“Help Destroy China’s ‘Internet Army'”

Sniffing out the "Triple Your Gains" Teaser from Bill Patalon's Private Briefing

By Travis Johnson, Stock Gumshoe, June 17, 2013

“Yesterday, I sent you an urgent briefing regarding China’s dangerous “Internet Army.” This situation is already moving fast.

“The small tech company critical to crushing China’s attacks just won another contract for an undisclosed “data center”… its third multimillion-dollar contract in less than a month.

“This is quickly turning into exactly the kind of win-win situation I expected. And I don’t want you to miss anything. So please read on to get my report… How You Can Help Destroy China’s “Internet Army”… And Make 300% In The Process… for free.”

That’s how the latest tease from Money Morning’s Private Briefing service launches — providing a nice feeling of momentum, secrecy and profits to those whose hearts are warmed by the copywriter’s art.

Private Briefing is one of those “best of the best” sampler newsletters — it features stocks that have been picked by other Money Map Press/Money Morning services and newsletters, not unlike the “stock of the month” services from Cabot or StreetAuthority. And it’s relatively inexpensive (though $7.99/month does add up after a while) and introduces people to picks from more expensive letters, so presumably it’s a nice marketing and “lead generation” tool for the publishers.

And as you can imagine, picking your favorite idea among several newsletters each month does not guarantee perfection — the last time I wrote about this service was last Fall, I think, when they were teasing Delcath Systems (DCTH) on an expected FDA approval and an anticipated 300% gain in the very short term, and that one certainly didn’t work out. But we won’t judge based on just one idea — so what’s the stock they’re pitching this time around?

It’s a small cap company that’s apparently involved in defense contracting , here’s a bit from the ad to get you excited:

“The company I’m so excited about is a small and highly specialized technology company trading for under $10 that already has its hooks very deep into the Pentagon.

“The folks in Arlington have awarded this small-cap leader a steady stream of contracts now worth about $1.1 billion.

“These projects are ongoing… and well spread out. It’s like they just keep knocking on more Pentagon doors and find piles of cash behind each one.

“I’m talking about guaranteed contracts from the Army, Air Force, Navy, NASA, the Defense Logistics Agency and the Department of Homeland Security, just to name a few.

“In fact, in the last few weeks alone, this company has received three multimillion-dollar deals: One to provide specialized equipment in support of a certain ‘radar-related’ National Security program. A second for electronic products for a ‘critical U.S. electronic attack platform.’ And the third for equipment in support of an undisclosed ‘data center.'”

Their biggest specialty, we’re told, is “Electronic warfare surveillance systems… including gear for electronic attack” — which places them in a strong position as the continuing hacking battle for data escalates between the US and China. And the ad letter, from their editor Bill Patalon, tells us that this kind of contracting is unlikely to get cut even in the face of ongoing sequester-related and other military budget cuts … partly because the contracts have cancellation clauses that cost more than the work itself.

So they’re looking for 300% gains as this company helps to “destroy China’s ‘internet army'” — but what company is it?

Well, we feed those details into the hungry Thinkolator, and after a wee bit of chewing we learn that the stock they’re teasing is … Kratos Defense & Security Solutions (KTOS).

Sound familiar? Yes, Michael Robinson has touted this one several times over the years — he’s the tech guy over at Money Map Press these days, and he teased KTOS pretty aggressively both in 2009 and last Fall, when he called it a “politics-proof” defense play. It’s been a very volatile stock, so if you bought it the first time he touted it at $8 or so back in 2009 you’d call him a fool, if you bought it back in November at $4 and change and saw a 50% rise to today you’d call him prescient.

Kratos is a small specialty defense technology contractor, with key areas of focus in drone aircraft and target drones, satellite communications, electronic warfare equipment, surveillance and infrastructure security, among others that I really don’t understand particularly well.

