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Why Kratos Stock Crashed Last Week

By now you've heard the news -- and the news was not good: Shares of Kratos Defense & Security Solutions (NASDAQ: KTOS) stock crashed 10% after the company reported earnings on Friday, and they haven't managed to bounce back since.

Here's why.

Kratos' future lies in drone sales. Drone profits may need to wait. Image source: Getty Images.

Kratos made commitments

Investors had high hopes heading into Kratos' earnings report last week -- and for good reason. Three months prior, the company had pumped up the volume on expectations that, after six straight quarters of reporting nothing but losses, it would finally turn profitable again in the second quarter.

This wasn't some vague declaration of aspiration, either, but something just short of a firm promise. In Kratos' post-earnings conference call with analysts in May, Kratos CEO Eric DeMarco declared in no uncertain terms: "I am fully expecting a return to profitability in Q2."

DeMarco then went further to predict that "profitability [would] increase significantly [in the] second half" of 2017. And then he went even further, assuring investors that "every Kratos business unit is expected to be operating cash flow-positive in 2017 except Unmanned Systems," and "every Kratos business unit" -- period -- would become "cash flow positive in 2018."

So how did those predictions turn out?

Overpromise, underdeliver -- or, wait, was it supposed to be the other way around?

For fiscal Q2 2017, Kratos reported 10% growth in quarterly sales to $185.7 million, but 12% growth in total costs, to $138.3 million. On the bottom line, losses shrank from $0.17 per share last year to $0.07 per share this year.

It was an improvement in financial performance, no doubt. But there's also no doubt that on the profit Kratos promised, it failed to deliver.

Moreover, one of the reasons Kratos lost so much less per share in Q2 2017 than it lost in Q2 2016 was that the company issued a lot of new shares to raise cash to fund its UAV development program. Kratos ended Q2 2017 with 86.6 million shares outstanding, 45% more than it had on the books in Q2 2016. And because the company's total losses were spread out among many more shares this year, the per-share loss was naturally much smaller.

Were it not for the dilution, per-share losses would have shrunk by 40%, instead of nearly 60%.

Promises, promises

So what about the other parts of Kratos' promises of three months ago? What's the situation with Kratos' cash flow, and what is Kratos saying now about its future prospects?

Well, there's potentially good news on the cash front. Kratos didn't provide any details on whether its business units were cash flow positive (or not) in Q2 in particular. But in the earnings press release, CEO DeMarco doubled down on his promise that "every Kratos business unit is expected to generate positive cash flow in 2017, except Kratos' Unmanned Systems Division." Furthermore, Kratos is still "forecasting a return to ... being cash flow positive [as a whole] in 2018."

As for profitability, while management made no promises about achieving GAAP profitability this time around, it does still seem to be moving in that direction. Kratos upped its expectation for this year's revenue, saying it now expects to book between million and $740 million in sales this year. Moreover, DeMarco stated that "we are expecting significant revenue and margin growth to continue into the second half of 2017, and 2018" [emphasis added]. 

So, fingers crossed.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.