Kraken Robotics | Very Speculative

An Interesting Investment Opportunity, But Too Many Unknowns

Name: Kraken Robotics Inc Ticker: PNG Exchange: TSX Venture Exchange in Toronto

Founded: 2013

Industry: Electronic Equipment, Instruments and Components

Implied Market Cap: $124m CAD

Theme: Speculative Assessment: Neutral Author’s Strategy: Wait And See

Date: 7th March 2023

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Disclaimer:

Views, information and opinions expressed in this analysis are those of the author. They should neither be construed as investment advice nor as a recommendation to buy or sell any particular security. Security specific information should not be relied upon as the basis for your own investment decisions. You must do your own research, seek independent advice and reach your own conclusions.

The author may have a position in securities named in this article and may change those position at any time

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The Story

Kraken Robotics (Canada: PNG) is a marine technology company. It provides advanced sonar and laser systems together with sub-sea power solutions for Unmanned Underwater Vehicles (UUV) used for both military and commercial applications. It is headquartered in Toronto, Canada but has operations in Brazil, USA, Germany, Denmark and the UK.

Kraken started life in 2012 as a spin-out from Marport Deep Sea Technologies Inc (MDST). The goal was to commercialize Synthetic Aperture Sonar (SAS) which is underwater imaging technology providing ultra-high-resolution pictures that could operate at extreme depths under exceptionally high atmospheric pressure.

The challenge that Kraken was created to address centred on SAS being too expensive making it impossible for commercial operators to own it.

So Kraken acquired SAS intellectual property from MDST and entered into an agreement with Triton Imaging to bundle Kraken’s hardware with Triton’s software. The technology completed successful trials with U.S. Navy’s Naval Undersea Warfare Center (NUWC) early in 2013.

The Kraken offering, known as AquaPix, offers comparable performance to existing high-end military systems at a fraction of the cost. AquaPix became the word’s first SAS priced under $150,000. This provided Kraken with a competitive advantage that helped enormously in terms of customer acquisition.

Then came the AquaPix MINSAS (miniature SAS) that could be used for a new range of purposes.

The business caught the attention of governments. The system was supplied to Canada’s Defence Research and Development Agency (DRDC) and to Australia’s Defense Science and Technology Organization (DSTO).

Kraken became a public company via a reverse takeover of listed Anergy Capital in 2015 on the TSX Venture Exchange in Toronto. The chosen ticker symbol was PNG (because ‘ping’ is the sound that sonar makes).

A combination of the capital markets, plus grants from the Canadian government and the Newfoundland RDC provided all the finance required to push the business to the next level and a great deal of activity followed:

• The business opened a new office in the USA

• Aquatrak, a derivative of the SAS technology, aimed at the oil and gas sector was announced

• The Katfish sub-aqua robot was commissioned (see cover picture)

• Soundpix, the next-generation seabed mapping technology was released

• The Unmanned Maritime Vehicles Facility was opened in Nova Scotia (with a team of former engineers from the Rolls-Royce Naval Marine division)

• The business expaned in to pressure tolerant batteries and rim driven thrusters.

The business went on to acquire robotic intellectual property from Marine Robotics Inc and evolved from manufacturing sensors to supplying complete robotic systems, software, and services in the global Unmanned Maritime Systems (UMS) market. This lead to a rebranding from Kraken Sonar Systems Inc to Kraken Robotics Inc.

In terms of R&D, the business has been exceptionally busy and constantly innovating. While this placed it in a very strong position in terms of product offerings, it came at the cost of profitability.

In 2017 a German subsidiary was opened. This coincided with the launch of the SeaVision 3D Laser System.

Then a year later Kraken announced that it had established a team, its new Acoustic Signal Processing Group, targeting anti-submarine warfare applications.

Then came a critical pivot which accelerates Kraken’s strategy from sensors and system sales to becoming an integrated provider of Robotics as a Service (RaaS) and Data Analytics as a Service (DAaaS), both higher margin businesses. Its OceanVision offering focuses on the development of new marine technologies and products to enable an underwater data acquisition and analytics. This division of the business was further enhanced with the PanGeo Subsea acquisition in 2021.

This is a potential game changer for Kraken.

Hardware sales are unpredictable and result in volatile lumpy sales and cash flows. Consider making a sale of sub-aqua robots to a government agency. It may not need to replace them for many years, perhaps decades, and no guarantee that Kraken will win the next tender for whatever technology is required at that time. So no recurring revenue.

The move towards services changes all that. There is a constant demand which ensures more predictable cash flows and recurring revenue. There is a great deal of demand for geophysical surveys, sonar surveys, and 3D laser inspections amongst both military and corporate clients such as operators of offshore wind turbines or those active in the marine oil industry.

