Kraken's competitive advantages lie in its technical superiority in battery and sonar systems, positioning it for continued growth in the NATO navy upgrade cycle.

Kraken Robotics (OTCQB:KRKNF) is a Canadian microcap (($260m)) trading on the Toronto Venture Exchange. Kraken's balance sheet is asset-light, with zero net debt and a small asset base. It is primarily a growth story. The stock has gone up 4x in the last 12 months on the back of explosive revenue and earnings growth. Revenue has grown at a 60% CAGR since 2018, and last year this finally translated into GAAP profitability. Today, shares trade at around 31x TTM earnings and 18x TTM EBITDA, close to the sector averages as calculated by SeekingAlpha. I think this is justified by Kraken's growth prospects, so I'm initiating coverage with a STRONG BUY rating and a two-year price target of $3. I have provided a brief overview of the business and its prospects below, but interested readers can also read the very cogent summary published here. This article builds on that research to understand Kraken's fair value.

Kraken is led by CEO Greg Reid, who has been with the company since 2015. Everyone else in the C-suite has been at the company for at least 5 years. Longstanding investors I have spoken with have high confidence in Reid's continued success in executing on the company's strategic plan. They highlight his strong track record and the fact that he and his colleagues have increased their ownership stakes over the last year.

The company has two core products: synthetic aperture sonar "SAS" and large battery packs for underwater submersibles. They started with SAS and then acquired the battery business about five years ago for only a few million dollars. It has turned out to be an incredibly good purchase. Over the last few years, they have put these two business lines together into what they call a "robotics as a service" (RaaS) business model.

Today, 80% of revenue comes from selling to the defense industry, where their systems go primarily into underwater unmanned vehicles "UUVs," and the remaining 20% is selling to companies which use Kraken systems to examine critical underwater infrastructure "CUI," such as fiber optic cables, wind turbines, and pipelines. The corporate business is mostly services and has slightly higher gross margins and more recurring revenue, but the defense business is growing faster and has greater growth potential.

My thesis below will focus especially on the portion of the company which is selling batteries to the defense industry because I think this is where the real potential lies for Kraken over the next 2-3 years.

Each of Kraken's business lines has technical advantages that make them difficult to replicate. Kraken buys lithium-ion batteries, but adds value to them through unique gel-encapsulation technology, which enables the batteries to withstand great pressure (up to 6000m, i.e. the bottom of the ocean). The result is that Kraken battery systems deliver more power in less space than those of its competitors, who use titanium or other casings. Given that UUVs need to be able to carry out long missions without recharging, this is a very important advantage. In sonar, Kraken's system can scan more of the ocean floor (a wider swath) at a higher speed, resulting in much faster surveying than systems offered by competitors. In both lines of business, Kraken has a count-on-one-hand list of competitors - mostly large defense contractors. Kraken is offering somewhat lower prices but also better products.

These product-specific advantages are now being compounded by their integration into larger product suites. First, Kraken developed their own UUV: the Katfish, which incorporates Kraken's batteries and sonar systems, and comes with a complete launch and recovery system which can be installed on the back of a boat. The Katfish has already been sold to Israel, Germany, Denmark, Poland, the U.S., and Australia, beating out comparable products from Northrop Grumman (NOC), Thales (OTCPK:THLEF), and Exail (OTCPK:GGRGF). Kraken has an end-to-end solution.

These qualitative markers of competitive advantage are backed up by the two key objective markers: above-average margins and a limited and stable number of competitors. Gross margins currently match industry averages, but these can be misleading because of the different ways companies classify expenses. This is why I prefer to look at EBIT margins, which are 15%, about 50-100% greater than those of large defense contractors. Kraken's sonar system took years to develop, and they had to buy their way into the battery business. These R&D hurdles now mean that Kraken is one of a few companies that can supply these critical parts.

Kraken's large and expanding TAM will likely lead to increased competition over the next 5-10 years, and we should expect their margins to drop due to this heightened competition. But for the time being, Kraken has clear competitive advantages. In an industry where customers (i.e. governments) are willing to pay for better performance, Kraken is delivering better products and earning better margins.

In a late 2020 interview, then-CEO Joe Mackay highlighted a major upgrade cycle underway among the NATO navies. Kraken had recently won contracts from Denmark and Poland, beating out much larger competitors. He discussed the prospect of further contracts with around 10 other countries, each for anywhere from 1 to 10 Kraken battery systems. Since then, Kraken's revenue has grown 5x in 3 years. As global competitions and conflicts have escalated in the Black Sea, the Baltic, the South China Sea, the Persian Gulf, and the Arctic, NATO has been investing in naval preparedness. That trend culminated this spring with the creation of a NATO "Centre for the Security of Critical Undersea Infrastructure" with contributions from Denmark, Germany, Norway, Poland, Turkey, the UK, and the US, "soon [to] be joined by" Greece, Portugal, and Sweden. This story has been widely covered in the press, so I won't go into too much detail here. The pain point is the asymmetric nature of threats to CUI: subsea mines are very inexpensive to install relative to the threat they pose to larger, more expensive ships. And the US and its allies own and operate the vast majority of undersea fiber-optic cables, presenting a huge security liability, as explained in this WSJ video. Add these details to the larger story about American naval under-preparedness and the expanding use of drones in the Russia-Ukraine conflict, and you have a powerful catalyst for Kraken's continued growth in the years ahead. NATO countries need to upgrade their navies for a new era of drone warfare and potential attacks on critical infrastructure.

