KTOS - In at $4.20 this morning.
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On the Pentagon's Shopping List
By DAVID ENGLANDER / Barrons Sept 15, 2012
Kratos Defense & Security Solutions has built a strategic portfolio of products that the Pentagon will keep buying, despite a much tighter budget. Why the shares could more than double.
Concerns about large-scale cuts in Pentagon spending have weighed heavily on defense stocks in the past year, leaving them at rock-bottom valuations. Shares of small defense companies, in particular, have sold off, as investors have tossed out the good along with the bad.
Kratos Defense & Security Solutions (KTOS) is a victim of such selling, having fallen 40% in the past year, to $5.07, as investors have turned a blind eye to its strong portfolio of defense-electronics products, which the military will continue to order despite a tighter budget.
Investors have gotten hung up, instead, on Kratos' leveraged balance sheet, and a streak of acquisitions that have muddied its results, obscuring the company's true earnings power.
That could change in the next 12 months, however. The $155 million acquisition in May of Composite Engineering, or CEI, a maker of unmanned-aircraft systems and targets, a deal that was partially financed with a dilutive equity offering, is likely to mark the end of the buying spree. Kratos now is focused on integrating its acquisitions, divesting noncore operations, and paying down debt.
At Friday's closing price, Kratos fetched just six times this year's expected free cash flow, and 6.5 times 2013 Ebitda, or earnings before interest, taxes, depreciation, and amortization. The shares could be worth more than double their current price.
Originally known as Wireless Facilities, a builder of telecommunications infrastructure and networks, Kratos has been transforming itself into a pure-play defense outfit since 2004, when CEO Eric DeMarco took the helm. DeMarco previously built up the defense-service company Titan, increasing its value to $1.5 billion by 2003, from $100 million in 1996. (It was sold to L3 Communications for $2 billion in 2005.)
At Kratos, DeMarco focused initially on buying defense-service companies. But in the past several years, he has been building a high-technology electronics portfolio, targeted toward national-security priorities. Kratos has made nine acquisitions beginning in 2010.
Its wares include unmanned surveillance planes; electronic-warfare products, such as radar systems for fighter jets; satellite ground systems; and ballistic-missile and rocket-testing systems. Kratos also makes security and surveillance products for government and commercial customers.
Specialty products and related servicing generate roughly 90% of revenue; traditional defense services, the rest. The U.S. government is Kratos' largest customer, accounting for 74% of sales in 2011.
Kratos is expected to lose $15 million, or 34 cents a share, this year, on revenue of $962 million, but much of that loss stems from one-time acquisition-related charges. Adjusted for depreciation and acquisition-related amortization, cash earnings are in the black. Mike Crawford, who covers Kratos for B. Riley, sees cash earnings of 62 cents a share in 2012 and 77 cents, on a higher share count, in 2013, as integration efforts take hold and as revenue grows 9%. Some $300 million in tax-loss assets will prevent the company from paying much tax for years.
Demand is strong for Kratos' products. In the June quarter, revenue from continuing operations rose 4.9% from the previous quarter's level. In the past year, revenue was up 28.5%, driven by acquisitions. The order backlog is $1.1 billion, with a proposal pipeline of $4.1 billion.
The acquisition of CEI is likely to boost sales growth further. CEI gives Kratos a strong position in high-demand programs, such as unmanned aerial targets for combat training, of which the company is the sole supplier to the Air Force and Navy.
While there is uncertainty about defense cuts, Kratos' product line could be safe from the axe. Crawford says, in a report, "The Dept of Defense is much more likely to prioritize funding for programs that are strategic in nature [rather] than tactical, items such as more tanks, radios, and other ground equipment."
Kratos has $650 million of debt to cash of $50 million. Net debt equals 58% of total capitalization. The debt is manageable, given the company's strong free cash flow, with $45 million expected this year and $67 million in 2013. In the next year, cash is likely to pile up on the balance sheet.
Kratos' shares trade significantly below historical multiples of similar defense companies, and could command significantly more in a buyout. Says one money manager who owns the stock and knows the company well: "The shares are stupidly cheap here. In a bad environment, they are worth eight to 10 times Ebitda, and in a good environment, even more."
At nine times 2013 Ebitda, Kratos would be worth $11 a share. |
