Kratos Defense and Security Solutions Inc (KTOS)

[chmcnfunds]

Kratos: At Just $5, This Drone And Defense Stock Is Giving Investors A Half-Off Sale

Dec. 19, 2014 3:37 PM ET | About: Kratos Defense & Security Solutions, Inc. (KTOS)

Disclosure: The author is long KTOS. (More...)

Summary

This little-known drone and defense sector stock is too cheap to ignore after a recent pullback.
Barron's and other analysts point out this company could be ripe for a takeover and at a significant premium to the current share price.
This company is poised to benefit from increased demand for security, surveillance, and the use of drones, which means the long-term future looks bright.
According to multiple analysts, this stock could be worth about twice the current share price.
This stock could also be poised for short-term gains as tax loss selling ends and potential short-covering increases in January.
Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) is a relatively small, but up and coming security and defense contractor. It has several divisions that offer a variety of products and services for the defense and security industry. These divisions include: "Electronic Products" which offers flight testing and instrumentation for fighter aircraft, ballistic missiles, radar systems, avionics and more. "Defense & Rocket Support Services" which offers expertise in logistics, engineering, target operations and advanced weapons systems research. "Public Safety & Security" which offers security systems, access control and video surveillance systems. "Modular Systems" which designs and manufactures modular tactical shelters, containers and other equipment for the U.S. Armed Forces, its Allies and other major defense contractors. "Technology & Training" offers defense simulations, cloud and cyber security solutions, satellite security and command and control solutions. "Unmanned Systems" provides aerial target systems, weapons guidance systems, unmanned vehicle control systems, flight termination systems, and radar tracking transponders. What makes Kratos very unique is that all of its products and services are geared towards modern warfare and security. The use of unmanned aircraft, ballistic missiles and satellites is likely to increase in the future. Its surveillance and security systems are also likely to remain in high demand.

(click to enlarge) (clink link below for charts/tables)


Photo credit: Kratos Defense & Security Solutions, Inc.

(click to enlarge)


As the chart shows, this stock was trading for about $7 per share in early November, but has since dropped to around $5, after the company reported an earnings miss. This stock is oversold and very undervalued now. It appears poised for a rebound. I believe that as tax-loss selling soon fades, this stock will push back towards somewhere between the 50-day moving average which is $5.70 per share and the 200-day moving average which is about $7.09 per share. However, that is just the potential I see for this stock in the short-term. The longer-term potential looks even more promising.

Investors have overreacted to a recent earnings miss:

Some investors were disappointed with recent financial results and that caused the stock to pullback. For the third quarter of 2014, it reported revenues of $217.1 million which missed analyst estimates of about $244 million. It reported an adjusted profit of 10 cents per share, which missed estimates of 13 cents per share. However, Kratos gave stronger revenue guidance for the fourth quarter, expecting it to come in a range of between $225 to $245 million. That stronger revenue guidance is one reason why the pullback in the stock seems excessive. It is worth noting that (as of the third quarter) this company has a contract backlog of about $1 billion. That is another reason why the recent pullback is undeserved. Furthermore, this $1 billion backlog is equivalent to about an entire year's worth of revenues and having a backlog of this size significantly reduces potential downside risks for investors. Analysts expect Kratos to earn 48 cents per share in 2015, and 78 cents per share in 2016. That means this stock is trading at just about 10 times earnings. Plus, analysts have price targets of about $10 and believe this company could be a likely takeover target which is detailed below. I believe this stock could rebound by about 30% or more, in early January. I also agree that the stock should be worth $10, based on defense and drone sector valuations that are averaging about 20 times earnings. There are a number of recent positives that investors should be focused on:

During the third quarter, it was awarded a contract for 20 unmanned aerial drone target systems which Kratos plans to produce in 2015. It also completed negotiations with an existing agency to provide 75 unmanned aerial drone target systems in a contract that is worth $75 million and this is expected to be formerly awarded in the fourth quarter. It also said that its Board of Directors has retained an investment banking firm to evaluate strategic alternatives which could lead to the sale of non-core businesses or possibly the entire company. A sale of one or more divisions could become a major upside catalyst for the stock and also significantly strengthen the balance sheet which currently has over $16 million in cash and around $663 million in debt. This level of debt appears conservative considering the company has nearly $1 billion in annual revenues and a contract backlog that is also worth about $1 billion.

