KTOS - Kratos: Expect Free Cash Flow To Improve From Here

2023-03-08 14:42:44 ET

Summary

• KTOS has strong potential to benefit from DOD initiatives to develop combat drone capability and potential space opportunities.
• Unmanned drones are the primary growth driver for KTOS due to numerous opportunities in the pipeline, but the market for combat drones is also fertile with potential.
• I expect FCF to improve in FY23 and FY24, but the company needs to do a better job of managing working capital.

Description

Kratos Defense & Security Solutions ( KTOS ) is still, in my opinion, in a strong position to benefit from any Department of Defense (DOD) initiatives to develop combat drone capabilities. In addition, KTOS has access to development programs and potential space opportunities. At its core, KTOS appeals to me as a way to gain exposure into rapidly expanding sectors of the defense budget and access to tactical unmanned products that have the potential to generate significant long-term upside. This together with my belief that KTOS will enhance its profitability and FCF profile has led me to recommend a long position.

4Q22 earnings review

KTOS stock's quarterly results were mixed, with revenue exceeding expectations but margin weakness leading to an EBITDA miss. As for FY23 guidance, KGS is expected to see double-digit revenue growth in 2023, while unmanned will be relatively flat, and profit margins are expected to be higher vs. last year.

Unmanned/combat drones

I expect unmanned to remain KTOS's primary growth driver due to the abundance of opportunities in the pipeline and the steady development of several programs. Given the staggered nature of the planned initiatives, management expects 2023 sales of $220-225 million. Here, I propose categorizing the underlying programs into three groups: highly visible, rapidly expanding, and highly speculative, in order to evaluate the business. For the first bucket, given LRIP, and production at maximum rates, SSAT and AFSAT belong to the group of highly visible. In contrast, the classified Valkyrie, Makos, and Air Wolf all fall into the high growth category and have the potential to significantly contribute to expansion in the near future. Lastly, the remaining platforms fall under the Speculative category. To address the final group, I think that it is challenging to assign a positive or negative value as they are speculative in nature, but I believe management can turn it positive given KTOS's position in the overall market and its ability to leverage technology that has been integrated into the key base of programs. And if you take a step back from the specifics of the near future, you'll see that opportunities for target drones are supported by new threats from strategic weapon systems even further out in the future. Additionally, a good evidence of demand is that KTOS was awarded a $338 million contract to begin production of AFSAT Lots 17-21 in August 2021, pushing the backlog of production from 2021 to 2027.

As interesting as the unmanned drone market is, I believe the market for combat drones is even more fertile with potential. Specifically, management highlighted a number of potential Valkyrie orders from a wide range of customers, reiterating the company's position as the market leader in the combat drone space. Although the current production facility can only make about 35-40 Valkyries per year, KTOS has options on the facility and could easily double production if there was sufficient demand. It is important to note, with regards to this production facility, KTOS has likely already front-loaded the CAPEX needed to meet the anticipated increase in demand, so the company's incremental FCF margin should be quite healthy in light of the new requirements. However, given the fixed prices associated with the contracts at hand, I anticipate margin headwinds for Valkyrie's current lot. My guess is that this will only be a temporary problem as margins return to normal when the next block is discussed.

FCF cadence

FCF was negative in FY22. This was mainly due to a negative cash flow from operating activities of $26 million, which was caused by an increase in working capital usage of $71 million. Additionally, the company had invested more CAPEX in Valkyrie and Space during that period. However, I like to point out that investing in Valkyrie and Space is a valid investment decision given their potential for growth in the future. From an FCF standpoint, things don't get interesting until FY23. For 2023, I expect KTOS to see enhanced profitability, decreased working capital headwinds, and stable CAPEX. This will all add up to a positive FY23 FCF performance. That said, I do think management needs to do a better job of managing their working capital, which has been slowing down the company's cash conversion cycle and cash flow generation. If consensus estimates for FY23 FCF of $13 million pan out, it will be the highest level since 2018. Importantly, I anticipate even more FCF expansion in 2024 (consensus estimates put this at $31.3 million) as a result of higher profits and moderate CAPEX.

Summary

KTOS has strong potential to benefit from DOD initiatives to develop its combat drone capability and potential space opportunities. I believe Unmanned drones are the primary growth driver for KTOS due to numerous opportunities in the pipeline. That is not to say combat drones are bad. The market for combat drones is also fertile with potential, and KTOS is well-positioned as the market leader in the space. In terms of FCF, I expect continuous improvement in FY23 and FY24, however, I also think the company needs to do a better job of managing working capital. All in all, I find KTOS attractive because it provides access to tactical unmanned products that appear to have substantial growth potential. These factors, along with my expectation that KTOS will improve its profitability and FCF profile, have led me to advocate for a long position.

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