Welcome to another edition of Company Spotlight! This article will focus on Kratos Defense and Security Solutions, Inc. (KTOS), or “Kratos” for short.

KTOS Business Summary

Kratos is not exactly a small or young company, yet I consider it to be on the smaller and younger end of the Defense Contractor roster when compared to some of its industry leaders. It currently operates in five business divisions: Propulsion and Engine Systems, Rockets and Hypersonic Systems, Space Communications, C5ISR Systems, and Unmanned Systems (KUAS). Obviously, the latter business division is what earned it a spot in my DRONES Index of the U.S. Drone Industry and will be the focus of this article.

The company we currently know as Kratos began as a wireless IT shop in 1994. It underwent rapid growth in the early 2000’s via mergers and acquisitions (M&A), and it now operates in multiple high-technology verticals.

Kratos might be the most diversified company I have covered in my blog thus far. Its offerings span both the Industrial and Information Technology sectors, and its revenue includes both Products and Services.

If there is one shortcoming in this company’s business strategy (from an investor’s perspective), it is that the overwhelming preponderance of its revenue flows from the U.S. Government: it is a B2G dominant company. This can be lucrative while defense spending is high, but conventional business wisdom suggests that revenue diversity reduces overall risk. Kratos does have some foreign government and commercial revenue, but not to the point that I would consider sustainable during a U.S. Government funding shortfall. (Defense spending on autonomous systems is unusually high at the moment, given current events in Ukraine and Gaza, and potential events in Taiwan.)

Kratos’ initial foray into military aviation was target drones. Very high-quality, high-performance, target drones; these drones support both test and evaluation efforts, and training efforts, for other manned and unmanned aircraft. These target drones are designed to be expendable so that other aircraft can fire live missiles at them. Kratos developed separate versions for the Air Force and Navy and continues to iterate the capabilities to match evolving offensive technology.

Target drones have been the KUAS lifeblood, but there is a new product offering that could change the KUAS landscape. Let’s dig into the Kratos Tactical UAS products.

I am not certain which of the company’s acquisitions produced the initial concept for the XQ-58 Valkyrie, but I do know that today’s version is gaining traction. The Valkyrie was the company’s initial offering to the Tactical UAS market. I cannot claim to be an expert on low-observable (LO, also known as “stealth”) technology; however, I see several common characteristics with F-22 and F-35 aircraft: angled air intake and exhaust, swept V-tail, minimal external protrusions, etc. I would venture to guess that this aircraft was designed to be partially low-observable while retaining a low production cost.

The XQ-58 Valkyrie is one of three tactical autonomous aircraft that are being considered for 5^th generation fighter “loyal wingman” concepts across the services.

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KTOS Stock Information

Before looking at Kratos’ future, let’s look at the present. Here is an investor’s snapshot of the company today. Kratos is in the Industrials sector, Defense and Aerospace industry. Its market peers are those companies that manufacture passenger airplanes, aircraft carriers, submarines, battle tanks, and missiles.

	KTOS	Industrials Sector
P/E Ratio	303.4	24.17
EPS	$0.07	$7.62
P/S Ratio	2.51	—
PEG Ratio	34.12	—
Price/Book Ratio	2.30	—
Return on Equity	1.54%	22.78%
Analyst Recommendations	Buy	—

The first thing I notice is how rich KTOS valuation is compared to its industry peers. P/E ratio north of 300? That is 4x the current NVDA P/E ratio as I write this. But, taking this number in context: KTOS conducted several M&A over the last two years, thus reducing earnings. Additionally, KTOS has steadily increased shares for the last several years (129,000,000 shares in 2023, up from 123,000,000 shares in 2020) to finance its growth.

Here is a look at KTOS technical indicators. Share prices have consistently beat its own 20-day and 50-day Simple Moving Averages (SMA) for approximately 18 months, and these two averages have now climbed above the 200-day SMA. This is generally taken as a Bullish trend.

Now, let us compare KTOS returns to its industry peers. The following chart pits KTOS against two ETFs which track the Defense and Aerospace industry (ITA and XAR).

Overall, KTOS has been keeping pace with its industry peers over the last two years. This is a remarkable feat for a high-growth company given the fiscal environment this country has endured.

Astute investors seek to understand a company’s sources of revenue, and where the money goes. Here is a graphical depiction of KTOS’s reported income in FY23.

Kratos ended 2023 with a minor loss (~$9M) which was covered by financing activities. Given the company’s activity with mergers and acquisitions (M&A) over the last few years, along with internal research and development investments and partnership with ShieldAI, I take this as a victory.

