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5 Things Kratos Defense & Security Wants You to Know About 2019

Rich Smith, The Motley Fool

Kratos Defense & Security (NASDAQ: KTOS) missed on sales but beat on earnings last week. But despite the earnings beat investors sold off Kratos stock -- partially because of the sales miss last quarter, but also partially because Kratos warned investors it might miss sales estimates again in Q1 of this year, making for back to back misses.

And yet if you listened to Kratos's post-earnings conference call, it really didn't sound like Kratos was experiencing a lot of weakness in the sales department at all. To the contrary, it sounded like Kratos's sales force was doing a great job.

Let's listen in on Kratos's end-of-year earnings conference call and find out why the stock lost popularity.

Drone silhouettes

To outfit the air force of tomorrow, Kratos is building drones of all shapes and sizes. Image source: Getty Images.

Growth less than expected, but still impressive

[O]ur Unmanned Systems division generated organic growth of 75% over the previous 24 months, and we are forecasting our target drone business to grow to approximately $250 million in annual revenue over the next few years or 90% organic growth over the 2018 revenues. In our tactical drone business, we now have six customer-funded tactical drone programs, with several additional programs expected to be under contract by the end of this year. The momentum in Kratos' tactical drone business continues to build. -- Kratos CEO Eric DeMarco

When a CEO urges you to focus on an unusual reference period, it's natural to ask why. Why "24 months" exactly? Why not talk about sales growth over the "last year," or even "the last five years?"

But there's a reason DeMarco picked this specific timeframe. One year ago Kratos set itself the goal of "doubling our 2016 UAS revenues in two years" in the "unmanned aerial drone system business" (i.e., growing 100% over what is now "the previous 24 months"). It looks like Kratos fell short of that goal -- but what's important here is that what sounded like Kratos crowing over 75% growth was actually the CEO admitting that Kratos came up short.

Though even if Kratos missed its target, 75% growth in 24 months still sounds pretty great. Now the question becomes: How much better can Kratos do going forward?

Who's who (and what's what) at Kratos today

Kratos' XQ-58A VALKYRIE is scheduled to fly in calendar Q1 of 2019, which means in the next 30 days. Once the successful series of VALKYRIE flights occurs ... we expect to receive initial unit orders ... in 2019...

Program F is scheduled for additional customer-funded demonstration flights in Q2 of this year and we expect initial unit orders later on in 2019 or early next year...

The DARPA-funded Gremlins program, with our prime partner Dynetics, has planned initial demonstration flights scheduled for Q2 of this year. ... we expect initial orders later in 2019 or in 2020...

On our confidential Thanatos program ... [should] be a meaningful financial contributor beginning in 2020...

We recently announced Kratos' AETHON ISR UAS, which is flying today ...[is] expected to be a meaningful contributor to Kratos in 2020...

Project Spartan continues to gain traction. We currently expect to be under initial contract in Q3 of 2019, with this program expected to be a meaningful financial contributor to Kratos beginning in 2020...

We have a new project ... called APOLLO, which we expect to be under contract by Q3/Q4 of this year and which is expected to be financially meaningful to Kratos in 2020...

Kratos' DIU MAKO UAS program [has] an expected Q2 2019 funding date ... [and is] now expected to be financially meaningful to Kratos beginning in 2020...

[We] now have a third customer for Kratos' MAKO, with this initiative named ATHENA, and we are looking for a contract award from this customer in the second half of 2019...

We also continue to work on Project A and Project Z and are looking for initial development contract awards in 2020.-- DeMarco

If you count all these up, Kratos has at least 10 tactical drone projects in the works, several of which we knew of previously -- but several more that we didn't. Granted, some of these are confidential or code-named projects about which we're unlikely to learn much more before they begin contributing numbers -- hopefully -- to Kratos's top and bottom lines. But the key point here is that Kratos' drone contract prospects are multiplying like bunnies in spring, and many of them seem likely to begin contributing to the company's revenue and profits within the next 12-24 months.

As for how much money these projects will contribute, that's not 100% clear. Still, later in the call DeMarco estimated the selling price of VALKYRIE unmanned aerial vehicles at "$2 million or $3 million each," and Gremlin UAVs at "$700,000 each." The mysterious "Program F" drones will sell for "$300,000 [or] $400,000 each."

But Kratos isn't the only company building combat drones anymore. As we learned last week, Boeing (NYSE: BA) is entering the market too.

Can Kratos compete with Boeing?

Very candidly, this competitor and it coming from Australia with a significant Australian investment, we don't think it could have worked out better for our company, and let me tell you why.