Another significant milestone has been the introduction of SeaPower pressure tolerant batteries. These have the best energy-to-weight ratio on the market and casings that allow them to operate at extreme depths under enormous pressure. Autonomous underwater vehicles are now able to more than double their previous survey times. This is another key competitive benefit in the Kraken armory.

Most recently Kraken has announced a major coup in that it had signed contracts with both the Royal Danish Navy and the Polish Navy (both NATO members). This is interesting because NATO members seem to be reinvesting in defence as a result of Russian aggression in Ukraine and the next global cold war.

The Kraken story is great. A superior range of products and services at a super competitive price, but is that enough to make it a viable investment opportunity for an intelligent investor?

Do the numbers stack up?

The Investment And The Numbers

When researching Kraken, I couldn’t help myself thinking about the luxury car company Aston Martin. It is a wonderful brand that makes fantastic high performance cars. It has a 110 year history and as early as 1922 it set world speed and endurance records at Brooklands. It was granted a Royal Warrant of Appointment by the Prince of Wales (now the British King) who has always driven Aston Martin cars. It even has James Bond as a customer! All of this makes for a great story, just like Kraken.

But Aston Martin has never been a good investment. It was rescued from insolvency in 1924, ran into financial problems again in 1932 and1972. It entered the equivalent of Chapter-11 in 1974. Ford then made a major investment in 1987 but gave up with the brand after two decades of trying to turn it around. Ford failed to find a willing buyer in 2006 and so auctioned the troubled company. The business was acquired at auction and eventually listed as a public company in 2018 with a valuation of £4.3bn GBP, but has since been steadily destroying shareholder value. The business is constantly raising capital most recently in September 2022 via a rights issue (it raised £650m and today only has a market cap of £1.1bn, so shareholders were significantly diluted).

The point that I am making is that buying into a story is not always the best course of action for an investor.

Why is this relevant to Kraken?.

Kraken has a wonderful story, a great range of products and it has won plenty of awards (a CDR top 100 defense company, Marine Technology Reporter top 100, Dr Williams Memorial Award in Ocean Technology, etc.) But to date it has not made a profit and has been operational now for a decade.

It is not about the story or the products, it is about the quality of management and capital allocation decisions that are made along the way.

History doesn’t repeat, but it rhymes. Is Kraken another Aston Martin? Or is it different? These are legitimate questions that every investor ought to be asking.

Perhaps we are now at the inflection point for Kraken. Revenues are growing fast which is good, and losses are narrowing which is also good. But what will it take for the business to become profitable?

Analysing the data reveals that gross margins are good, although steadily contracting. Kraken used to achieve percentages in the mid-50s for gross margins have been in steady decline for several years and have contracted to just over 40. We have no idea where sustainable gross margins will eventually settle.

I am discounting the inflation impact as an explanation for lower margins because the margin declines pre-date the inflationary pressures that we have seen over the past 12 months.

The contraction in gross margins tells us that the very impressive top line growth (69% CAGR over the past 5 years) is almost certainly down to sacrificing gross margin. In other words, the company may be buying top line sales with gross margin as its currency.

As a side note, don’t be dazzled by the 69% top line growth. It only translates to 9% shareholder returns (more on this later).

However, why would the business need to compete so aggressively on price having claimed that its products, such as the AquaPix, were developed to deliver the equivalent quality of competitors at a fraction of the cost. Perhaps competitors have reduced their pricing requiring Kraken to follow suit. I have been unable to find an answer to this quesiton. Either way, sacrificing gross margin for increases in revenue suggests that the business has very limited pricing power which is another potential concern for the investor.

Is top line growth sustainable at these exceptionally high rates of 69% CAGR? Almost certainly not. Top line growth will inevitably slow as the business scales. But when gross margin percentage drops from mid 50s down to approximately 40, the business needs to sell 33% more just to generate the same gross profit in dollar terms. In other words, it needs to run faster simply to stand still. It is for this reason that investors would like to see margins stabilize.

Where gross margins will settle is unclear at this stage. One would imagine that the margins on the RaaS and DAaaS offerings are far larger than on the hardware so perhaps this will help to prop up gross margins in future.

On that note, the business has clearly evolved into segments:

1. Robotic Hardware

2. Component Hardware (such as SAS)

3. Batteries

4. Services (such as hardware maintenance, RaaS and DAaaS).

Each of these segments will have entirely different unit economics.

For example, a buyer of Robotic Hardware, perhaps the military, will place a financially significant order but once filled may not need to replace that equipment for many years and even then there is no guarantee that Kraken will win the replacement order. This results in unpredictable cash flows and little or no recurring revenue on this segment.

By contrast, the robotics as a service or data analytics as a service is likely to be a more reliable source of customer loyalty and regular business. The margins on this segment are also likely to be significantly higher than on the hardware due to having lower capital intensity.

