Sentiment can shift rather quickly. While the outlook for defense companies has been gloomy in recent years due to budgetary cuts, recent events such as the Boston Marathon blast have put the limelight back on national security issues and defense companies.
Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS), a technology company providing mission critical products and services for national security, is well-positioned to benefit from this, given its single awardee status for many of its contracts. Moreover, if sentiment changes for the worse, revenue from Kratos’ commercial security companies and international security agencies will help provide some form of buffer.
No or limited competition for most of Kratos’ contracts
Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) is the single awardee in many of its contracts, where no bidding is conducted and the government agencies only approach them for negotiations. This is a result of the highly specialized nature of its products. Government agencies do not call for bidding for certain types of unique products and services, since only a single provider might bid, which defeats the purpose of organizing a bid in the first place.
For those who have participated in government tenders, they will understand the onerous tender process from the filling up of countless forms to getting the right specifications for envelopes. Moreover, a bidding process naturally leads to competition and lower margins. The longer time involved with bidding vis-à-vis negotiation also comes with associated opportunity costs in terms of missing out on alternative contracts. Also, Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) tends to be on the list of pre-qualified preferred contractors for other contracts awarded on a competitive bidding process, which helps limit the amount of competition.
Well-diversified base of clients and contracts
Most investors will seek to find the best proxy for what is the flavor of the month, but I prefer to hedge my bets. While Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) allows investors to play the defense theme, it is sufficiently diversified to weather any change in investor sentiment.
According to its January Investor Conference Call, Kratos derives about 30% of its revenue from commercial security companies and non-U.S. security agencies. This means that it will be affected to a lesser degree by any reduction in funding from the Department of Defense. In addition, Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) boasts of a diversified base of clients and contracts, with no single contract accounting for more than 4% of its 2012 revenue according its most recent 10-K.
Peer comparison
Kratos’ peers include CACI International Inc (NYSE:CACI) and ManTech International Corp (NASDAQ:MANT).
CACI International, like other defense companies, is witnessing the impact of budgetary cuts in the form of deferment of orders and a slowdown in the initiation of new defense programs. CACI International Inc (NYSE:CACI) is drawing on insights from its clients, and shifting its attention and resources to areas which are long-term strategic defense priorities of the government.
It has a remarkable track record of profitability and positive free cash flow in every single year in the past decade. With so much uncertainty over the sector, shareholders have called for a return of capital and CACI International Inc (NYSE:CACI) responded with a share repurchase program last year. According to my reading of management comments on its most recent earnings conference call, a dividend initiation is unlikely in the short-term, while share repurchases will be considered in view of valuations and the availability of M&A opportunities.
Not all areas will suffer from the same degree of reduction in defense budgets. In particular, cyber security remains the priority of the U.S. government, given the spate of cyber attacks. Mantech International Corp (NASDAQ:MANT) is well-positioned to benefit from this, given its long history and track record, having started its cyber practice more than a decade ago. Similar to CACI International Inc (NYSE:CACI), ManTech International’s business is free cash flow generative. It initiated dividend payments in 2011 and currently sports a 3% forward dividend yield.
Conclusion
Like all investors, I want the best of both worlds: upside potential and downside protection. For Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS), the upside comes from its competitive edge as the single awardee or preferred contractor in many contracts, which puts it in a position to win more contracts in the current climate. If current sentiment shifts and momentum slows down, Kratos’ diversification in terms of clients and contracts will help mitigate any negative impact.
Mark Lin has no position in any stocks mentioned. The Motley Fool owns shares of ManTech International.
The article Play Offense With This Defense Company originally appeared on Fool.com.
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