Description

I am recommending the purchase of Kratos Defense & Security Solutions, Inc. (KTOS) with a price target of $20 per share based on the likelihood it will be acquired by a large defense company at an enterprise value to earnings before interest taxes depreciation and amortization (EV/EBITDA) multiple of at least 10x 2011projected pro forma EBITDA of $120 million.  KTOS is a defense contractor based in San Diego, California that specializes in national security technologies by providing products, solutions and services for critical United States security programs.

KTOS primary customers include the US Department of Defense, Intelligence, National Security and other Federal Government agencies.  They are involved in Space Systems, Radar, Sensors, Communications, Avionics, Micro Electronics, Unmanned Aerial Vehicles, Missile Systems, Land Systems, Aircraft, Marine Systems, and Training Systems.  Based out ofSan Diego, KTOS has a technical and engineering workforce of over 4000 employees and a significant number of their workforce hold active National Security clearance.

KTOS CEO Eric DeMarco was previously CEO of the defense company Titan Corp, which he grew by acquisitions and eventually sold to L-3 Communications Holdings, Inc. for an EV/EBITDA multiple of 12.18x.  The KTOS strategy is the same one that Titan Corp. utilized to garner its ultimate sale.  Since 2007, KTOS has acquired 10 companies (#11 was announced 1/3/12) with their two most significant acquisitions being done in 2011.

On top of the experience that CEO Eric DeMarco brings with him from his Titan success, he also brings along some extra motivation in that he didn’t feel proper treatment was given when Titan was sold.  Upon arrival at KTOS, Mr. Demarco changed the name of the company to Kratos from Wireless Facilities, Inc. since Kratos was the Greek god of strength who slayed Titan. 

The most recent large acquisition by KTOS has been Integral Systems, Inc, which specializes in developing, managing and operating secure communications networks, both satellite and terrestrial, as well as systems and services to detect, characterize and geo-locate sources of RF interference.  KTOS paid an EV to projected adjusted EBITDA to KTOS of 7.6x. 

The other large acquisition this year was Herley Industries, Inc. whose products have established positions in numerous defense platforms, including manned and unmanned aircraft, tactical and ballistic missiles, sensor based and radar platforms, electronic warfare systems, electronic attack systems and representative threat systems.  KTOS purchased Herley Industries, Inc. at an EV to EBITDA multiple of 6.75x.

Investment Thesis:

TheUSdefense industry has fallen out of favor due to the uncertainty caused by anticipated budget cuts.  However, not all defense companies are created equal.  With the Budget Control Act slated for automatic cuts, the market does not expect Congress to come to any sort of resolution soon to prevent the cuts from falling into place completely.

KTOS is currently trading at depressed levels that are affecting the whole defense sector due to projected budget cuts of 23% to the Department of Defense which include the effects of the Budget Control act and sequestration.  However, I believe KTOS provides products and services in areas which allow the military to provide for increased security and efficiency, which are not likely to be cut.

In addition, KTOS receives only 75% of their revenues from the Federal Government or customers of the Federal Government.  This amount includes orders from International Governments as well.  Assuming all 75% of the US Government Revenue gets cut by 23%, it would mean that the reduction to KTOS’s top line would be 17.25% in the downside scenario.  Again, this assumes that all defense cuts are evenly spread across the board and that certain programs are not cut more than others.  That scenario is very unlikely as realistically there are programs that are more likely to be cut compared to others.  The department of defense has stated that after prevailing in the wars overseas, the next priority is to prevent and deter conflict.  In their overview for the 2012 budget, they mention the following under deterrence:

“Our deterrent is rooted in land, air, and naval forces capable of fighting limited and large-scale conflicts against the full range of state and non-state groups in anti-access and irregular environments engaging.  These forces depend on a sustainable global posture and a resilient basing infrastructure, and are enabled by cyber, space, and ballistic missile defense capabilities, as well as capabilities to counter weapons of mass destruction (WMD).  This budget also supports maintaining strategic deterrence and stability at reduced nuclear force levels, strengthening regional deterrence and reassuringU.S. allies and partners.”

