Kratos CEO Eric DeMarco on Disrupting Defense

What’s the secret to being a cost-effective innovator, especially in a capital-intensive sector such as defense? 

“It’s the culture, it’s the DNA of the company,” explains Kratos [KTOS] CEO Eric DeMarco. 

DeMarco’s long career has given him unique insights into the industry. “Even when I was a child, my dad worked in Area 51. I can talk about that now … virtually all my life has been involved in national security.”

DeMarco joined Kratos back in 2003, when it was still known as Wireless Facilities and operated primarily as a commercial wireless infrastructure provider. After briefly serving as Chief Operating Officer and President, he took on the role of CEO in 2004. Prior to that, he had served as President and COO of Titan Corporation, an information technology firm later acquired by L3Harris [LHX]. 

In the latest edition of OPTO Sessions, DeMarco sits down with us to discuss Kratos’ role in the defense supply chain, and how it maintains its competitive edge in an industry dominated by legacy players. 

Value Chain Linchpin

Founded in 1994, San Diego-based Kratos is a US government contractor producing high volume, cost-effective defense technology such as drones and microwave electronics. As DeMarco outlines, the company operates in four distinct segments: hypersonic systems, tactical jet unmanned aerial drone systems, space and satellite communications, and propulsion. 

Despite its long history in the defense industry, Kratos targets a different segment of the market than the so-called “five-and-a-half primes”, DeMarco says. While much of the resources of other companies go toward building “exquisites”, Kratos focuses on mass production of hardware and systems. This, in turn, has given the firm a competitive moat.

“We focus competitively. We are the low-cost provider. We do a full hypersonic system, solid rocket motors to the glide vehicle, all upshot. No one can get under $100m–150m. We do it for $15m. Our most expensive, our most exquisite tactical drone is $10m. We’re building small jet engines for $15,000, military grade. That is our key differentiator.”

Thanks to its unique space in the supply chain, Kratos is able to have an outsized influence on the defense industry. DeMarco highlighted recent deals with Airbus [EADSY] and Northrop Grumman [NOC] in which the legacy defense firms purchase Valkyrie drones from Kratos, refit them with proprietary mission systems and sell them to government clients. 

DeMarco credits Kratos’ well-developed manufacturing process and customer connections with helping the company maintain low costs. “There’s a lot of noise out there right now about people building mega factories to drive costs down,” he says. “That’s not the way it works. The way it works is you have to have the engineering capability and the customer knows what they want you to build and what specific security requirements that facility is going to require.”

Being able to produce in volume is part of what gives Kratos its competitive edge, DeMarco says. While technology with high price tags often steals the limelight, “quantities do matter, affordable mass does matter” — especially in the age of drone warfare.

Courting Contracts

Keeping a healthy balance sheet is a key factor to driving business, DeMarco explains, because it represents a business’ ability to fulfill contracts. The company’s most basic equity offering — expected to raise approximately $1.17bn — aims to offset the cost of the acquisition of Israeli satellite communications firm Orbit Technologies, which ultimately supports ongoing business. “My balance sheet is still very strong, so certain government customers won’t hesitate to give us opportunities.”

In general, however, the sector is struggling to meet demand. After decades of post-Cold War de-armament, “the US industrial base for strategic systems to take on Russia and China has atrophied … so we have a defense budget of $1trn.”

This opportunity has drawn new players into a market once dominated by legacy players. “There’s not enough companies to address the demand.”

Ultimately, Kratos is able to leverage both its agility and its experience in the sector and offer existing products, not just promises. “We have products now,” DeMarco says. “It’s not a PowerPoint of what’s going to maybe be there three years from now.”

Software Differentiation

While Kratos has made a name for itself providing affordable hardware for defense purposes, in the medium term, software is more likely to help define the company’s competitive edge. With “jet drone hardware, you have fifth generation, maybe sixth generation, but the software enabling that platform is going to really make it do a lot more things better, faster, smarter with multiple different payloads … more of our stuff is by necessity going to have to be software-based to get the most out of that low-cost hardware.”

Although artificial intelligence (AI) is certainly a buzzword these days, Kratos has been incorporating analytic tools — what DeMarco calls “augmented autonomy” — into their hardware for decades. Countless test flights and real-world usage of Kratos technology has provided the company with the perfect opportunity for data collection. “We’re flying every week, multiple times a week with multiple customers in incredible threat environments up against the highest-performance manned fighters, radar systems, interceptors in the world.” The company gathers the data it collects in these high-performance environments to optimize future autonomous performance. 

No matter the sophistication of AI systems, human staff are the key. 

With a small pool of qualified people, competition can be fierce, he explains. “The hardest thing is getting the qualified people that are willing and able to get a national security clearance. Once you obtain them, if you get them trained up, retaining them [is the next challenge], because Lockheed Martin [LMT] is going to want them, SpaceX is going to want them, and that’s bidding it up.”

“The most important asset of Kratos is our people today,” DeMarco emphasizes.