Defense spending, as a whole, is not going anywhere. Some cuts are probably for the best, because there is no way that any government agency is allocating its money with complete efficiency. When I took a national security policy course many, many years ago, I learned that most armies have the blowing stuff up strategy down pat. The United States has a lot of hardware for traditional warfare, but the next-generation tactics that have become possible with the digital age are mostly under served.
Electronic warfare is not to be underestimated. This is not just important offensively, because it poses a massive threat to a modern technological society, it is important defensively. Hacking computers or disrupting radio waves can create a lot of problems. Nothing would indicate to me that much has changed over the years, meaning that electronic warfare is behind traditional armaments. The world is catching on to the importance of protecting sensitive data and systems, along with the utility of attacking them. The cutbacks mean that companies need to be chosen judiciously with an eye on the future.
Attention and producing free cash
Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) is a small cap stock with a market cap of $351 million. In my book, it is nearing the mid-cap point, but people differ on definitions. Massive earnings are not on the cards, but the recent earnings report forecasts $50 million in free cash flow. Free cash flow is that last level after all the accounting and capital expenditures. Free cash flow builds extra cash on the balance sheet.
I think that the projection of free cash flow is a reason to follow the Zacks recommendation and buy the stock. There are also quite a few insider transactions stretching back into last year. These are direct purchases on the open market and not just option exercises. Insider buying in the past was rewarded with almost a 25% gain, but that only led to more insider buying. Insiders do not always get it right, but it is definitely a positive sign against the backdrop of free cash flow.
The company has finally finished sorting through its acquisitions. GAAP earnings are negative because of amortizations, probably from these acquisitions, which gives hints at the complications surrounding a series of acquisitions even if they were not bad ones.
The earnings call had some positive news regarding contracts won. They have a solid backlog despite defense cuts. The revenue mix is good too. When considering revenue mix, a government contract is one customer, and another contract is another customer. That is true even if the government is the same one.
With customers that are corporations, there is the risk that the company goes with another company for their needs or goes out of business. Governments are not going out of business and any pool of government authorized contractors can bid on a project. So, one government can go with a multitude of vendors for their projects.
Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) does not have singular immense contracts, but many smaller contracts. It makes projecting growth harder, because it can be uneven with one quarter having more contracts than others. Free cash flow makes it easier to see how the company is doing, but always glance at net income when looking at free cash flow. Meeting the $50 million free cash flow target might be even better if overall earnings were far higher than expected, because that could translate into more cash flow later.
Small is better
Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) can probably weather the storm better than a company like Raytheon Company (NYSE:RTN), only because it has less eyes on it. Raytheon is doing a good job of handling the spending cuts. In April, the company narrowed its range of revenue, but it was still within analyst expectations. The stock has performed admirably, and that is why I would rather go with Kratos. Raytheon’s future is baked into its stock, and now it’s probably too late to benefit. Kratos needs less money to make a difference. Raytheon Company (NYSE:RTN) would suffer more if government tightening goes further.
If you want to own a stock that benefits from defense, but is fit to hold long-term, you can go with The Boeing Company (NYSE:BA). The company’s stock has done very well, and I do think a breather is necessary. The Boeing Company (NYSE:BA) handled the battery issue, and there are always going to be problems with new planes, and the fairly rapid uptake of the new plane early in its design is a sign of the demand for new planes.
The Dreamliner problems would not be news if it had only been a few planes sold at the beginning. Planes generally have a 20-25 year lifespan, and the design has a longer life. The Boeing Company (NYSE:BA) is a good stock that mixes defense and commercial demand. Net income and revenue are holding solid, and I think revenue will accelerate as more orders for Dreamliners come in.
Conclusion
I like stocks that have the potential for large and possibly fast gains, meaning the movement occurs in a short-period of time even if it takes one year for that to happen. Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) fits that the best. As the company reports better and better earnings, it might attract attention that could send the stock higher. There is potential there and the company is making a profit if you ignore amortization, which is non-cash. Kratos Defense & Security Solutions, Inc (NASDAQ:KTOS) is small enough that its lack of attention is understandable. The company does not need much from shrinking government budgets to really make a difference to its growth.
Nihar Patel has no position in any stocks mentioned. The Motley Fool owns shares of Raytheon Company. Nihar is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Defense and Security Will Be Mainstays Despite Cuts originally appeared on Fool.com is written by Nihar Patel.
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