Kratos Defense & Security Solutions, Inc.

Moat: 2/5

Understandability: 4/5

Balance Sheet Health: 3/5

Kratos Defense & Security Solutions, Inc. is a technology company specializing in unmanned systems, satellite communications, cybersecurity, and defense and security solutions for the U.S. government and its allies.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview: Kratos operates within the aerospace and defense industry, serving governmental clients, including the U.S. Department of Defense. The company’s solutions are focused on supporting national security initiatives and involve a range of products and services. These include the design, development, manufacturing, and sustainment of advanced, unmanned, and weaponized systems, as well as specialized engineering services and software development for mission-critical operations.

Revenue Distribution: Revenues are primarily generated through three segments:

Kratos Government Solutions (KGS): Provides specialized communications, training, and integration services to U.S. government agencies.
Unmanned Systems (US): Develops and produces high-performance unmanned aerial systems, jet-powered drones, and related command and control.
Microwave Products: Designs and manufactures advanced microwave electronic products used in radar, satellite communications, and defense systems.

Industry Trends: The defense industry is currently experiencing increased demand for advanced technology solutions. Key trends influencing Kratos’s business are:

Rising geopolitical tensions that necessitate investment in advanced defense systems.
The increasing adoption of unmanned systems by armed forces and security agencies.
The growing threat of cyber warfare, which has heightened demand for cybersecurity solutions.
The modernization efforts by the Department of Defense to replace legacy systems with innovative technological solutions.

Competitive Landscape: The competitive landscape is varied, featuring companies that focus on components, systems, or services in different areas of the aerospace, defense, and security industries. Kratos competes with:

Large defense contractors: that possess scale advantages and established relationships within government agencies. These firms will often serve as their competition for large DoD contracts. These include Lockheed Martin, General Dynamics, Raytheon, and Northrop Grumman.
Specialized technology companies: with expertise in niche areas such as robotics, software, and satellite communications. Some of these smaller and mid-tier businesses may be leaders in their niches, which could be a threat to Kratos in its specific domains. These include companies like AeroVironment and L3Harris
In-house development programs: that the government may pursue in some areas, such as cyber security and software development which threatens the revenue flow from this sector

What Makes Kratos Different?

Kratos stands out due to its focus on specialized high-performance unmanned aerial systems and communications infrastructure for governmental customers. It does not compete in mass markets but rather pursues niche opportunities which it believes have favorable long-term returns. Its unique offerings, such as weaponized drones and software and communications solutions, set it apart. Furthermore, the company has cultivated strong relationships with the US government and the US’s allies, often in areas where they are seen as the most trusted providers of solutions. Additionally, the company emphasizes in its press releases its ability to deliver value creation as it has successfully transitioned from a technology research and development company to a full-fledged manufacturing and systems company that can deliver at scale.

Financials In-Depth: Kratos’s financials have shown mixed results in recent years. They recently improved margins but the long-term profitability is still not there. Some key highlights include:

Revenues: Kratos has experienced fluctuating revenues since 2019. In 2022, revenue increased to $834 million, a substantial jump of nearly 10% from the previous year. In the latest earnings report, they are guiding for $1.1 billion in revenues for 2024, representing another 17% jump in YoY revenue. The long-term growth plan is to continue to increase revenue year over year.
Operating Margins: In 2022 operating margins were around 5%, compared to negative numbers in 2021, showing the beginning of turnaround. This is still below the historical values which has seen margins as high as 12%. Their long-term goal is to drive higher margins by selling more product and services directly to the government. They seem to be improving in this area.
Profitability: Kratos is still unprofitable, although they have demonstrated improved profits in the last quarter and are trending to become profitable by 2024 and beyond. The company has spent a lot on research and development (R&D), and this needs to come down in order to turn a significant profit. Despite their lack of profitability for years, the company has still managed to receive a favorable rating in the market.
Cash Flow: Their cash flow is not consistent, and is fluctuating in-line with earnings. But their management has indicated that they expect to be able to produce positive cash flow beginning in 2024 and beyond.
Capital Structure: Kratos is highly leveraged with a debt-to-equity ratio over 1. There seems to be a reasonable expectation to pay back this debt, although it is currently high.
Order Backlog: As of 12/31/22, total backlog (unfunded orders) is at $960 million, and funded backlog was $10.1 billion which represents a great number for further growth of the company.

Moat Rating: 2/5 (Narrow Moat) Kratos’s moat is relatively narrow based primarily on their specialized technology and the relationship with the US government. They have built up a reputation as being a trusted provider, which makes it hard for competitors to displace them in certain government segments and niches. But the competition is still there and is constantly improving their game, meaning that Kratos could be easily displaced at any point. They have built strong relationships in the government, however these are not guaranteed. In addition, the products they produce are not unique and are only distinguished by higher level contracts with the government. Kratos still faces competition and potential loss of major contracts with the government or their allies. In short, they have a decent niche business but are far from a true “monopoly,” which a higher moat rating would indicate.