The assumption about margins being higher on the services segments is logical, but not necessarily supported on the facts. Consider that that gross margin fell to 39% from 46% as the services segment grew from 10.8% to 38.2% of the revenue mix when comparing the nine months to 30 September 2021 against the same period a year later, which implies that the cost of providing services may be higher than providing product. This seems odd and is worthy of further investigation.

It is way too early to be able to break these segments out meaningfully as some are so new to the business. It is also difficult to understand at this stage how the business is likely to evolve. This makes evaluation of this business very difficult, if not impossible, for the purpose of calculated risk.

As noted above, service revenue has grown to nearly 40% of the revenue mix for Kraken. The increased proportion of service revenue was evidently not caused by a decline in product revenue, because that was up 109% in the same period. I am left wondering where this ratio will settle in the longer term?

• Will service revenue soon cross the 50% threshold and dominate the business?

• Will management deem one of these segments to be more worthy of capital allocation than the others?

• Will it make sense to spin-off parts of this business into stand-alone corporations?

• Will it transpire that all capital should be focused on the most lucrative segment(s) with a disposal of the remainder being in the best interests of shareholders?

We simply don’t know at this stage.

The other wild card to throw in to the mix is that as of January 1, 2023, Karl Kenny (Founder and formerly the President and Chief Executive Officer), moved to being Executive Chairman of Kraken. The President and CEO role was given to Greg Reid who joined the company 7 years ago as Chief Financial Officer and since 2019 has been its Chief Operating Officer.

• Why did this management change occur at this time?

• What prompted it?

• What was it designed to achieve?

Again, we simply don’t know as it has not been well communicated by the company.

It is nice that the new CEO is a long standing insider who understands the business and has a good existing relationship with the other members of the management team. However, it is not clear how his approach will differ from that of Mr Kenny or whether Mr Reid will steer the business on a different trajectory.

It is noteworthy that Mr Kenny’s background is technical with expertise in communications, electronic navigation systems, and digital imaging. This contrasts starkly with the qualifications and experience of Mr Reid, a chartered accountant and chartered financial analyst with a focus on businesses in the technology sector.

It is hoped that Mr Reid’s financial acumen will help navigate the business onto a sustainable path to profitability, but only time will tell if this is the result of the shift in management.

One of the key areas of focus for Mr Reid, who is now the effective trustee of shareholder capital, is to allocate that capital well and more particularly in a manner that is accretive to shareholder value.

The enlargement of the share count and SBC (Stock Based Compensation, or as I prefer to call it a Serious Bleed on Capital) has been problematic until now.

Every year, without exception, has seen a significant enlargement of the share count and corresponding dilution of shareholders.

In the last five years the share count has ballooned from 73m to 201m which means that shareholders have watched 63.2% of the value of their investment evaporate. What this means for the shareholder is that despite revenue growth of 1,306%, cumulatively 69% per year, the share price has only increased from $0.39 to $0.60, a total 54% gain in 5 years (9% CAGR). So everyone that invested based on top line growth of almost 70% CAGR will be exceptionally disappointed with a 9% return, but that’s what they’ve achieved.

We are all familiar with the law of diminishing returns. It is very easy for a new company with one customer to double sales by winning one additional customer, but far more difficult for an established business with millions of customers to double its top line. This is why revenue growth always starts high and always, inevitably, declines over time. As such, shareholders should not count on top line CAGR of 69% going forward. So lower growth combined with continuing dilution will have a more profound effect on shareholder returns going forward. This is why it would be great to see Mr Reid introduce some discipline in this regard.

Stock options outstanding as at 28 Nov 2022 are 9.43m, so this will increase the share count by another 4.7% and so shave investment returns still further by way of dilution.

So what might a Kraken investor hope to achieve over the next 5 years to 2028?

Well, let us assume that top line growth continues at a lower rate but still impressive 40% CAGR taking sales from $47m to $253m. Let us assume that the business is profitable with earning margins of 20% (reasonable against 40% gross margin currently if discipline can be introduced around costs – more on this later). Now we need to apply our mind to multiples. Currently, Kraken is trading at just under 3x sales. Multiples should never be compared to industry peers, as many mistakenly do, because they depend entirely on the margins of the business. Unless margins are identical, multiple comparisons are meaningless. So what sales multiple should an intelligent investor ascribe to Kraken? Well the risk free rate is currently approximately 4% based on a 10 year T-bill at the time of writing and equity risk premium is 5.94% based on Professor Aswath Damodaran’s calculations at NYU. So an intelligent investor will be looking for a 9.94% annual return (not even that great in real terms against prevailing inflation rates). So this implies a sales multiple of no more than 2x on an assumed earnings margin of 20%. This in turn gives us an implied market cap of $536.36m. If the share count (including outstanding options) does not expand further, then we have 210.65m shares which gives a 2028 share price of $2.54. Discount that back on a NPV basis and you have today’s fair value. This will depend on your discount rate but would be $1.57 at 10%. So far, so good. However, if the share count dilution continues at its existing pace then by 2028 the number of shares outstanding will be closer to 545m suggesting a 2028 share price of $0.98 discounted at the same rate to $0.61 (which coincidentally is almost exactly where the shares are trading today.)

