KTOS - Kratos Stock Still: A Buy Or Hold?

2023-11-24 00:02:34 ET

Summary

• Kratos Defense & Security Solutions reported strong Q3 results, exceeding revenue and profit expectations.
• The company increased its 2023 guidance, expecting growth and margin expansion.
• Despite being overvalued compared to peers, the stock has upside potential due to the nature of UAV companies, trading at higher multiples.

I previously discussed Kratos Defense & Security Solutions ( KTOS ) and back then I marked it an overvalued buy recognizing that the company, like many providers of unmanned aerial vehicles, is trading at elevated EV/EBITDA multiples compared to the aerospace industry. That buy rating has paid off rather well I would say with the stock gaining 26.4% against the 2.4% return for the S&P 500 perfectly demonstrating that aerospace can significantly outperform on a flattish market. In this report, I will be discussing the most recent results, the guidance update and re-assess whether KTOS stock is a buy after its recent rally.

Kratos Results Fly Past Guidance

Kratos reported total revenues of $274.6 million exceeding its guided range of $240 million to $260 million. The 20.1% increase in revenues was carried by growth in all business segments. Unmanned Systems revenues grew by 13% resulting in the operating income swinging from a $0.1 million loss to a $2.6 million profit which could be seen as an indication that a revenue of >$50 million is required to turn the business segment profitable. Kratos government Solutions saw a 22% increase in revenues while its profits grew to $15.9 million which is almost five times the profit seen last year. Overall, the company swung from an operating loss of $3.6 million to $12.2 million which provides some evidence that at revenue levels around $235 million the business can turn an operating profit. The operating profit also exceeded the $3 million to $6 million that was guided for. The company still had a $1.6 million net loss, but this was materially better than the $8 million loss reported in the comparable period last year.

Kratos Increases 2023 Guidance, Sees Lower Operating Cash Flow

For the fourth quarter, Kratos has guided for $237 million to $257 million in sales which is a sequential decline and would provide little room for year-over-year growth in revenues, but its operating income could end up in the higher range despite supply chain challenges, labor and raw material costs.

More interesting would be to assess the updated guidance which includes a $20 million bump in revenues basically encapsulating the strong Q3 2023 performance. The lower end of the operating income bracket has been increased by $1 million to $25 million with no change to the targeted adjusted EBITDA and operating cash flow is going to be worse with a cash burn of $20 million to $25 million expected compared to previous expectations of $10 to $20 million in cash flow generation on operating level. This is driven by continued inventory built to accommodate higher production targets as well as padding for supply chain disruptions.

The company even provided some pointers on 2024 expecting 10% growth and adjusted EBITDA margin expansion pointing at EBITDA growth exceeding 10% and that is without tactical drone production contracts which could boost results.

Kratos Stock: What Is It Worth?

I have processed the most recent balance sheet data for Kratos as well as the forward projections. In terms of EBITDA, we don’t see net changes for 2023-2025 but we do now that some EBITDA has slid into 2025 from 2024 while on free cash flow the current padding to inventory has brought down the free cash flow for this year with a negative net impact of around $23 million in the 2023-2025 time frame. For 2023, there is virtually no observable change to the fair value of the stock based on the company median but it went down for 2024 due to some EBITDA growth sliding from 2024 to 2025.

Using the company median EV/EBITDA as a reference there would be 46% upside to $27.88 with a hold rating as the company is significantly overvalued compared to peers. If we allow the company to trade at a multiple that lies in between the industry median and the company median, the 2023 target would shift to $18.93 indicating that the stock is more or less fairly valued. However, as we are entering the final month of the year soon I feel like we should start looking ahead and taking the midpoint would point at a $22.35 price target pointing at an additional 17% upside. As a result, I am bypassing my automatically calculated score rating and apply a buy rating recognizing that UAV manufactures tend to trade at higher multiples.

Conclusion: Kratos Stock Has Upside

Kratos booked Q3 2023 results that exceed analyst estimates and the company’s own guidance. The company also provided an update on the 2023 expectations which including a cash flow pressure due to continued supply chain disruptions for which the company is padding and to align for higher production in 2024. For 2024, the company sees higher revenues coupled with higher margins. Given the nature of UAV companies to trade at higher EV/EBITDA multiples, based on a moderated multiple I maintain my buy rating.

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