I often check insider trading for any indications of the company officers’ conviction in the stock price future. Most of the time, the insider transactions consist of Option Exercises and Sales: many companies include stock as part of the executives’ compensation, which they must sell for cash in order to pay mortgages and buy groceries. However, KTOS has an insider Buy, from the President and CEO, reported on August 15 (the day prior to me writing this article on August 16). The purchase totalled approximately $250,000, and seemed to increase the CEO’s personal stake by almost 30%. I am taking this as a somewhat Bullish signal.

When conducting a Company Spotlight, I like to break down the sources of revenue and expenses among business divisions if the company’s Annual Report supplies enough itemized information. Conveniently for me, the Kratos Annual Reports as far back as 2014 have broken out Revenue from the Unmanned Systems Division (KUAS) from the rest of the company (as you can see in the graphic above). I find this an interesting method to categorize: KUAS is not the largest or oldest division, but it is treated differently than the other divisions. Perhaps this is an indication of intent to sell or spin off the KUAS division.

Kratos Unmanned Systems (KUAS) Division

The Kratos Unmanned Systems division (KUAS) offers Products and Services to the U.S. government, foreign governments, and commercial partners. This is a good step in diversifying revenue. Here is how its revenues looks year-over-year.

So the Services are not very impressive, but they do offer some sustainable recurring revenue to the division.

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Up until around 2020, my only real knowledge of Kratos was its Aerial Target drones. I vaguely heard about the Valkyrie in passing, often in the same conversation as other advanced Tactical UAS prototypes circulating through industry. I did not take the company or its platform seriously at the time. Now, I believe the XQ-58 might push Kratos over a financial tipping point of explosive growth.

The Kratos Unmanned Systems (KUAS) division first piqued my attention in 2021, when it was awarded a $50M indefinite delivery, indefinite quantity (IDIQ) contract by an undisclosed government agency, for its XQ-58 Valkyrie drone. I then learned of its history with the U.S. Air Force Research Lab (AFRL) and its Skyborg and Low Cost Attritable Aircraft Technology (LCAAT) programs. Kratos was also selected as a vendor on the USAF Advanced Aerospace Systems Technology Research IDIQ. KUAS then received an order for two tails from the U.S. Marine Corps in 2022, supporting both the PAACK-P and MUX-TACAIR programs. In researching for this article, I was surprised to learn that KUAS was even awarded a U.S. Army contract in 2023, for its Advanced Subscale Aerial Program (ASAP); this contract (presumably an IDIQ or similar) has a ceiling value of $95M!

The Marine Corps order was for two XQ-58A aircraft (plus accessories and services) for about $15.5M. Knowing that the aircraft itself only represents some fraction of the overall cost, my wet-finger-in-the-air math predicts roughly $5M price tag per aircraft in small quantities. The production capacity is immature and the learning curve is steep at this point in a product’s life cycle; I would hazard an estimated $3M-per-aircraft price point in large quantities (20+ tails) as the production capacity matures. (For comparison, the MQ-9A Reaper is estimated at $32M per tail, as reported by Wikipedia.)

Each year, the services (particularly the Navy) Aerial Target programs purchase parts, equipment, upgrades, and maintenance services, on a non-competitive sole-source basis. Sole-sourcing is an important part of the KUAS business strategy, as it eliminates market competitors from consideration. This revenue is the lifeblood that keeps the KUAS division alive while it reinvests into more aggressive pursuits.

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For Defense Contractors, a successful product sales strategy requires two external conditions:

1. The Contractor must be accessible via a contract vehicle to the U.S. Government for delivery of the product, allowing for the proper funding appropriation.
2. The Government customer must have a budget line with a proper funding appropriation, purpose, timeline, and dollar value for the product.

The first item (a contract vehicle) for aircraft production appears to already be in place via the multiple IDIQ’s previously mentioned.

I will now turn attention to the second item: the defense budget.

Defense Budget

There are many challenges associated with tracing Government budgets to company revenues. One of which is linking budget line items to contracts—the titles simply do not match. Beyond this, it is also difficult to link Government fiscal year funding with company revenue, with the assumption that the contract award date is somewhere in the middle. Most Government funding appropriations are valid for multiple years; this means that a 2021 DoD budget may have been applied to a 2022 contract, which was reported as revenue on the 2023 KTOS Annual Report.

As a case-in-point of a budget line-item title not necessarily matching the program: I referenced the Air Force Skyborg program earlier in this article, which is known to have funded KUAS development. There is, unfortunately, no budget line item labeled “Skyborg”, nor is there a contract with the title “Skyborg”. We analysts have to make best guesses. So, in the following sections, I will make an honest attempt to match a budget line with a contract, and ultimately with a Kratos Income Statement.

To add one more layer of complexity: only a mere fraction of the funding is awarded to industry vendors, and there are cases where multiple vendors are in play. Some portion of the funding supports internal Government processes; the remainder is what is allocated to the vendor(s). To make an example: the Army has a budget line titled “Future UAS Family”, and I am confident that the major portion of this $200M budget line goes to AeroVironment (AVAV) for their Future Tactical UAS (FTUAS) program. Therefore, I apply a multiplier to approximate what proportion is destined for KTOS.

