Kratos Defense & Security: Progress Towards Long-Term Growth (NASDAQ:KTOS)

Investment action

I recommended a buy rating for Kratos Defense & Security Solutions (NASDAQ:KTOS) when I wrote about it the last time as I see it as a long-term investment, riding on the secular trend of the Department of Defense move to build combat drone capability. Based on my current outlook and analysis on KTOS, I recommend a buy rating as the secular trend continues to be strong and KTOS performance so far in terms of results and underlying execution has been on track.

Review

KTOS has reported robust financial performance for the second quarter of 2023. The business revenue witnessed an impressive 11% year-over-year growth, accompanied by an adjusted EBITDA margin of 8.4%. The strong performance was seen across both KTOS Unmanned Systems [KUS] and KTOS Government Solutions [KGS]. Looking ahead, I continue to believe KTOS is poised for continued growth across multiple fronts. The Air Force’s Collaborative Combat Aircraft [CCA] program presents a promising market opportunity, with KTOS actively participating by deploying its Valkyrie combat drones in recent Air Force tests. The initial test runs have been successful thus far, which increases my confidence that KTOS can take full advantage of this market opportunity. For instance, KTOS designed and built these stealthy unmanned combat aerial vehicles for the U.S Air Force’s Low Cost Attritable Strike Demonstrator program, and they successfully completed a three-hour simulated combat mission utilizing Skyborg AI capability.

Recall previously I wrote about the secular trend in deploying drones, the Pentagon has just released news that they are going to field thousands of drones in the sea, in the air, and land to counter the large size of China’s military under the Replicator Initiative. This is a clear indication that the US is explicitly focusing on driving up the deployment of drones, and I expect KTOS to benefit from this trend either directly (DoD allocate budget to KTOS), or indirectly (KTOS becomes more embedded into the supply chain).

Furthermore, KTOS has made substantial progress in hypersonics [Zeus] and satellite ground controls [OpenSpace]. Notably, their Rocket Systems business achieved milestones such as launching a new hypersonic payload and conducting the first fire test for the Zeus rocket motor during the second quarter. KTOS plans to conduct tests for the hypersonic vehicles named Erinyes and Dark Fury in the coming year. I expect the hypersonic weapons market is expected to become a key driver of growth, especially as the DoD has indicated increased investment in hypersonic technology.

The Department of Defense continues to deliver on the President’s strategic objectives of supporting industrial sectors critical to our nation’s national security needs and strategic interests,” said Dr. Laura Taylor-Kale, Assistant Secretary of Defense for Industrial Base Policy. The Biden Administration has identified hypersonics technology as a critical need for ensuring American national security. U.S. Department of Defense

With the Russia/Ukraine war ongoing and the growing geo-instability in the Indo-pacific oceans, I expect the US to continue allocating resources to defense, and believe The Air Force, Army, and Navy will all deploy hypersonic missiles in the near future. However, these hypersonic missiles carry very high unit costs which is an obstacle to DoD development effort. As such, the success of KTOS in the hypersonic weapons market hinges on its ability to maintain affordability.

All in all, I believe the case for KTOS remains very attractive. The business possesses substantial upside potential, primarily due to its disruptive presence in the defense industry, offering high-tech, cost-effective solutions. In a market constrained by weapons program cost caps imposed by the U.S. government’s defense budget, KTOS’s low-cost offerings provide a distinct competitive advantage. Additionally, the FY24 Authorization bill mandated cost caps for drones in the CCA program, which favors KTOS. This is especially significant given the Air Force’s inclination to upscale requirements could disadvantage KTOS given that its competitive advantage is affordability. If these mandated cost caps on CCA drones make it into the bill’s final version, they could alleviate this challenge and further secure and boost KTOS’s revenue growth.

Valuation

With KTOS posting impressive 2Q results, including organic revenue growth of 11%, and its ongoing commitment to advancing its Collaborative Combat Aircraft, hypersonic weapons, and satellite ground control systems, which hold the potential to fuel sustained growth in the near term, coupled with a consistent increase in annual revenue since 2020, my model includes growth projections that are more optimistic than the general consensus. Regarding margins, I anticipate them to expand in the future as KTOS’s weapons programs transition from development to production.

At present, KTOS is trading at a multiple of forward EBITDA of 21x, whereas peers median stands at 13x. In my model, I assumed KTOS would continue to trade at 21x, maintaining its premium vs peers as I see KTOS having the most direct exposure to the secular trends I mentioned above, as can be seen from the faster expected growth rate.

Risk and final thoughts

KTOS is at risk of a larger competitor narrowing the gap in the tactical drone and hypersonics market. If rivals manage to successfully create similar weaponry and drones, KTOS’s substantial investments in research and development may not yield any return on investment unless they secure contracts. Additionally, any rise in the Air Force’s demands and cost constraints could significantly undermine KTOS’s potential for future growth, as their primary advantage of delivering cutting-edge, cost-efficient solutions would gradually diminish. The level of government expenditure on defense also plays a crucial role in KTOS’s business. If government spending were to decrease, it would likely have a negative impact on their revenue and profits.

In summary, KTOS remains a compelling long-term investment choice. The company’s strong second-quarter performance, coupled with its active participation in key defense initiatives like the Collaborative Combat Aircraft and hypersonic technology, underpins its growth potential. With the Department of Defense’s emphasis on combat drones and hypersonic weapons, KTOS is strategically positioned to benefit either directly through budget allocation or indirectly by becoming integral to the supply chain.