Description

Investment Thesis (Short): Kratos Defense and Security (ticker: KTOS)

We believe Kratos is worth 50-70% below the current share price. The defense company roll-up is a collection of below-average assets, levered 10x, and valued at a 45% premium to peers. Shareholders are wishful into believing free cash flow or asset sales will accrete to equity holders through debt pay-down. Conversely, the contingent that believes the hype that a next-gen UAV program will grow the company out of its leverage is likely to be disappointed. We expect the stock to move lower on: 1) a reduction in 2016 estimates, 2) granularity on the FY17 defense budget that fails to support the UAV growth hype, 3) a subsequent de-rating due to business deterioration / liquidity fears, and 4) capitulation of the levered equity thesis.

Greek Mythology 101: How Kratos Transitioned from the Mythological God of Strength to a Fallen Angel

Understanding the investment thesis requires a brief Greek mythology lesson.  Kratos is the God of strength, might, and power. He is a guardian of Zeus who ends up slaying Titan. A couple thousand years later, Titan resurrects as a defense information technology company (former ticker: TTN). Titan grows revenues from $300 million to $1.5 billion, mostly under the leadership of CEO Eric DeMarco. A war in the boardroom ensues and DeMarco falls victim. Shortly after, Titan is acquired by L-3 Communications and DeMarco vows to avenge his demise.

In 2004, DeMarco becomes CEO of a public company called Wireless Facilities and changes the company name to Kratos. His goal was to outgrow, out build, and outlast his former nemesis by replicating a roll-up strategy that had been very successful in the defense industry. For anyone who has followed the industry, the closest case study is L-3 Communications that grew from $100mm in 1998 to $15bn in 2008 through 60+ acquisitions. In our opinion, DeMarco is enamored by the success of L-3’s long-time CEO Frank Lanza. DeMarco’s thesis was Federal budgets would be pressured due to deficits, high priced next-gen programs would be cut, which would force the DOD to sustain older, legacy assets. This was a very contrarian thesis since most defense companies were focused on acquiring “higher-tech” assets during this period (at inflated multiples). For full disclosure, we were initial believers of the strategy and long the stock in the 2010-2011 timeframe.

Kratos’ strategy worked well for a couple of years, in part buoyed by an ever-growing defense budget and NOLs to support cash flow reinvestment. From 2007-2010 KTOS made 8 core acquisitions for $500 million. The strategy (and our long thesis) cracked in 2011-12 for both internal and external reasons. First, the defense budget cuts finally came but instead of cancelling high priced next-gen programs in lieu of cheaper legacy programs, the sequester was instituted, which brought across the board defense  at a flat rate. Hence, the thesis that the most expensive programs would be cut to sustain cheaper legacy programs was invalidated. Second, Kratos acquired Herley and Integral Systems. These assets were the exact opposite of what the strategy espoused -- two companies long believed to be on the block for considerable time, acquired at the peak of the cycle and at hefty valuations. The nail in the coffin came with the 2012 acquisition of Composite Engineering, an R&D outfit bidding for next-gen UAV programs. Again, the exact type of asset the initial strategy was designed to forego. As an indication of management’s failure, the stock began its descent from $15 to $3.

With defense budgets in decline, a capital structure that was 11x levered, and a falling stock price, what was Kratos to do? The answer, reverse course. In 2014, Kratos launched strategic alternatives. After an exhaustive process, only the company’s highest quality assets (Electronic Products Division) received an adequate bid and sold in June 2015. This business is essentially the combined Herley/Integral businesses that focuses on Electronic Warfare. Since then, Kratos changed its strategy to focus on its high-tech, disruptive-technology UAV programs. The exact type of uncertain asset the company once despised.

Key Point #1: A Collection of Below Average Assets, Levered 10x, Valued at a 45% Premium to Peers

Almost every attribute that makes the defense industry a quality industry to invest in – high visibility, barriers to entry, consistent 10%+ EBIT margins, strong FCF generation and balance sheets – are unequivocally lacking in Kratos. Despite inferior fundamentals on nearly every metric, Kratos is valued at an astonishing 25-45% premium based to peers. We are somewhat baffled by this in light of the comparative metrics below:

• Earnings CAGR (2007-2015E): N/A (KTOS has no earnings) vs. 15% (peers)

• Average Annual Organic Growth (2011-2015E): -12% (KTOS) vs. -3% (peers)

• Average Returns on Capital (4-Year Avg): 2% (KTOS) vs. 9% (peers)

• Debt/EBITDA: 9.5x (KTOS) vs. 2.6x (peers)

Since Kratos has no history of generating earnings, we will have to use an EBITDA valuation metric. Noted too, we are using Kratos’ definition of “Adjusted EBITDA” as well as 2016 consensus estimates of $55mm in EBITDA (both of which are inflated). If we used our 2016 EBITDA estimate of $50mm, KTOS would trade at a 40% premium to peers.