On November 6, the company announced it was awarded with an $81 million contract to provide a specialized security system for a major mass transportation authority. This is a major contract and there is good reason to expect that more public transportation authorities will be upgrading security and surveillance systems to prevent crime and to monitor and prevent potential terrorism threats.

The market for unmanned aircraft is expected to surge in the coming years:

The United States Department of Defense has budgeted $28 billion in spending on unmanned aircraft through 2018. A market study by the Teal Group shows the huge growth potential for unmanned aircraft in the coming years. The report states:

"Despite near-term U.S. budget cutbacks, Unmanned Aerial Vehicles (UAVs) continue as the most dynamic growth sector of the world aerospace industry this decade, report Teal analysts in their latest integrated market analysis.

Teal Group's 2014 market study estimates that UAV spending will nearly double over the next decade from current worldwide UAV expenditures of $6.4 billion annually to $11.5 billion, totaling almost $91 billion in the next ten years.

"The UAV market continues to evolve and become an increasingly global market," said Philip Finnegan, Teal Group's director of corporate analysis and an author of the study."

Kratos is a strong candidate for a takeover by much larger rivals:

Multiple analysts see significant upside and buyout potential. Michael Crawford, an analyst at B.Riley & Co. is bullish and sees takeover potential, but believes that this stock will reach $9.50 in the next year, even without a takeover. An MSN.com article details why Mr. Crawford believes Kratos is an attractive acquisition target for bigger military contractors and it also states:

"What makes the business especially attractive is that Kratos works on "long-tail" jobs that can last decades, says Michael Crawford, an analyst with the Los Angeles investment banking firm of B. Riley & Co. As a result, even if future defense spending falls or grows at only a tepid pace, Kratos' revenues are unlikely to drop precipitously. Another plus is that Kratos' products are on the small and comparatively affordable side."

Kratos has been considered to be a potential takeover target by analysts at KeyBanc as well. Earlier this year, Barron's called the stock undervalued and points out that Mark Jordan, an analyst at Noble Financial Capital Markets says the stock is worth $10.50 per share, which is about twice the current price. Kratos has a significant amount of business from the U.S. Government but also with high profile corporations like Chevron (NYSE:CVX) and Calpine (NYSE:CPN), both of which need state of the art security and surveillance for refineries and power plants. The Barron's article goes on to point out that Kratos Defense could be a takeover target, it states:

"We've made the point before that with its product portfolio, Kratos could make an attractive acquisition target for a larger defense concern. Any deal would likely occur at a large premium."

A recent article points out some very interesting comments that were made by the CEO of Kratos during the latest third quarter conference call. It seems like he slipped and gave away a hint that suggested some type of deal for Kratos could be coming quite soon. The comments also seem to imply more than just the sale of one or more divisions because unless the entire company was acquired there would be no reason for the CEO to not be speaking with analysts again in the next conference call. The iMarketreports.com article points out that the low valuation and a major contract backlog could make Kratos Defense an attractive takeover target for a number of companies to consider, it states:

"CEO Eric DeMarco provides a mildly intriguing sign off to its 3Q call, promising to talk to analysts again in January "unless something transpires" before that. True, KTOS is shopping non-core assets, but the share slump following its profit warning could make a $1B backlog enticing to a wider audience."

Compared to other drone and defense stocks, Kratos is deeply undervalued now:

AeroVironment, Inc. (NASDAQ:AVAV) is a maker of unmanned aircraft and it generates revenues of about $247 million per year. Analysts expect AeroVironment to post break-even results for 2015 and to earn just 52 cents per share in 2016. Its shares trade for about $28, and that puts the price to earnings ratio at about 55 times (based on 2016 estimates). This comparison makes Kratos shares (and its market cap) appear extremely undervalued, here's why: Kratos generates nearly $1 billion per year in annual revenue and yet the market cap is just about $300 million. Analysts expect this company to earn 48 cents per share in 2015, and 78 cents per share in 2016. That puts the price to earnings ratio at just about 10 times for 2015 and what would be just 6 times earnings for 2016. That is way too cheap and this is another reason why I expect this stock to rebound soon. Compared to major defense contractors, Kratos Defense & Security shares also appear very undervalued. For example, Lockheed Martin (NYSE:LMT) trades for nearly $200 per share, and with earnings estimates of about $11 per share, this puts the price to earnings ratio at about 19 times. If Kratos shares were to trade at that level the stock could be worth nearly $20 per share.