The following table represents my educated guesses, multiplied by my uneducated guesses. I began with actual numbers from DOD Budgets that might apply to Kratos products, and estimated a Budget Multiplier for each line, until the total dollar amount was in the same ballpark as the Kratos Annual Reports for the KUAS Division. It is not perfect, but you can see how a trend might be extrapolated.

		Numbers expressed in thousands $USD
ARMY		2022	2023	2024	2025
Air Platform Applied Research		6,597	40,372	48,163	53,206
Budget Multiplier	0.05	330	2,019	2,408	2,660
Air Platform Advanced Technology		754	13,062	14,165	17,076
Budget Multiplier	0.01	8	131	142	171
Future UAS Family		0	0	53,453	149,059
Budget Multiplier	0.3	0	0	16,036	44,718
Army Total		337	2,149	18,586	47,549
AIR FORCE		2022	2023	2024	2025
Aerial Targets		1,528	1,316	6,915	7,685
Budget Multiplier	0.9	1,375	1,184	6,224	6,917
Autonomous Collaborative Platforms		0	54,954	118,826	51,666
Budget Multiplier	0.1	0	5,495	11,883	5,167
Target Drones		116,169	113,706	42,226	37,581
Budget Multiplier	0.9	104,552	102,335	38,003	33,823
Air Force Total		105,927	109,015	56,110	45,906
NAVY/MARINE CORPS		2022	2023	2024	2025
Advanced Tactical Unmanned Aircraft System		16,204	11,735	539	3,504
Budget Multiplier	0.9	14,584	10,562	485	3,154
Tactical Unmanned Aerial Vehicles		9,837	10,576	11,235	0
Budget Multiplier	0.3	2,951	3,173	3,371	0
Unmanned Aerial System		16,879	96,337	108,225	99,940
Budget Multiplier	0.01	169	963	1,082	999
Aerial Targets		150,339	182,134	176,588	182,463
Budget Multiplier	0.5	75,170	91,067	88,294	91,232
Navy Total		92,873	105,765	93,232	95,385
DOD Total		199,138	216,929	167,927	188,839

Based on the U.S. Defense budget alone (and my interpretation thereof), there does not appear to be an impending windfall of KUAS orders for the U.S. military in the next 6-12 months. The preponderance of KUAS revenue has been Aerial Targets, with a small handful of Tactical UAS sales.

What might the future bring? Read on to find out.

Kratos Future Programs

There are some early indications of an emerging USAF program called OBSS (Off-board Sensing Station) program. While Kratos has been associated with OBSS in some internet posts, OBSS does not have a dedicated budget line that I was able to locate and any attempts to assign a dollar value are merely conjecture.

One important defense program that does not yet appear by name is the Replicator program. Replicator is intended to mass-produce attritable autonomous systems for mass fielding in a contested environment. The FY24 budget was intended to be internal reprogramming of various budget lines, and the FY25 budget is said to be spread among multiple budget lines of different names. Perhaps some of them are included in the table above.

Replicator’s initial tranche of purchases was the AeroVironment (AVAV) Switchblade-600 loitering munition. As far as I can tell, this consumed most of the initial $500M in FY24. Follow-on tranches are the stuff of rumors and speculation, potentially valued at another $500M in FY25, more in future years.

What if KUAS wins a mass production for XQ-58 under Replicator? Let us assume the DoD orders 50 tails of XQ-58, plus support equipment and services. Using my previous estimates, that would be roughly $150M for major end items, plus another $100M for support equipment, spares, and support services. That $250M falls well within the bounds of budget projections and still leaves room for other industry competitors.

Such an order would certainly change the landscape with KUAS. What I really like about this business model is that the product is expendable: similar to Aerial Targets, the customers would require annual replenishment–say 20 tails per year at $3M per tail. The product would inevitably upgrade over time to match the sophistication of adversarial systems, adding even more life to the Tactical UAS program.

Is KTOS a Buy? Let’s just say that I would not be writing about it if my suggestion was to stay away. Its current price target is nearly $24, representing 11% anticipated growth from today’s $21.30.

I think that, for a mid-cap Industrial company, it has shown sustainable revenue growth over the last decade. It has gained some traction with a new product line offering, and that new offering meets a significant customer requirement at a critical time. I also believe that there is some potential for the KUAS division to spin off if the company receives a bulk order for its Tactical UAS. There is Bullish sentiment all around this company, and I believe the latter half of this decade will be lucrative for its investors.

As always, please conduct your own research and consult a Financial Advisor for any potential investments. The author holds a long position on KTOS.