First of all, our price point. As you know, the price point on our VALKYRIE depending on quantities is $2 million to $3 million, and we have basically proven that out, because as you know we've built three aircraft. All right? Our aircraft has at least published 50% greater range. Our aircraft has internal weapons space, right? We're runway-independent, which is critically important to the U.S. customers. We're launched off of rail and recovered by a parachute, including in water where we soft seal, and the turnaround time for our drones is incredible, right? Very importantly, our drones exist today and they're flying today. The competitors, they have a model today. They say they'll be flying late next year. -- DeMarco

Much has been written already about Boeing's announced "Loyal Wingman" combat drone, which it's developing in cooperation with partners in Australia. As my fellow Fool Lou Whiteman has observed, Boeing's combat drone "measures 38 feet long and should be able to fly more than 2,000 nautical miles between refuelings. It's equipped with an integrated sensor package ... and is designed to be able to both fly independently or in support of crewed aircraft. The jet is designed for standard runway takeoffs and landings but can be modified for carrier operations."

All of that sounds impressive, but Kratos's CEO doesn't hesitate to throw shade on his larger rival's drone. The clear implication behind citing VALKYRIE's low cost, for example, is that Boeing's Loyal Wingman will cost significantly more. Tied to a runway or aircraft carrier, it also won't be as versatile as Kratos's drone -- actually, Kratos's drones, because, as I already mentioned, Kratos has about ten of 'em in the works.

And, of course, some of Kratos's drones are already flying. Boeing's isn't, and that makes this a curious tale of man bites dog -- gigantic Boeing now has to play catch-up to tiny Kratos.

A once-in-a-decade acquisition

Today we announced Kratos' acquisition of Florida Turbine Technologies or FTT. This was the first acquisition Kratos has made since 2012. FTT is a technology and products company strategically positioned for the small- to medium-sized affordable turbo fan and turbo jet market, including for high-performance unmanned aerial drones, missiles and weapon systems.

The affordable leading-edge technology that FTT brings to Kratos and to our Unmanned Systems business is truly incredible ... As you know, the No. 1 cost in most Kratos drone and weapon systems bill of materials is the engine, and affordability is a key differentiator for Kratos' platforms and systems. Accordingly, we are looking for FTT to further Kratos' vertical integration of our drone and weapon systems, increase Kratos' technology, and our performance lead in these systems and also reduce system costs. ... FTT will now become Kratos Turbine Technologies, or KTT, a new Kratos division. -- DeMarco

To maintain its cost edge over Boeing (and future rivals), Kratos bought FTT, which will allow the company to control its most important input cost. As a side benefit, Kratos can now use FTT to sell engines to future drone rivals like Boeing.

And there's an added bonus: Kratos notes that FTT's engines are well-suited to power "extended-range and low-cost cruise missile systems, and next-generation unmanned weapon systems" that the Pentagon has been seeking to buy, including from vendors such as Boeing.

With all these opportunities ahead of it, Kratos expects FTT to add "approximately $45 million" to Kratos's revenue for this year. Incidentally, this explains why Kratos's guidance for $720 million to $760 million in fiscal 2019 revenue (so $740 million at the midpoint) wound up being significantly more than the $722 million that Wall Street was projecting for it.

Subtract the $45 million boost to revenue from FTT, though, and Kratos would be looking at closer to $700 million in 2019 revenue -- significantly less than what Wall Street was projecting. This helps to explain why investors viewed the company's earnings release as a disappointment.

Free cash flow at last?

Today we are providing ... full-year revenue guidance of $720 million to $760 million and ... full-year 2019 cash flow from operations guidance of $40 million to $50 million, capital expenditures of $28 million to $30 million, and free cash flow guidance of $10 million to $20 million plus the expected final cash receipt of the retained working capital of the company's divested PSS business of approximately $4 million to $6 million.

We expect CAPEX to be at elevated levels for 2019. -- Kratos CFO Deanna Lund

Investors upset with Kratos's revenue growth, however, can take some comfort in the fact that it looks like Kratos is finally going to resume making some profits on that revenue. This here is a double -- perhaps triple -- whammy of good news. Not only is Kratos committing to generating positive free cash flow in 2019, but it's affixing a firm number to its objective, well above mere breakeven. Furthermore, Kratos is holding out the possibility that free cash flow will go even higher thanks to this "expected final cash receipt."

On Wall Street, analysts are predicting Kratos will end this year with about $15 million in positive free cash flow (according to S&P Global Market Intelligence) -- but as I read Kratos's comments, it looks like $25 million in real cash profits aren't out of the picture.

Granted, with Kratos selling for a $1.7 billion market cap (nearly 70 times hypothetical free cash flow), the stock still doesn't look like a huge bargain. Still, positive free cash flow is better than negative free cash flow. That much is undeniable -- and good reason for Kratos investors to feel optimistic.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.