-UNITED STATES DEPARTMENT OF DEFENSE

FISCAL YEAR 2012 BUDGET REQUEST

It’s not likely that funding will be cut from items in defense that relate to cyber, space and ballistic missile defense, which is much of what KTOS does.  Cuts will likely occur in other areas to meet the required budget cuts (such as cutting the F-35 Joint Strike Fighter and the Joint Light Tactical Vehicle).

Other likely cuts will take place against projects that would upgrade the national defense to next-generation fleets of jets, ships or other new items that would require heavy levels of research and development as well high new manufacturing equipment.  Instead, to save money the focus will turn to extending legacy systems already in place.  These systems and items will still need to be repaired and renewed as their useful lifecycle ends but instead of moving forward with a brand new platform, they will upgrade using the existing platform instead.  It is similar to the difference between a version update and upgrade.  Updates are always cheaper and require less time and effort to integrate.  This gives an edge to existing suppliers as they already have proven technologies and manufacturing abilities which work and can continue using their existing infrastructure which will only add marginal expenses.

CEO Eric DeMarco owns 45,768 shares directly and bought 17,916 shares at a price of $5.58 per share on 11/9/2011.  He also owns 125,000 restricted stock units that would vest upon a sale of the business.  Mr. Demarco will eventually look to sell KTOS as he had done with Titan in the past and there are logical buyers.  With overall defense cuts expected, companies are looking to backfill lost revenues through acquisitions.  The companies who are losing revenue must find some way to makeup for them and in the defense industry it is difficult to grow organically and growth is typically done through acquisitions.

At a recent investment conference, Lockheed Martin Corp’s Chief Financial Officer (CFO) Bruce Tanner stated:

"We're not out of the acquisition game," the finance chief said. "Frankly I would love to have more acquisitions going forward than we've done in the past few years."-REUTERS

It is clear that a company like Lockheed will need to make up for their revenue losses and look to make acquisitions.  The government has even been encouraging small and medium sized companies to get together so that they can achieve better overall margins and offer the government better products while keeping overall profit margins the same.

Recently there have been issues with counterfeit micro-electronics that have been used in vital equipment for the defense industry.  This can create huge security problems for National Defense and congress has just passed legislation to strengthen protections against having counterfeit electronics infiltrating the system.  This bodes well for KTOS as they are one of the few companies who have policies and procedures already in place to detect counterfeit parts and can be trusted by the customers who use parts from KTOS.

Another area of large growth for defense is unmanned aerial vehicles (UAV).  The Air Force now recruits more pilots for UAV’s compared to fighter and bomber pilots combined.   Surveillance has and will continue to be done increasingly by drones and KTOS supplies parts that are used in such vehicles.

There are a few different ways in which the value of KTOS can be unlocked.  One is by the continued growth in the demand for their products.  As they are involved mostly in products that the defense industry will need to be lean and efficient, as well as in areas which are of continued need and importance as the style of warfare has been shifting, KTOS profits and cash flow should continue to grow.

In looking at comparable companies to KTOS, you can see from the chart below that it is trading in line with others.  For KTOS, it is important to look at next 12m EBITDA levels since they have made acquisitions recently that skew their results over the last 12 months.  Please note that Mantech and SAIC trade at discounts to the group since they are suffering from margin compression that is unique to their niche in the government IT industry.

However, I believe it is more likely that KTOS will be purchased by an outside party.  There are strong incentives for one of the large defense contractors to purchase a company like KTOS to make up for lost sales due to the budget cuts in defense.  There are going to be some companies that are hurt more than others and the ones that know that they will be hurt will look for ways to make up for the lost revenue.  The large majority of the budget cuts will take place beginning in 2013 so as that time approaches I suspect there will be a flurry of acquisition activity within the defense industry as companies look to find a way to make up for the revenue and profits they will inevitably lose.

The two important factors to consider here are what the possible EBITDA levels can be as well as the EV/EBITDA multiples.  Starting off with EBITDA levels, I decided to model 3 different scenarios:  One where the full effects of budget cuts get taken proportionately to KTOS revenue line, another where KTOS keeps their revenues flat assuming that any effects they have from budget cuts are made up for by the growth in areas which are unaffected, and finally a model where their revenues grow by around 5% each year.