Prior to the acquisition spree that consummated in 2010, KTOS had roughly $15mm of EBITDA. From 2010-2012 it spent $950 million acquiring 9 companies that were expected to contribute $120mm of EBITDA. Pro-forma for the divestiture of the Electronics Product Group ($22mm in EBITDA), one would think run-rate EBITDA would be roughly $113mm. Instead the company is guiding to $40-45mm of EBITDA in 2015. Where did all the EBITDA go?

The disconnect is completely due to the below average nature of Kratos’ assets. Simply put, the assets are either 1) being driven to obsolescence, 2) commoditized, or 3) acquired at peak cycle / multiple. It can be seen by comparing KTOS organic growth to the large cap primes, which are a proxy for industry organic growth.

If KTOS was valued at an industry average multiple on inflated 2016 estimates (neither of which should be the case), the stock would be worth $1.20/share (65% downside).  We believe the stock is worth a lot less but concede there is some option value if management’s UAV hype plays out. However, even if one were to be gracious and value the company off its option value, the current equity value representing 33% of enterprise value is far too high a premium to pay. Arguably, the equity valued as a long dated option should really only be worth 10-15% of enterprise value, which again points to a stock 70%+ lower.

Key Point #2: 2016 Estimates Likely To Be Reduced 

The bull thesis mainly rests on fundamental acceleration in 2016+, driven mostly by the company’s UAV programs. We are doubtful as to the long-term success of the UAV programs as well as the impact on the financials. We believe expectations are far too high and will need to come down. Below is a review of consensus estimates:

Source: Capital IQ.

We will first topically address why we do not believe 7% revenue growth and 130 bps of EBITDA margin expansion seems plausible to us in the current industry environment.

1. Revenue growth of 7% in 2016 seems highly unlikely. Aside from the UAV specific issues (which we detail separately), the overall defense environment is tepid. The industry will likely see negative organic growth this year driven mostly by -2% investment account outlay growth. Kratos is a well-diversified contractor with no contract representing more than 5% of sales, making it difficult to garner the relative outperformance consensus expects. Additionally, as with the prior 5+ years, the government failed to enact a Defense Budget on time requiring it to operate under a Continuing Resolution. While this essentially pushes spending out for a few months and is largely a timing issue, it nonetheless has a disproportionate impact on shorter cycle services / sub-contractors such as Kratos. We expect the impact to result in a Q4 miss and likely reduced 2016 estimates. Management will likely use the opportunity to focus investor attention on 2017 when the UAV program should “ramp.”

2. EBITDA margin expansion of 130 bps seems aggressive. When KTOS divested its EPD business last year it sold its highest margin businesses (20% EBITDA margin). Given the current mix of business, we only see two ways the company can achieve such large YoY margin expansion: a) the UAV programs quickly transition from R&D into full-rate production (the transition is typically done over multiple years with good visibility), and 2) the PSS business shows drastic improvement (no signs point to that).

Key Point #3: Don’t Buy the UAV Hype

The majority of the bull thesis rests on the hype that the company’s UAVs (unmanned aerial vehicles) are going to provide some type of exponential growth. Kratos became UAV-centric with the July 2012 acquisition of Composite Engineering. In 2011, the business generated revenue and EBITDA of $94mm and $16mm. In 2015, Jefferies expects the same business to generate revenue and EBITDA of $70mm and $(6)mm. Obviously, the business has not done well. After some early competitive losses, the Kratos began to self-fund their UAV program R&D. While the company touts this as a competitive advantage, we believe it actually is a sign of desperation. There are two key points that management makes that we need to identify (before we refute them): 1) the company is at the tipping point of reaching exponential growth based on UAVs, and 2) the company has spent millions internally funding the UAV development, which provides a huge competitive advantage.

Controversy #1: Is Kratos At the Tipping Point of Exponential UAV growth? We believe the answer is no. If we are wrong, we believe the company will not see meaningful growth until late 2017 / 2018. Here are our key points:

1. KTOS is about 10 years late to the UAV party. UAVs really started taking off in the 2000-2005 timeframe. Every prime defense contractor now has a major UAV presence. It is a highly competitive space with the likes of Northrop, Lockheed, Boeing, etc… competing for the large programs. That is not to say that there are not smaller UAV programs that Kratos could win. When asked on January 16^th at the Noble Conference what keeps him up at night, DeMarco responded that his UAVs are now encroaching on the sandbox of the much larger, better funded companies.

