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Kratos Defense Stock Still Not Profitable — and That's OK

Last quarter, Kratos Defense & Security Solutions (NASDAQ: KTOS) made a big mistake, outright promising to deliver a positive profit in its fiscal second quarter and then failing to do so. Investors balked at the betrayal, bidding Kratos shares down 9% when the company failed to deliver what it had promised.

This time around, Kratos was careful not to make that same mistake. Prior to reporting Q3 earnings, Kratos had made plenty of positive noises about how it hoped most of its business divisions would "generate positive cash flow in 2017," how revenues would grow and profit margins would expand -- but management was very careful not to promise investors a GAAP profit this time around.

And they didn't, because...

Kratos Defense's UTAP-22 Mako drone got the centerfold treatment from Popular Science last week. Image source: Kratos Defense.

Kratos reports

When Kratos reported earnings on Thursday, there was nary a profit to be found. Announcing its earnings results for fiscal Q3 2017, Kratos reported:

  • An 18.6% year-over-year increase in revenues to $196.2 million.
  • Nearly a 1,000-basis-point improvement in gross profit margins to 24.5%.
  • Operating profits of $3.1 million (which worked out to a 1.6% operating profit margin).
  • On the bottom line, a $0.05-per-share loss -- much better than the $0.39 loss booked in the year-ago quarter, but a loss nonetheless.

Cash burn at Kratos was also higher than investors probably would have liked. In contrast to last year's Q3, Kratos used $5.4 million in cash from operations this year. Capital spending nearly quadrupled to $6.3 million, resulting in total negative free cash flow of $11.7 million -- a disappointing result given that Kratos had generated positive free cash flow in the year-ago quarter.

That result didn't quite jibe with CEO Eric DeMarco's assertion of widespread "positive cash flow" at divisions not involved with Kratos' new combat drone projects. But as bent promises go, this one was a whole lot less high-profile than promising a GAAP profit and then failing to deliver it.

How investors reacted

Accordingly, up on Wall Street, Kratos' results received a much more favorable response this time around. Street analysts had predicted that Kratos would generate $186.3 million in sales and earn (pro forma only) profits of $0.03 per share in Q3, and Kratos exceeded that revenue goal and met analyst expectations for profits (such as they were). The fact that management then went on to raise its guidance for full-year revenues to a range of $735 million-$745 million -- higher than previously projected -- was just icing on the cake, and helped to lift Kratos' stock in after-hours trading.

What's next for Kratos?

So where does this leave investors today, in the wake of the Q3 earnings release? Despite the cash flow problems, I have to say that Kratos looks like it has the wind at its back at last. The company brought in more new business than it pushed out the door as booked revenue, boasting a book-to-bill ratio of 1.2 for the quarter. New projects available for bidding are up more than 10% over the past three months at $6.6 billion, opening up the possibility of more backlog, and revenue growth, ahead.

A Kratos (unnamed) drone has been awarded a Low Rate Initial Production contract from the U.S. military, and "multiple new unmanned aerial drone system programs" are ramping up in anticipation of receiving similar awards.

On top of all this, Kratos' new UTAP-22 Mako combat drone received favorable mention -- multiple times -- in the most recent issue of Popular Science, including a first-hand account from one of the drone's designers, who compared the ease of flying Mako to playing StarCraft. All in all, I'd say Kratos is exiting this week on a high note.

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