This is a very significant opportunity for Kraken. 2024 revenue is expected to come in somewhat below $100m. As recently as 2023, Kraken was estimating their sales pipeline at around $200m. Today, they are talking about a pipeline of over $900m. Where is this growth coming from? The first answer is: more ships being sold to a wider set of navies. In June, industry disruptor Anduril announced that they are building a plant in Rhode Island capable of manufacturing 200 UUVs per year, each of which would require around $2m in Kraken batteries. But the second, and perhaps more important, answer is that Kraken is making larger sales. Management has highlighted the rise of extra large UUVs ((XLUUVs)) capable of undertaking longer, more complex missions than traditional UUVs and requiring correspondingly larger battery packs. Whereas smaller models would require $1-2m in batteries, these require $6-10m. While this opportunity is particularly exciting for Kraken, management also claims that SAS sales for new ships is an even bigger opportunity. As CEO Greg Reid commented on the Q4 2023 results: "we are in the second inning."

There are several possible ways of valuing Kraken. First, some writers have suggested that Anduril will buy them out. This seems possible but not that likely, given that Kraken is already valued at a competitive multiple and Anduril is focusing on acquiring technologies which horizontally expand their defense software platform, rather than on cutting costs by buying out suppliers. Even if a buy-out is imminent, it is hard to estimate what the price might be.

Second, it's worth looking at existing price targets:

I think these comparison-based valuations are not very useful in Kraken's case, given that the company is simply not comparable to its peers. Small competitors such as Nauticus Robotics (KITT) and Ocean Power Technologies (OPTT) are not growing at all, and large defense contractors like Northrop (NOC) and Raytheon (RTX) are growing much more slowly. All of these competitors are significantly less profitable than Kraken.

Last month, Deep Sail Capital published a bottom-up valuation model, using forecasts for individual product sales to model revenue growth over the next two years, and then applying conservative EV/EBITDA multiples to those numbers. They found that even without the large - and seemingly imminent - opportunity in the RI Anduril facility, shares should be worth around $2 USD per share in 2026 given an EV/EBITDA multiple of 15, below the current number and industry averages. Assuming a 20x multiple, which I view as more plausible, they get a price target of $3.

It is worth comparing these estimates with the most obvious source for future expectations: management guidance. The current CEO is a CPA and a CFA, served as Kraken's CFO for five years, and is heavily invested in the company. His estimates are worth taking seriously. Management guides for 40% revenue growth and 20% operating margins over the next few years. The revenue growth numbers are significantly lower than they have been over the last five years. In 2024, management guidance is for ~35% YOY growth without landing any more new contracts. And if anything, it seems like revenue growth has been accelerating as the faster-growing battery business becomes a larger proportion of revenue. (In Q2, product revenue was up 83% while services revenue was only up 11% YOY.) While 20% operating margins are higher than current numbers (TTM is 15.6%), I think it is reasonable to expect further decreases in relative operating costs (SG&A, R&D, and D&A) as revenue grows. The business has seen operating margins increase by about 70% over the last 8 years. While this cannot continue indefinitely, I believe there is still room for additional operating leverage. For (a very distant) comparison, consider Northrop, where operating expenses are 10% of revenue, far lower than Kraken's 30%.

I think that Deep Sail Capital's base case valuation is too conservative given Kraken's likely growth prospects. In my base case, revenue would grow 40% p.a. over the next two years, while margins and multiples stay flat. This would imply a 96% upside or a 2026 price target of around $2.20 USD. More realistically, I would expect operating margins to hit 20% by 2026, yielding a price target of $2.90. Since Kraken's products have already been integrated into so many existing systems, and sales to NATO navies are set to accelerate over the next few years, I think this revenue growth estimate is probably too conservative. Even without the ~$500m/year from the Anduril plant in RI, I see a clear path for shares to trade at $3 USD by December 2026.

I have bought shares myself, and I am rating the company a STRONG BUY.

Kraken is a small company traded OTC with relatively little book value; the downside potential is very high. The company recently raised $20m in capita to finance expansion capex, so there is the risk of further dilution. Since the company is already valued at 30x earnings, if growth falls short of expectations, I think shares could easily fall back below $0.50. While I think it is unlikely that NATO navy spending declines rapidly over the next few years, it's possible that increases slow. A more existential risk would be if one of Kraken's competitors is able to develop better batteries or sensors. Since this market is rapidly expanding, there is the potential for a competitor to win market share quickly if they develop a better product. And Kraken is competing against some much larger and more sophisticated companies. Of course, in a company of this size there is also always execution risk and the higher uncertainty associated with having a smaller organization. It will be important to continue watching whether Kraken is able to win contracts with new navies, especially the US. Investors should take these risks seriously and size their positions accordingly.