Earnings Hindsight: Kratos Defense & Security

I knew it. The minute I complained this earnings season was rather boring, interesting things happen. Mr. Market, don’t ever change!

Kratos & Defense & Security 3Q 2023

• EPS: $0.12 vs. $0.09 estimate

• Revenue: $274.6 million vs. $251.6 million

• Sees Q4 revenue of $237 million to $257 million (Consensus $260M)

• Book to bill: 1.1x

Key quote: “We're making sure we meet or beat our numbers while also positioning ourselves to go after and win some of these new opportunities.” - Eric DeMarco, CEO

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Why we should have seen this coming: I’ve said before, defense done right is boring and plodding. Today’s headlines will play out in results a year from now, or longer. But to every rule there is an exception, and Kratos is the constant drama child in this sea of tranquility.

I’m old enough to remember when this was a telecom infrastructure company called Wireless Facilities, a good idea that never really turned into the superstar that some had hoped it would become. The company pivoted to defense and took the Kratos name back in 2004, and today supplies everything from dumb drones used for target practice to defense electronics, communications equipment, and software.

Kratos in recent years has been a lightning rod among investors. The company has made strides in sci-fi like areas including the development of the XQ-58 Valkyrie, an autonomous “Loyal Wingman” drone that would fly in waves into battle alongside F-35s, overwhelming enemy defense systems and handling some of the more lethal assignments in place of piloted aircraft. It also has positions on other futuristic projects like “Gremlins,” a flurry of small, lethal drones that can be released and recovered by a cargo plane.

But like its Wireless Facilities past, all of this amazing tech has not yet turned into a steady payday for investors. The Air Force has been playing with the Valkyrie for years and has given it enough plaudits for Kratos to put in place manufacturing plans. And yet, we wait.

So, it is very on script for Kratos to both post solid numbers but see its stock fall (down more than 5% as I type) on a blah outlook. This is the story of Kratos over the past five years: The stock has visited a lot of places but has gone nowhere.

How to think: DeMarco’s quote above is an attempt to explain the tepid forecast for the fourth quarter. The U.S. government has failed to get next year’s budget in order, relying instead on short-term continuing resolutions. That eats into procurement, at least in the near-term. Kratos has some orders it was hoping to get in the current quarter that it now fears won’t happen. There are also upfront costs, and distractions, associated with bids for future business. There’s a case to be made that the company, as DeMarco says above, is under promising in hopes of overdelivering.

Yet, it is hard for an investor (disclosure: yes, I am an investor) who has lived with that chart over the past five years to get too excited by the potential. Kratos going back to the WiFi days has been the story of waiting on potential.

FWIW I do believe we will see some sort of real Valkyrie order in 2024, but the size and the scale remain to be seen. The focus among investors appears to already be shifting towards the next big thing: Kratos’ OpenSpace satellite and ground station management platform. There are also newer, better drones like the Thanatos that could (emphasis on could) leap ahead and become the catalyst. Or I could be sitting here a year from now typing the same words about the potential in this portfolio.

In the mostly plodding world of defense stocks, Kratos stands out for its uncertainty. To use baseball terms, I am more certain than I once was this won’t be a strikeout, but I still have no idea if it is a home run or an infield single.

I’ve waited this long for the answer to that question. I might as well hang on for another couple of quarters or years to find out how all of this ends up.

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