KTOS has been a gyrating stock and has obviously made money for some people, but they’ve been undergoing pretty massive changes in their focus, reorganizing and looking for new government contracts in key areas. That has also meant several acquisitions along the way, lots of debt, and lots of share sales to fund acquisitions and operations. So they’ve more than doubled revenue over the last couple years (from 2010-2012), going from $409 million in 2010 to $969 million last year … but they’ve also almost tripled their share count (from 17 million shares outstanding to 47 million), and they’ve tripled their interest expense even with crazy low interest rates (to $66 million last year), so shareholders don’t have much to show for all that revenue growth. Profits have not shown up yet, though they do usually manage to generate operating income in quarters when they don’t have a special “other” cost on the books (meaning, there’s some money left over after they account for the cost of revenue, their R&D expenses and their regular operating expenses (selling, general and administrative costs, usually called SG&A) — but interest and taxes (they don’t pay much in income taxes, not surprising given the lack of income) usually eats that operating profit up and then some.

So if you just browse through the filings, you don’t see much that makes you want to own this company — losing money, diluting shareholders, heavy debt burdening their balance sheet, no sign of scaleability as the costs rise as quickly as the revenues. What, then, is there to like?

No, really, I’m asking you.

OK, fine — there are some positive signs, beyond the fact that the stock has risen 50% since the trough last Fall.

Analysts expect them to book a profit next year … though we should temper that by saying that the analysts have been ridiculously over-optimistic at guessing at their earnings over the past four quarters.

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And probably more importantly, if you look at their finances on an EV/EBITDA basis to adjust for the impact of acquisitions and debt the valuation looks like it could possibly be reasonable if they’re going to grow at a decent clip (they’re carrying an EV/EBITDA of about 10 right now, and they did have decent free cash flow last year of about 79 cents/share, so real cash operations look a bit better than the accounting earnings. It doesn’t make them look cheap, at least not to me, but it does make them look better. If you use the numbers they publish to account for amortization and use actual cash tax expenses because of their huge loss carryforwards that reduce their cash tax obligations, their “pro forma” earnings would have been six cents for the first quarter (actual accounting loss for the quarter was 19 cents). So the cash picture is better than the income statement.

And they are booking orders and haven’t seen major cancellations as far as I can tell, so the revenue is still coming in and will probably keep coming in on the current pace as long as the next budget doesn’t “hard code” the sequestration defense cuts (half of their $1.2 billion in backlog is funded as of the last quarter). They just reaffirmed their guidance in the first quarter, with some delays from the Federal budget sequester being made up for by new orders. No one thinks they’re on the verge of real financial trouble, if anyone expected severely bad news their outstanding debt wouldn’t trade where it does right now, with a yield to 2017 maturity of about 5%. Do keep an eye on that 2017 maturity, though, that’s $625 million they may have to refinance in would could be a very different debt market.

And most importantly, perhaps, the insiders have been buying — the CEO and several other insiders have shown patterns of insider buying lately, with a slew of purchases back in March when the stock was wallowing down near $4, and the CEO even stepped up and bought a bit more in May at prices above $5 a share. Those kinds of patterns of insider buying tend to point to stocks that will rise over the following 6-18 months — but, of course, the stock is already up a good 40% since most of that buying happened, and the stock has already gotten attention for that insider buying and arguably risen partly because of those purchases (and probably because of their better than expected revenue in the first quarter, and general sentiment about defense spending improving post-sequester).

If you look at Kratos’ materials, the story and their breadth of programs are the reason to buy the stock — and there’s probably at least something to that, they do have their finger in a lot of very important pies, from missile defense to drones to electronic warfare and cyber security. That said, it’s not going to be an easy company to analyze given their dozens of different significant business lines and their history of serial acquisitions — they do issue press releases to trumpet their ongoing order wins, and they say they’re maintaining a book/bill ratio of 1:1, which is at least mildly positive if not necessarily indicative of ramping revenue growth (that means they got as many orders as they fulfilled in a given time period, so they’re usually at least treading water and replacing the business they complete with new orders). And many of their orders are multi-year or secretive when it comes to details, so it’s hard to get terribly excited about a $3 million order when you’re talking about a company that had sales of a billion dollars over the last twelve months.