2. KTOS UAVs are all early stage, and by management’s own admission, not expected to go into production until late 2016-2017. This again refutes the consensus estimates for meaningful revenue growth and margin expansion in 2016. If Kratos does succeed, it would not become evident until 2017-2018.

3. Even if Kratos does succeed, we do not believe it will move the needle as management suggests. The UAVs Kratos produces costs a few million vs. $60+ million for a Global Hawk. With $650mm in run-rate revenues, it is not enough to drive growth especially considering the headwinds the company is already facing from legacy business declines.

4. Dedicated funding seems absent in FY17 budget. Management had been hopeful their programs would get their own “line item” in the defense budget. This would essentially secure funding as opposed to being clumped into general line items where there could be more discretion on who the recipient finally is. We scoured thousands of pages of FY17 budget docs and could not find any line items specifically for Kratos’ UAVs.

Controversy #2: Is Self-Funded R&D a Competitive Advantage? Kratos has spent millions chasing their UAV dreams, which we believe is foolish. The defense industry is a cost-plus business, with the DOD funding $70 billion of R&D annually. Internally funded R&D is typically very minimal (<1% of sales). In 2012, KTOS started aggressively internally funding R&D at around 2.5% of sales with the justification of wanting to retain their IP. This is nonsensical to us. The DOD provides vast funding resources for these purposes and then rewards success via procurement contracts. Our take on the situation is that KTOS acquired Composite Engineering in 2012, failed to win UAV contracts (which accounts for the large revenue declines since acquisition), and in order to stay relevant, has been self-funding the R&D portion of these programs in hopes to still compete for the procurement contracts. If Kratos’ programs provided the value and benefit that management touts, why would the DOD not fund it? DOD spends billions on UAVs, why wouldn’t Kratos’ programs get any funding?

Key Point #4: Asset Sales Will Likely Be Dilutive at Best

Part of the bull thesis also resides in a levered-equity thesis and belief that free cash flow or asset sales will be able to reduce debt. This thesis fails in several respects.

First, while the senior notes trade at 70-cents, the prospectus contains provisions preventing the company from using asset sales to purchase bonds in the open market. Therefore, any proceeds from assets sales would have to retire debt at the call price of 105.

Second, the company trades at 14x 2015 EBITDA and most private market transactions have occurred in the 7-12x range. We could easily make the case that since KTOS assets are below average, they should fall at the lower end of this range. For example, when the company divested its Electronics Products division in June 2015, KTOS reported a sale price of 12x EBITDA while the buyer Ultra Electronics reported a purchase price of 8x EBITDA.

Below is a rough example on the dilutive nature of asset sales. At best, the company would lower its leverage multiples and at worst the equity value will further shrink due to dilution. For purposes of illustration, we assume KTOS sells $10mm of EBITDA at 10x EBITDA and the current 2016 valuation multiple holds (using 2016 consensus EBITDA). We further assume $5mm of advisor fees for net proceeds of $95. The math actually works out to be 8% dilutive to equity value. The one benefit is a reduction in leverage from 8.2x to 7.9x. Again this is using consensus 2016 EBITDA, which we believe needs to be reduced.

Risks

1. KTOS is acquired: The biggest downside risk is the entire company is acquired or the assets are acquired for premiums. It seems hard to justify given the current valuation, the exhaustive process management ran last year with minimal success, and the fact that synergies are limited in defense M&A. For the purposes of our risk analysis, we assume $50mm of EBITDA and $15mm of synergies ($10mm from the reduction in R&D and $5mm from corporate overhead). We believe this is actually generous because the majority of company sponsored R&D is for the UAV program and an acquirer would likely purchase KTOS for those assets and hence would not want to cut that type of funding. At 10x EBITDA, our take-out analysis indicates a purchase price of $4.00 or 20% premium.

2. The severity of fundamental weakness will not become apparent until late 2016. Management has a very long history of providing aggressive guidance early in the year only to reduce it later in the year. This year may be no exception. Additionally, if the FY17 budget turns out to lack funding for KTOS UAVs as we expect, management will likely spend the next several months lobbying for funding (and include that in initial guidance). This is more timing than fundamental to our thesis.

3. Insider buying: Several months ago, there was some insider buying by both CEO Eric DeMarco and #1 shareholder Oak Investments (at much higher prices). With the stock price plummeting DeMarco recently purchased $1mm of bonds in the open market. We find it interesting that he chose to buy the bonds and not the stock. DeMarco has a history of large insider purchases (all way above the current share price). My only explanation for this move is that I truly believe he is in denial over the state of the company. Either that or my analysis is completely wrong.

Catalyst

1. Q4 miss / reduction in 2016 estimates

2. Granularity from FY17 defense budget

3. Potential liquidity issues.