It is important to remember that the 3^rd quarter of 2011 was the first full quarter where the recent large acquisitions that KTOS has made recently have been in effect.  So when projecting out I used 3^rd quarter numbers to make my assumptions.  This is why the 2012 figures look like they have grown a lot, since 2011 only has half a year of all of the merged companies on the financial statements.  Also, all of my cases are the same for 2012, since the budget cuts do not come into effect until 2013 and this is where much of the future uncertainty lies.

Based upon the different scenarios I have outlined, the lowest estimated EBITDA for KTOS in 2013 (where most of the budget cuts can start taking effect) is still over $100 million.  Going back to my sensitivity analysis chart, the key now is to figure out what multiple KTOS will fetch from an acquisition.

I took many different approaches to try and understand what EV/EBTIDA multiple KTOS would be able to get.  First, I looked at comparable recent acquisitions:

From the comparable transactions, it can be shown that under normal circumstances, the average multiple is between 10-12x EV/EBITDA multiple.  I decided to look further at the acquisitions made by the large defense contractors over the last 20 years.  I also narrowed the search to deals that were over $100 million in total value.  Below are the results:

From the data, the averages lie between 10-16x EV/EBITDA multiples for acquisitions by the 4 large defense companies.  The median multiples range from 8.7x-12x.  In addition to the above screens, I did a screen of all Defense-Electronics company acquisitions over $100 million which returned 49 results and had an EV/EBITDA average multiple of 9.58x.  Finally, I did a screen of all Defense company acquisitions over $100 million and received 185 results with an average EV/EBITDA multiple of 9.45x.

By looking at past acquisitions in the defense industry, one can see that that typical EV/EBITDA multiple of 10-12x is easily warranted.  For a company that has continued growth prospects, I can argue that it would be purchased towards the high end of this range, but to be conservative I used the 10x multiple.  With a current 12 month EBITDA run rate of $120 million, the EV at the 10x multiple would be $1.2 billion.  With their net debt at approximately $521 million, this creates an equity market value of $670 million.  Divide that by the approximate 33 million shares outstanding and you have an acquisition price of $20.58/share.

Based on the data I found of previous acquisitions, I would feel comfortable assuming that KTOS would be able to get a 10x-12x EV/EBITDA multiple if it is acquired by another company.  Using the bear, base and bull cases that I outlined previously, I created the following sensitivity chart:

Thus, with a 10x EV/EBITDA multiple and a bear case of $100 million in EBITDA in FY 2013, I get a stock price for KTOS of $14.52.  You can see from the chart that the upside in addition to the “bear” scenario is rather large, if you take into account either an increased multiple of 11x or 12x or the other scenarios where EBITDA levels can be higher in the “base” and “bull” case outcomes.

Also, it is interesting to notice that if you take KTOS 2011 3^rd quarter EBITDA, the first quarter reflecting the full effect of their acquisitions and extrapolate out to a full twelve months, the EBITDA level is at just under $120 million.  Therefore, the current price of KTOS is trading at a 6x multiple of the $120 million EBITDA level.

As more clarity comes of the budget in terms of specific cuts, KTOS will begin to see its value unlocked.  The market is worried about the uncertainty in the defense budget and it shows throughout the defense sector.

Risks:

• Additional pressures for the government to make budget cuts greater than the ones that are currently set to take effect beginning in 2012 and 2013 and them actually getting implemented.
• Cuts in the defense budget directly to programs that KTOS revenue stream is tied to.

Catalyst

• Increase in M&A activity in the Defense sector.
• Republicans who are generally pro-defense spending win the senate and/or Presidency leading to an increase in defense spending compared to where things are headed now.
• Increased threat of attack or another war started through an escalation with another country.
• Cyber attack on a critical piece of infrastructure in theUSor an affiliate abroad which will increase the need to increase funding and expenses in securing infrastructural systems.