The programs they’re involved with definitely have potential for significant growth — they have some promising drone programs (they bought a drone company last year), and they’re very involved in satellite programs and missile defense (including the Israeli Iron Dome program as well as Aegis and others), so there are likely to be good stories to tell about this stock for some time. You can get a decent overview of those programs in the recent investor presentation from Kratos.

When it comes to valuation and estimates going forward, this is what they say in the last conference call:

“As we look forward, even though we are off to a strong start for the first quarter of 2013 due to the current sequestration and significant federal budget uncertainty, we are affirming our previously provided guidance of revenues of $950 million to $1 billion; adjusted EBITDA of $115 million to $125 million; and free cash flow generation of $50 million”

So that means they’re trading for about 8-9X expected (adjusted) EBITDA, which is probably decent if they can grow but it’s not necessarily cheap given the companies inability over the last few years to turn cash flow or EBITDA into profits for shareholders … the free cash flow, in this case, is after interest payments — that’s important because interest for them on their primary note/bond runs at $62.5 million/year. The company is talking up the impact of some new orders, including new drone aircraft, that will increase expenses in the first half of this year but boost cash flow in the second half of the year when they make deliveries, so it might be that if you’re interested in this stock there will be opportunities to buy on weakness if they have a rough time in the next couple quarters. Investors should expect the next couple quarters to be weaker, given the guidance, but who knows how they’ll react once the numbers actually come out.

And that’s about all I can say about Kratos — it’s a pretty widely diversified tech contractor with lots of different programs that provide a potential growth story, and the cash performance of the company is better than their income statements indicate, but they’ve also got a history of debt, acquisitions, reorganizations and dilution that have eaten up past shareholder optimism. Are they on the right track this time? Let us know what you think with a comment below.

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June 17, 2013 1:45 pm

Anyone buying this insidious company is complicit in the murders by the scandalous U.S. drones that are killing innocent civilians, women and children in Pakistan, Afghanistan and elsewhere. Your profit will deistinctly be blood money……

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Alastair Rutherford
Alastair Rutherford
June 17, 2013 2:00 pm
Reply to  concertmasters

There is always one nut in a fruitcake.

Alan Harris
Alan Harris
June 17, 2013 3:06 pm

Actually, Im the cherry on top. War always has killed the innocent. If Afghanistan, Vietnam, Korea, Iraq and too many others have proved anything its that we should mind our own business. I cant avoid taxes, but I’m damned if I’m going to invest any extra to poke my money in where its not essential. Sure Ill be first on the line if someone invades my country, but I will kidnap my sons before I allow them to risk their lives in Timbuktu.

Any profit would be blood money.

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Hugo Persijn
Hugo Persijn
June 19, 2013 8:36 pm
Reply to  Alan Harris

Well said sir !

June 17, 2013 3:26 pm

Insidious companies list enlarged:

Tobacco: Killing innocent civilians not by the hundreds but by the millions, not only in some far off places, but at home.
Chemical companies: Bhopal long ago, but stuff has happened since …
Pharmaceuticals: Drug interactions, “side effects”
Hospitals: Mistakes, wrong prescriptions.
Car manufacturers: All over the world traffic deaths…
Oil companies: Killing the planet?
Coal companies: Same?
Facebook et.al. Killing the human soul?
GM (not the car biz) companies?

You get my drift. Just haltingly applying the logic of the poster.
Having said that, let’s not pollute this excellent site any further.

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June 17, 2013 4:50 pm
Reply to  Hans

Kudos for “Facebook for killing the human soul”, Hans. Made my day. The whole stock market scenario gives me a sick feeling of degradation. “The world is swirling in the toilet, there’s nothing we can do to stop the flush, and here’s how YOU can profit from it!”

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