KTOS - Kratos: An Overvalued Buy

2023-09-08 00:32:48 ET

Summary

• Kratos exceeded financial expectations with strong revenue growth and increased profits.
• Growth drivers for Kratos include strategic defense programs and hypersonic technology.
• Despite stretched valuations, KTOS is considered a long-term buy due to its involvement in high-demand areas and potential for future growth.

I previously covered Kratos (KTOS) and assigned the company a Hold rating but noted that I could understand why analysts had a Buy rating on the stock due to its exposure to hypersonics, drones, and aerial target drones while interest in space-based solutions is increasing. Since my last report, the stock has outperformed with a 12.4% return compared to a 6.6% return for the broader markets. In this report, I revisit Kratos to assess whether an upgrade to Buy is warranted.

Kratos Financial Results Exceed Expectations

Kratos booked revenues of $256.9 million exceeding the guidance of $230 million to $240 million and beat analyst expectations by $21.2 million. So, on topline, there was a strong beat and strong year-over-year growth of 14.5%. Important to note that the Unmanned Systems segment or KUS saw revenues decline by 7.6% to $52.1 million. Following the news from Ukraine, one would think that the drone business should experience significant growth. The reality is that the type of unmanned systems provided by Kratos focuses to a lesser extent on the small unmanned aerial systems or sUAS and is more focused on the higher-end systems such as the Valkyrie. Kratos Government Solutions saw its revenues increase by 22% driven by full quarter contribution of Southern Research acquired in May 2022 which contributed $9 million to revenues with strength for the KGS business in space and satellite, turbine technologies, microwave products, and C5ISR.

Profits came in at $6.7 million compared to a $1.9 million loss driven by the Unmanned Systems business generating a $1.2 million profit instead of a $5 million loss and KGS booked $11.6 million in profits providing a 22% increase, which was in line with the revenue growth. So, we saw profit growth in line with revenue growth for KGS and lower revenues but higher profits for KUS driven by a $5.5 million litigation settlement last year. Excluding this settlement, the profitability still improved from break-even to a 2.3% margin.

Adjusted EBITDA for KUS grew by 24% to $3.6 million pointing at margin improvement from 5.1% to 6.9% while KGS saw adjusted profits grow in line with revenue growth to $18 million. Total Adjusted EBITDA grew 22% to $21.6 million pointing to margin expansion from 7.9% to 8.4%. So, the results were good with stable margins on KGS coupled with revenue and profit growth and better profit generation at KUS on lower revenues.

Growth Drivers For Kratos

For the third quarter, Kratos is guiding for revenues and adjusted profits more or less in line with the second quarter results and maintained its full-year guidance. This year, the drivers will be the Ground Based Strategic Deterrent or Sentinel, aerial targets, the B-52 re-engine program, and the Satellite Communication Augmentation Resource program.

Next year, the growth drivers are expected to be the Integrated Air and Missile Defense Battle Command System or IBCS. That is a Northrop Grumman ( NOC ) program just like the Sentinel where Kratos is a subcontractor. Furthermore, in the fields of hypersonics with the MACH-TB hypersonic test capability and the Mayhem program.

Our evoX Defense Contracts Monitor shows $6.4 billion in contracts obtained by Kratos over the past years. Not included are multiple award contracts where multiple awardees can compete for orders, but this is an area where Kratos, with history as an indicator, thinks it can be one of the beneficiaries out of multiple awardees.

Is Kratos Stock A Buy?

Valuing Kratos stock without doubt is very challenging. The company trades far above the industry median EV/EBITDA according to the projections from our evoX Financial Analytics tool and seemingly provides little to no upside towards 2025. However, Kratos is one of those companies that continues to trade at elevated levels compared to the market. I wouldn't say that there is 84% upside for Kratos stock but even if we were to seek the mid-point in the valuation, which already means Kratos would be trading at a significantly lower EV/EBITDA multiple, we still get to a price target of $18.66 providing 25% upside which I consider to be attractive.

Conclusion: A Buy Despite Stretched Valuations

The results that Kratos booked in the second quarter were strong and the guidance for Q3 2023 is similar. With a backloaded profile of inventory, the H2 2023 results should be strong. The company is valued extremely rich but perhaps that is the premium you pay for a company such as Kratos. The company has involvement in aerial target drones, hypersonics, and space-based solutions. All of these areas are areas where customers want to expand their capabilities in the coming years. Kratos is seemingly not benefiting much from the drone demand in Ukraine, but that might not be a bad thing as it also provides some indication that the company leans on sustained long-term demand growth for its products. The company aims to double its drone output in the coming 18 months from 150 to 300 units and the XQ-58 Valkyrie, which currently is in low-rate production, could eventually be produced at a rate of 150 per year which would significantly transform the business results. With fighter jet-drone pairs and more demand for unmanned solutions, Kratos has a lot of growth ahead which likely justifies the premium paid now. As a result, I am marking Kratos stock as a long-term buy.

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