Insiders have been accumulating shares throughout 2014:

Earlier this year, multiple insiders bought shares when it was trading at about $7. In particular, the 200,000 shares that William Hoglund (a director) bought for about $7.25 was notable since this was valued at nearly $1.5 million. Just recently (in late November and early December) a couple of insiders have bought more shares which is shown below. (Data sourced from Yahoo Finance)

Date Insider Shares Type Transaction Value*
Dec 1, 2014 MILLS THOMAS E IV Officer 2,000 Direct Purchase at $5.06 per share. 10,120
Nov 28, 2014 JUDD JANE ELIZABETH Director 3,000 Direct Purchase at $5.13 per share. 15,390
May 20, 2014 HOGLUND WILLIAM A Director 149,668 Direct Purchase at $7.25 per share. 1,085,093
May 19, 2014 HOGLUND WILLIAM A Director 50,332 Direct Purchase at $7.19 per share. 361,887
May 5, 2014 DEMARCO ERIC M Officer 10,000 Direct Purchase at $7.29 per share. 72,900
May 5, 2014 LUND DEANNA H Officer 2,000 Direct Purchase at $7.26 per share. 14,520
Mar 17, 2014 POIRIER RICHARD Officer 3,500 Direct Purchase at $7.14 per share. 24,990
Mar 17, 2014 DEMARCO ERIC M Officer 3,043 Direct Purchase at $7.12 per share. 21,666
Mar 14, 2014 JUDD JANE ELIZABETH Director 1,820 Direct Purchase at $7.07 - $7.08 per share. 13,0002
Mar 14, 2014 DEMARCO ERIC M Officer 6,957 Direct Purchase at $7.19 per share. 50,020
Kratos shares appear poised for a "Santa Claus" and "January Effect Rally":

Obviously, the multiple factors noted above indicate significant long-term potential but I also see a couple short term factors that could push this stock higher. This stock has a 52-week high of $9.18 and with it now trading near a 52-week low at just about $5.00, it is likely that it is experiencing tax-loss selling. Most of the tax-loss selling pressure should fade by December 19th this year since that is the last Friday before the Christmas Holidays. If this stock is going for about $5.00 while it is experiencing tax-loss selling, it is probably going to trade at significantly higher levels once that ends. Beaten down stocks often get a lift from the end of tax-loss selling towards the end of December in what is known as a "Santa Claus Rally".

Shorts benefited significantly from the recent pullback, but the stock appears to have bottomed out. According to Shortsqueeze.com, there are nearly 4.5 million shares short. With an average trading volume of about 490,000 shares per day, the short interest is equivalent to about 9 days worth of trading volume. The thing is that many shorts probably don't want to cover until after December 31. This way they will defer paying taxes on their gains for another calendar year. That means short covering in the first week or two of January could create significant buying pressure in the first couple weeks of 2015. Many beaten-down stocks experience this type of rebound thanks to the end of tax-loss selling and also due to short covering. This is known as the "January Effect Rally".

In summary, this stock is oversold after a pullback from about $7 to just about $5.00, due to the earnings miss and tax-loss selling pressure. This pullback is excessive when you consider that this company has announced some large contracts and that it expects revenues to rebound in the fourth quarter. The backlog of about $1 billion is another very positive factor. It also looks too cheap when compared to other companies in this sector. This stock is undervalued when evaluating the PE ratio, analyst price targets and the potential for the company either sell a non-core division (due to the recently announced strategic review with investment bankers) or potentially a complete buyout. The potential for a Santa Claus and January Effect Rally is just one more reason to buy now.

Here are some key points for Kratos Defense & Security Solutions:

Current share price: about $5.00
The 52 week range is $4.21 to $9.18
Earnings estimates for 2015: 48 cents per share
Earnings estimates for 2016: 78 cents per share
Annual dividend: n/a
Data is sourced from Yahoo Finance. No guarantees or representations
are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for
informational purposes only. You should always consult a financial
advisor.
______________________________________________
http://seekingalpha.com/article/2769475-kratos-at-just-5-this-drone-and-defense-stock-is-giving-investors-a-half-off-sale?uide=996949&uprof=46

KTOS