KTOS - Kratos Defense & Security: Splendid Quarter Secular Tailwinds Remain Intact

2023-11-23 09:24:04 ET

Summary

• I continue to recommend a buy rating due to strong secular tailwinds and growth catalysts.
• KTOS has shown strong performance, with revenue growth, improved margins, and a healthy backlog.
• The KUS segment, particularly the SSAT and AFSAT projects, is expected to drive growth, supported by increased demand for drones in the defense industry.

Investment action

I recommended a buy rating for Kratos Defense & Security (KTOS) when I wrote about it the last time as I expected KTOS to continue benefiting from the strong secular trend, especially in its Unmanned Systems [KUS] segment. Based on my current outlook and analysis of KTOS, I recommend a buy rating. I believe the secular tailwinds remain very strong, and KTOS has showcased its ability to deliver products that work. Also, there are additional growth catalysts (reinterest in previously de-emphasised projects) that could further enhance growth.

Review

KTOS 3Q23 performance was splendid, and the stock price reflected this strong performance, increasing by ~28% since my last update. Revenue saw $275 million, posting a 20% annual growth, beating my FY23 estimates by a full 700bps. In segments, KUS sales grew 13% organically, while KGS (Kratos Government Service) grew 22% organically. At the EBITDA level, margins were 10.1%, a 140 bps improvement vs. last year. Similarly, at the EBIT level, KTOS saw printed revenue of $12 million, which was a pivotal improvement from 3Q22, where it was generating negative profits (-$3.6 million). Forward-looking metrics continue to point to healthy growth ahead as the total backlog improved 9% to $1.17 billion, driven by 3Q23 bookings of $282.3 million (15% growth). Importantly, the funded backlog continues to stay above 70% at $850.9 million.

In my opinion, KUS will remain KTOS's primary growth driver due to the abundance of opportunities in its pipeline. At the moment, 12 different types of projects are active on KTOS:

1. AFSAT (US Air Force)
2. SSAT (US Navy)
3. Unmanned Command and Control
4. Mako
5. Valkyrie
6. Gremlins
7. Program F
8. Program Thanatos
9. FireJet
10. Athena
11. International
12. Classified R&D

Of all of them, SSAT and AFSAT are the ones with the most visibility. I believe the growth potential is huge here because drones are just so much cheaper. Based on the US Air Force definition (as mentioned in the 1Q23 earnings call), the expected drone cost is a fraction of that of an F-35, at around $20 million per unit, while the SSAT has an even lower cost of $10 million (2Q22 earnings call). Given the current geopolitical outlook across the globe, I expect (unfortunately) a step up in demands for drones, especially in the Indo-Pacific theatre . One of the key strategies is collaborative combat aircraft [CCA], which needs to be agile and be able to move around the battle space . To facilitate this, one of the execution initiatives is integrating unmanned combat aircraft across diverse missions, according to the PACAF's 2023 strategy.

Another indication that the US government is getting more serious about unmanned drones can be seen in their budgeting plans. In the FY23 budget overview , there are 19 instances of "unmanned" search results, vs. 13 instances in the FY13 budget . The budget increase is also another good indication. With KTOS's expertise in the drone's space, I believe they will be able to take full advantage of this outlook. In terms of execution, KTOS is clearly delivering as it should. Supporting this claim, the US Air Force recently made an announcement regarding the successful flight of an AI-enabled combat Valkyrie at the Eglin Gulf Test and Training Range as part of the CCA programme. In another flight, Valkyrie successfully demonstrated all defined, AI-enabled, high-performance, uncrewed air vehicle functions.

KTOS has begun manufacturing the 12th batch of Valkyries. Given that KTOS can increase production of tactical drones from 150 this year to 300 in the next 18 months, I anticipate that The Valkyrie project will serve as a near-term driver. Given the secular trend, the demand should come eventually, and KTOS will be able to deliver given supply is not a constraint. With the resurgence of interest in Thanatos and Athena, there is another possible growth catalyst besides Valkyrie. Clients have begun negotiating awards for each of these de-emphasized programmes as early as the middle of 2024.

Valuation

I believe KTOS can grow at a faster pace than I expected previously given the secular tailwinds from the US defence force, the successful execution of delivering products that work (Valkyrie project), and the reacceleration in interest for Thanatos and Athena. The exact magnitude of growth improvement is hard to gauge, and as such, I am increasing my growth expectations modestly by a 100bps points to match the recent growth peak in FY19. Given the fixed-cost nature of KTOS, if the growth accelerates, margins should continue to see improvements. As such, I revised my EBITDA margin upwards to reflect this change.

In my model, the biggest update is the increase in valuation expectations. I believe the market is coming in line with my expectations for KTOS, as its valuation increased by 5x compared to when I last wrote about it. I expect KTOS to continue trading at this level, at a premium to peers, given the strong secular tailwind (I mentioned this previously) and also the fact that it has showcased continuous EBIT margin expansion sequentially, which I believed was a weighing factor in its valuation previously.

Risk and final thoughts

In my opinion, execution risk is the biggest risk. The secular tailwinds are likely to stay for a very long period of time, so the constraint on growth is whether KTOS can meet this demand. In other words, is KTOS able to deliver as expected? Hence, if KTOS messes up on execution (i.e., the drones don't work), it would significantly reduce KTOS's ability to grow. In addition, KTOS's reputation will take a big hit within the industry, deterring other customers from doing business with KTOS.

Overall, I reiterate my buy recommendation. I continue to see the KUS segment as a key growth driver, notably SSAT and AFSAT projects which should continue to provide demand due to the developments in the Indo-Pacific theater. KTOS's ability to deliver is evident, exemplified by successful AI-enabled Valkyrie flights.

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