Description
I believe Kratos Defense & Security (NASDAQ:KTOS) remains well-positioned to take advantage of any Depart of Defense [DOD] moves to build a combat drone capability. While Unmanned performance in 1Q23 was not great, I think it is alright as this is a long-term game. 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. KTOS also has opportunities in space and exposure to growth programs as well. I see this as a long-term investment that short-term performance might be choppy given the project-based nature of the revenue stream. However, what matters to me is KTOS should improve profitability and FCF profile overtime, which will eventually be reflected in the stock price/valuation.
Unmanned/combat drones
My focus continues to be on the Unmanned programs, the long-term value driver for the stock. As I see it, Valkyrie and Air Wolf are the major forward growth drivers in tactical unmanned, and they have gotten the field off to a good start. Currently, KTOS’s Pentagon customer still testing and evaluating their unmanned systems to explore their various applications, but I perceive an implicit urgency for the government to swiftly comprehend the practical combat uses of these products. This urgency arises from the increased geopolitical risks and heightened tensions of potential conflicts, such as the situations involving Russia and Ukraine, as well as China and Taiwan. Evidence to support my logic can also be seen from the increase number of Valkyrie customers (Google search will show a list of them. I think what is even more interesting to note is that KTOS is becoming more entrenched into the underlying customers supply chain they are now producing more custom-made Valkyries (equipped with customer-requested capability). If the product works out well, it is likely for these orders to be repeated as KTOS already has the blueprint to mass produce the custom-made product.
In terms of revenue, management has projected $220-225 million (flat growth vs last year) in 2023 sales, largely attributable to the timing of the programs. As I mentioned, this is a long-term game, and given the large pipeline of opportunities, with a number of programs still progressing in the development stage, I think a 3-year or 5-year stack growth comparison will make more sense. Given their LRIP (Low Rate Initial Production) and full rate production with an established clientele, I believe the SSAT (Sub-Sonic Aerial Target) and AFSAT (Air Force Subscale Aerial Target) provide the most transparency within the pipeline. With regards to initiatives that may have the greatest impact on growth prospects in the short-term. By contrast, classified projects like the Valkyrie, Makos, and Air Wolf belong to the high growth category and could make sizable contributions to development in the near future. Although the other platforms may be seen as more speculative, it doesn’t imply that they lack current value, as KTOS holds a strong position in the overall UAS market and has the capability to utilize technology integrated into crucial program foundations..
USAF Agile combat Employment
In addition, management brought up a potential opportunity with the United States Air Force’s Agile Combat Employment [ACE] initiative in the Pacific theater. For the years 2023-2027, the United States Air Force has designated ACE as a top priority in order to rapidly deploy, disperse, and maneuver combat capability across a theater, regardless of the condition of the runways. Given that KTOS can supply its drones meeting the program’s affordable, runway-independent, and survivability requirements (as per KTOS 2022 AGM), I see this as an exciting opportunity for the company.
Margin / FCF
I think one benefit that KTOS stock has is that there are investors that focuses on the long-term, and short-term volatility in the numbers do not matter as much. For example, 1Q23 margins may appear low, but I believe they will soon recover as contracts are renewed and prices can be adjusted to account for the higher cost environment. New contracts in the industry can now, crucially, also incorporate inflation escalators. All these factor should contribute to the increase in FCF, which I see further support from the absence of certain non-recurring cash expenses in 2022 and heightened level of capital expenditure at expanding Valkyrie production capacity. In particular, management has provided guidance indicating an expected FCF range of $10 to $20 million for 2023, suggesting a potential turnaround in FCF during 2H23.
Summary
I believe KTOS is well-positioned to capitalize on potential DOD initiatives related to combat drones. While the performance of the unmanned programs in 1Q23 may not have been exceptional, I consider it acceptable considering the long-term nature of the game. The company’s focus on unmanned programs, such as Valkyrie and Air Wolf, demonstrates significant growth potential, especially given the increasing geopolitical risks and tensions globally. The guided unmanned revenue for 2023 may appear flat, but considering the pipeline of opportunities and the potential contributions from classified projects, the long-term growth prospects remain promising.
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