Once again, you can see why the share count expansion needs to be curtailed.

It is welcome that SBC as a proportion of top line revenue has steadily declined, but it would be nice to see the company break into profitability and to remunerate employees with cash instead. Yes, I know that some readers will say that SBC aligns the interests of insiders with management and that there is a short term cash flow benefit until the vesting of the grant, but SBC is hugely problematic and entirely misunderstood by most investors (click here for more).

Warren Buffett sums it up nicely: “We have no interest in large salaries or options or other means of gaining an edge over you. We want to make money only when our [shareholders] do and in exactly the same proportion".

The Kraken management could learn much from the great man.

Returning to the assumptions around valuation, achieving an earnings margin of 20% on 40% gross margins will require some discipline around costs. This appears to have been absent until now. I like to see a business set budgets for expenditure defined with reference to gross profit.

Even excluding depreciation and amortization from OPEX, the company has, for most of its life, consumed all of its gross profit and then some with operating expenditure alone. The five year moving average to the end of FY21 stood at 106% of gross profit. CAPEX also needs to be paid for as do financing costs and tax. This is clearly unsustainable as net profitability can never be achieved on this basis.

Coming from a finance background, I am confident that the new CEO will rectify this situation. It certainly needs to be addressed. On an LTM basis I am pleased to report that OPEX appears to be running at 67% of gross margin, so perhaps a sign of improvement already.

CAPEX has been very high in recent years, but the company has been on an acquisition spree. Again, it would be nice to see these acquisitions reach the stage of being accretive to earnings before the business acquires anything else.

After a decade of rapid growth and expansion, I believe that now is the time to steady the ship and to let everything settle on a sustainable trajectory towards that 20% net margin target.

Capital allocation decisions are key. We have only just emerged from a decade and a half of cheap and easy money: the ZIRP era. It seems odd to me that during this period the business relied more heavily on the equity part of the capital markets than the debt part. Equity finance is so much more costly. Perhaps the company had exhausted all of its debt financing limits, I simply don’t know.

Another observations is that the business seems to be consuming more and more working capital which is also a concern. On a standard sized basis, for every dollar of top line revenue, receivables are relatively stable but payables are in steep decline suggesting less favourable payment terms for the business, and at the same time inventories have trended higher. The business is now requiring twice as much working capital than it did a few years ago and it isn’t clear why this is.

The business has not had any surplus capital to repurchase shares in order to offset dilution, but this would not be the answer. Buy-backs as an offset generally destroy shareholder equity and are bad news for investors (click here to learn more), even though they are often dressed up as returning capital to shareholders. The answer is to stop the share count expansion, period.

Not being profitable, Kraken pays no dividend. This for me is a positive. I dislike dividends as they are super tax inefficient. They are paid out of taxed corporate earnings and then subject to income tax when received by the shareholder who then faces the friction of transaction costs to reinvest the money! The key to successful growth is to reinvest earnings, benefit from the tax deduction and then allow the gross sum to compound. Why do you think Berkshire Hathaway, Google, Amazon and other highly successful companies never pay dividends and grow so rapidly? They are growing at the tax mans expense, all perfectly legitimately. That’s good management. This is all out of the John Malone playbook (click here to learn more.)

Conclusion

Kraken has a great story and a wonderful suite of products and services. Now it needs to prove that it has a profitable business and the ability to act in the best interests of its shareholders.

This may turn out to be a wonderful investment opportunity, but much needs to change. In the alternative, it may turn out to be one of those speculative investments that looked great at the time but which never achieved its full potential.

There are many unanswered questions, as set out in this article, which encourage me to move this investment opportunity into the “Too Difficult” pile for now.

The new CEO may solve the issues that I highlight, or perhaps not. Time will tell.

I engaged with the Kraken investor relations team, who were very helpful, but despite best efforts of all concerned Mr Reid (the new CEO) would not give me 15 minutes of his time for a telephone call to discuss the questions that I raise in this article. It would have been nice to have been able to include his responses in this research piece. C’est la vie!

The reluctance of senior management to engage with shareholders and potential shareholders is another red flag for me.

If I manage to speak to Mr Reid in due course, I shall update this analysis with his comments. Until then I cannot commit my capital into the unknown.