in the years to come. It also has a mixed track record of producing results, and with the stock's run-up, it would appear that much of that potential is already priced in.

It's hard to find bargains in the defense sector, and Kratos is no exception. The company's recent share price jump has it trading at 10-year highs in terms of price-to-sales and price-to-book ratios.

Kratos' appeal is that it -- unlike the defense primes -- has at least the potential for rapid growth should those high-tech drones prove to be a success and the Pentagon bites. That's an intriguing possibility, but one still well off in the future. With long, drawn-out procurement schedules and a customer that can get bogged down in political battles and competing priorities, government contractors are a poor area for speculative investing.

My preference is for more traditional contractors like Huntington Ingalls, which has admittedly more limited potential upside, but also much less potential downside. For now, I'm watching Kratos from the sidelines.

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