Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) had been having a pretty unremarkable 2018. Investors were optimistic that Trump’s policies would lead to more defense spending and contracts. But operational results weren’t strong enough to make KTOS stock move that much, and it largely traded in a range.
Then March happened. Short-selling research firm Spruce Point Capital Management published a lengthy report entitled: “Target Locked: Ready to Fire Management.” This report suggested that KTOS stock would plummet 40% to 70%. Shares got whacked, plummeting from $11.50 to $9 in the space of a week.
Since then, however, KTOS stock has bounced back, and it has just reached the pre-report $11.50 price again. Did Spruce Point miss the mark? Or should KTOS investors use this rally to get out at a better price? Let’s take a look at some of Spruce Point’s allegations.
Is Kratos Management Trustworthy?
A main point of contention is that Kratos’ management has a mixed track record at best. Spruce Point notes that Kratos acquired 10 businesses between 2008 and 2012 for a combined near $1 billion. And yet these resulted in significant losses and a bankruptcy scare in 2015.
Spruce Point goes on to connect this to Kratos management’s past work. Both the CEO and CFO were executives of defense company Titan Corp.
Titan was a defense contractor that violated the Corrupt Foreign Practices Act and was forced to pay a massive fine. Furthermore, a shareholder lawsuit alleged that Titan used inaccurate accounting to overstate revenues. As an investor, it’s worth remembering that past problems don’t guarantee problems now, but it’s certainly a red flag.
Spruce Point goes on to raise several transactions that Kratos has made that it considers may have been fraudulent, such as using a shell company to obtain U.S. Army contracts in Georgia.
Is the Drone Program Credible?
The negative report on KTOS stock also calls into question the company’s pivot to drones. The report offers a variety of reasons to conclude that Kratos is hyping up the potential here to help boost its stock price. That would be convenient, since it has raised equity three times since its recovery from the 2015 lows.
A fact I find most interesting is that Kratos has spent only a quarter of the money on research and development as main rivals such as AeroVironment, Inc. (NASDAQ:AVAV) and Parrot SA (OTCMKTS:PAOTF) have spent over the same time span.
Spruce Point adds to that by noting that the company appears to already be losing confidence in several of its development programs. The report characterizes many of Kratos’ drone plans as “experimental and high risk in nature, with no guarantee of commercial success, and not currently making money.”
That’s a far cry from analysts, who seem confident in Kratos’ continuing success. The bears would suggest, however, that given Kratos’ own underperformance over the years, and management’s history at Titan, that taking these bullish future earnings estimates at fair value would be a mistake.
What’s Happened Since Spruce Point’s Report
Initially, KTOS stock sank like a rock. But it stabilized and has now rallied. Analyst defense played a significant role. Canaccord Genuity came out with a strong statement in support of KTOS. It maintained a $15 price target, representing huge upside from the then $9 share price.
While Canaccord conceded that Spruce Point raised some valid points, it said that the report was too focused on past events rather than current developments and potential Department of Defense contracts.
Now, to be fair, that is what Spruce Point was getting at: If a management team has failed previously, why expect better results now? For example, management promised a return to profitability in 2017. Instead, it’s continued to lose money.
Kratos also issued their own rebuttal to the report. It addressed some, but certainly not all, of the concerns raised in the Spruce Point and made some good points.
For example, Spruce Point suggested, “Management owns virtually no stock and appears more focused on milking its cash compensation.” However, in fact, Kratos responded that management owns 15% of KTOS stock, among the highest levels in its industry. Always good to see management with skin in the game.
KTOS Stock Going Forward
Earlier this week, KTOS scored more points. Canaccord Genuity noted that Kratos will strongly benefit from a new DARPA contract for the development of Phase 3 of the Gremlins drone program. The contract is for $32 million, and Canaccord estimates that Kratos will get 30-40% of the revenues as the sole supplier of the drones.
This is interesting news. Not only did KTOS stock pop nicely, but it pokes another hole in Spruce Point’s rhetoric. It had said, “Kratos has already stopped commenting on certain programs, including Gremlins and UTAP-22,” suggesting this was more badly invested capital by the company. A month later, and Kratos wins a contract with Gremlins.
All this points back to a broader theme. Kratos is now a classic battleground stock. Short sellers have bet against 12% of the float, leaving them with a similar-sized position to insiders on the long side. Expect more back and forth between the two camps in coming months.
Ultimately, the fundamentals for defense contractors are bright. It’s hard not to get excited about the outlook for companies in the space. But KTOS continues to lose money, and that’s well after management had promised a return to profitability.
Canaccord itself called KTOS a “show me” stock, and they’re right. If the drone developments pay off, KTOS could certainly hit $15. But the stock is highly speculative, and investors should carefully consider the risks before putting any capital to work.
At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.