Kratos Defense & Security Solutions: Lots Of Headwinds (NASDAQ:KTOS)

While Kratos Defense & Security Solutions (NASDAQ:KTOS) didn’t do too bad in the last quarter when taking into consideration the macro-economic environment it operated in, the future performance of the company looks very challenging based upon some of the headwinds mentioned in its earnings report, which we’ll get into later in the article.

Even though the company has bounced from its 52-week low of $9.06 on October 13, I think it’s going to continue to struggle to break up much more over the months ahead because of struggles in some of the companies making order to get funding for their orders, as well as the government refusing to allow inflation-related adjustments to existing contracts.

In this article we’ll look at recent earnings, the company’s backlog and implications, supply chain issues and why the headwinds associated with the macro-economic environment aren’t going to go away in the near future.

Latest earnings

Revenue in the third quarter climbed to $228.6 million, up by 14 percent or $28 million, from the $200 million in revenue generated in the third quarter of 2021.

When considering a significant portion of that revenue came from acquisitions of Cosmic Advanced Engineered Solutions, Inc., CTT, Inc., and the Engineering Division of Southern Research Institute, organic growth was fairly weak.

The company reported a GAAP loss of $8 million, or $0.06 per share in the quarter, compared to the net loss of $2.4 million, or $0.02 in the third quarter of 2021.

Adjusted EPS in the reporting period was $0.08, slightly down from the $0.09 last year in Q3.

Cash flow for operations for the quarter was $2.8 million, with free cash flow for operations at $15.7 million after funding of capital expenditures of $12.9 million.

I think the company is going to struggle to repeat those numbers going forward, because of several headwinds that will be difficult to mitigate in the near term. Before getting into them, I want to make a few comments on the price share movement of the company over the last couple of years.

Share price movement

On February 15, 2021, Kratos traded at a high of close to $34 per share. Since then, it has continued to decline to the point where it fell to a 52-week low of $9.06 on October 10, 2022. Since then, it has had a modest bounce, but I’m not seeing how it’s going to sustainably break out from there under current economic conditions which are impacting numerous areas of the company.

If the backlog of the company fails to meet expectations in a big way, which is a strong possibility, the company will not only not climb in any sustainable way over the next year but could very easily drop a lot more before finding a bottom.

There’s no visible catalyst I see that will change that outlook. Even in the best-case scenario, it appears the market is pricing in the probability of the company’s backlog will not meet expectations. Not only that, but supply chain and labor issues, even if the funding is there, would prohibit the company from fulfilling its part of the obligations in a timely manner.

Again, if that’s how it plays out, the share price of KTOS is going to come under heavy, downward pressure.

Headwinds

We’ll start first with the potential disruptions in the backlog of KTOS. First, one of its customers under contract told the company that funding for a Kratos tactical drone program was no longer available.

Another example is a project it was working on related software associated with its satellite program has been delayed to a future period. Management said that “both of these were previously forecast as important contributors to our fourth quarter.” That means the current quarter, combined with other headwinds, could bring very disappointing results.

Another significant headwind was a letter the company received from the DoD which stated that companies like Kratos wouldn’t be allowed to make adjustments in existing contracts or receive additional funding to compensate for rising inflation. Next, KTOS stated that supply chain disruptions aren’t only continuing, but increasing in magnitude, as are increasing costs of materials. We know how it’ll impact the company in the near term, but how that plays out in an ongoing inflationary period is an unknown. Either way, it’s going to have an impact on the performance of KTOS through 2023. With demand for its products continuing to grow, the company has had enormous challenges in finding and retaining qualified employees. Costs are rising for hiring and keeping qualified workers, which already resulted in the company having to defer about $11.3 million in third quarter 2022 revenues into future quarters. Approximately $5.9 million of that is related to operating income.

These are the key reasons the $1 billion in backlog isn’t as compelling as the numbers suggest.

The company confirmed that it won’t be able to hire enough employees to execute on its backlog or reach its financial guidance.

Conclusion

KTOS is a company that competes in a market with high demand, but because of macro-economic conditions, employment issues, funding problems of its clients, and backlog that it is struggling to fail, it isn’t able to deliver the goods.

I think it’s probably going to get worse from here throughout 2023 because the headwinds it faces don’t appear to have any near-term solutions. The company seems to have no answers as well, based upon the comments it made in the earnings report.

The question isn’t so much of demand, but of the ability to meet that demand, and the limitations it has in relationship to business it does with the U.S. government.

For those reasons, I think it’s going to be a tough year for KTOS, and there is little in the way of tailwinds that could change that outlook, including recent announcements it’s winning more contracts. That doesn’t help if the company can’t fulfill those contracts, or as in past contracts, isn’t allowed to mitigate inflation that has made the original terms detrimental in relationship to profitability.