Risks to the Moat:

Technological Obsolescence: Rapid advancements in technology can quickly render Kratos’s existing systems obsolete. The government is always looking to upgrade or replace their current offerings, and in the high-tech world, a better competitor could arise quickly.
Government Spending Decisions: Changes in defense spending priorities and budget cuts can dramatically reduce funding for their programs. They are highly susceptible to policy changes and shifts in priorities with the US Government.
Increased Competition: New entrants and well-funded competitors may emerge and provide similar solutions at lower cost. Competition in the defence industry is fierce.
Dependency on Government Contracts: A significant portion of their revenue is tied to contracts with governments. Changes in government priorities or regulatory policies could severely affect their bottom line. The contracts they receive are not guaranteed, making them highly exposed to this risk.
Acquisitions: Acquisitions have been core to their business in the past, but the inability to integrate new businesses to streamline operations could cause a decline in value. Furthermore, purchasing assets at a high premium also threatens their profitability.

Business Resilience: Kratos is moderately resilient. While they are a trusted supplier with the US government, they are still prone to significant disruptions.

They are a trusted supplier for the US Government and their allies, meaning that even if their revenue falls short in the short term, they will still likely be considered for later contract options.
Their business model is scalable, as they mostly sell their specialized products and software, allowing for a high degree of growth.
While their R&D costs can be expensive, they have a proven record of product development and therefore they can still operate efficiently in their market.
The US government is very likely to continue to support and prioritize the kind of tech and services that Kratos produces.
Their past experience with the US Department of Defense and various other governments enables them to be more competitive than smaller new entrants.

Understandability Rating: 4/5 Kratos’s business model is relatively straightforward to understand, but the specifics of their contracts, systems and technology is difficult to fully grasp for non-technical individuals. Their reliance on government contracts also adds a layer of complexity to understanding their operations. For the most part, an average investor will be able to understand how they generate revenue but will need more info to make informed conclusions about their future performance and ability to earn a moat.

Balance Sheet Health Rating: 3/5 Kratos’s balance sheet has areas of both strength and concern:

Strengths: Their large order backlog shows stability, and their contracts ensure a reliable flow of revenue that will allow for long-term investments.
Concerns: Their profitability is currently an area of concern, as is their high level of debt. This debt may limit their ability to take advantage of any future acquisition opportunities or to expand their operations.

This makes their business slightly unhealthy from a balance sheet perspective, they need to bring their profitability to positive before they can truly be healthy. They are improving in this aspect but not there yet.

Recent Concerns & Management’s Response:

Supply Chain Disruption: Like other businesses across the globe, the ongoing supply chain constraints have affected material costs and production time. They are attempting to use alternative materials and to diversify their supply chain to reduce this risk and are having some success. They are also increasing prices for their products to cover increased costs.
Inflation: They have been affected by the general rise in prices across many industries, and they’re trying to offset these costs by incorporating pricing measures into their contracts. This was also causing a small decrease in margins, although the most recent earnings report has shown improvement in this area.
Hiring and Retention: Like all US companies, they are struggling to find qualified engineers and workers, and are struggling to retain their most experienced employees. This is a challenge that can hurt growth prospects if these hires are not made.
Government Contracts: Because Kratos has contracts from the US Government and US allies, any changes or decreases to these contracts or any shifts in the budget would directly negatively affect their business and revenue stream. Therefore, Kratos has a high sensitivity to these policy changes. However, they are also working on diversifying their revenue, and are continuing to expand into new sectors.
Unprofitable: The fact that Kratos is an unprofitable business is a great concern for some investors. They rely on new contracts and long-term agreements to grow the business and their profitability. However, the company has a lot of promise and has a good outlook on future growth prospects with management projecting profitability within the next few years.

Management has been actively trying to address these issues. They seem to be managing issues with the supply chain well. They have been trying to negotiate better contracts with better pricing strategies, and to also push more products and software that they control the pricing on. They have also said they’re increasing efforts to recruit top level talent that can perform in a high-stress environment.

The most recent earnings call in August 2023 highlighted management’s view that they can hit their revenue guidance and turn a profit within the next few years. They also stated that while they might miss the 2023 earnings forecast, the long-term trajectory of their growth and their profitability is still positive, and they expect these long-term goals to be met. They emphasized their expansion into the hypersonics area and their continued growth with the US and its allies as a major source of revenue.