The Firejet is a high-performance drone used during military exercises. A Kratos Defense subsidiary, Composite Engineering Inc., builds the unmanned aircraft.

The Firejet is a high-performance drone used during military exercises. A Kratos Defense subsidiary, Composite Engineering Inc., builds the unmanned aircraft. Photo by Kratos Defense & Security Solutions Inc.

Directors at Kratos Defense & Security Solutions Inc. are mulling some major changes.

The board of the $868 million contractor is privately discussing strategic alternatives, which in corporate-speak often means some sort of sale. The business will make the decision public by June 30, CEO Eric DeMarco said.

DeMarco said Kratos (Nasdaq: KTOS) first disclosed the internal discussions in November. He offered few other details, saying the alternatives might include the sale of a business unit — or the sale of the entire company.

Kratos “is continuing to work with an investment banking firm to assist the board in formally reviewing Kratos’ businesses, markets and competitive positioning and in evaluating strategic alternatives, including the potential divestiture of certain of the company’s businesses,” Kratos said in its quarterly report May 7. The company did not name its investment banker.

Kratos, which has 240 employees locally, runs a number of defense and security businesses around the United States which employ 3,600.

Projects are as varied as high-speed target drones built for the U.S. Army, U.S. Navy and U.S. Air Force, and command-and-control electronic modules for the Navy’s next-generation, Zumwalt-class destroyer. Kratos businesses are sometimes unheralded subcontractors on projects.

Delivering Value

The point of any sort of sale would be to deliver value to Kratos stakeholders, both shareholders and bondholders, DeMarco said. One option, the CEO said, would be to put proceeds of a sale toward acquiring a business that brings additional cash flow. DeMarco gave a hypothetical example of acquiring an unmanned systems business.

Kratos’ defense electronics segment could be on the block, said a May 8 research note from B. Riley & Co. LLC, citing a March report from Mergermarket. The electronics business was once a freestanding, publicly traded company called Herley Industries, which Kratos acquired in March 2011 for $270 million, a 17 percent premium at the time.

With a record defense electronics backlog, “we can see why strategic buyers would be interested,” B. Riley analyst Mike Crawford said in the note. The business in question might get some additional subcontracting work on a major Air Force contract award that rival bidders are now protesting.

“At the same time, we also believe the price would have to be right to convince KTOS’ board to sell given the assets’ core nature to the business,” Crawford’s note said.

Crawford said Kratos Defense’s review of alternatives could have grown broader as time went by: “… we continue to believe that what started as an exercise in realizing cash value for non-core assets and businesses like Public Safety and Security appears to have expanded to include more substantive ‘core’ assets as well. We further believe that KTOS’ defense electronics assets are unique and valuable, and any such sale is likely to accelerate de-leveraging of the enterprise and accrue unexpected value to the equity.”

Kratos reported $34.4 million in cash and $622 million in long-term debt principal in its March securities filing.

The business reported on May 7 that it had a net loss of $16.3 million on revenues of $182.5 million during the quarter that ended March 29. In the same quarter one year ago, net loss was $15 million on revenues of $200.1 million.

DeMarco said he prefers to talk about EBITDA, which is “closer to the checkbook” and is a metric that shareholders, bondholders and banks evaluate. The initials stand for earnings before interest, taxes, depreciation and amortization. Kratos reported an adjusted EBITDA — excluding certain losses and expenses — of $11.6 million in the quarter ended March 29. It was $16.9 million in the year-ago quarter.

Strong on Defense

Analysts from KeyBanc Capital Markets said they expect Kratos to steadily improve its financial performance from quarter to quarter in fiscal 2015, adding that they see Kratos in the “sweet spot” of Defense Department spending.

One of the attractive things about Kratos, DeMarco said, is that it has net operating loss carry-forwards from a business it sold about 10 years ago. The carry-forwards ought to provide a future tax benefit of about $120 million.

“We believe this [net operating loss] will be viewed as a key asset should KTOS find itself the target of an acquisition,” wrote the KeyBanc note’s authors, Michael Ciarmoli and Kevin Ciabattoni.

In its May 7 report, the company reported its funded and unfunded backlog at $1.1 billion — unchanged from the last quarter.

Both B. Riley and KeyBanc forecast that Kratos stock will go to $9 per share. As of last week, shares were trading at around $5.50. KTOS had a 52-week range of $4.21 to $9.08.

Both companies disclosed they have done investment banking work for Kratos in the last 12 months.

Asked about the stronger areas of the business, DeMarco’s first answer was high-performance unmanned aerial drone systems.

Other programs the CEO considered most important are ballistic missile defense target systems and Aegis readiness assessment vehicles; satellite communication command-and-control and radio-frequency interference products and systems; hypersonic systems and support; and electromagnetic railgun systems support.