After a Strong 2018, Is Kratos Still a Buy?

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Kratos Defense & Security Solutions (NASDAQ: KTOS) has always been a bit of an anomaly in the defense sector: a high-risk, high-potential-reward company competing in a sector full of slow and steady Dividend Aristocrats. The company's 2018 share performance reflected that divide: Kratos gained 33% on the year, compared to a 20%-plus loss for General Dynamics and Northrop Grumman, and double-digit declines for most of the major contractors.

Kratos' performance was even more impressive considering that the company last March was the target of a critical report by short-seller Spruce Point Capital Management, which argued that the company's stock could drop 40% to 70%. Kratos did fall an initial 11% following the report but recovered nicely over the course of the year as it was able to win new business and make progress on some of its most promising development-stage projects.

Defense Chart
Defense Chart

KTOS vs. major defense companies, 2018 data by YCharts.

Kratos has been a battleground stock for a long time. Can it deliver another year of outperformance, or will the shorts carry the day in 2019? Here's a look at Kratos' outlook for 2019 to try to determine whether it's too late to jump on board.

Drone warrior

Kratos started as a wireless-infrastructure vendor and pivoted to become a government contractor last decade. As Spruce Point notes, the company has had its challenges over the years. It spent about $1 billion to assemble a hodgepodge of defense assets that, despite promises to the contrary, until recently had failed to generate a profit.

The current optimism surrounding Kratos is focused on the company's portfolio of jet-powered drones: They're fast enough to simulate missiles in test runs and could one day fly as wingmates to combat aircraft. The company primarily sells missile simulators today, while working on its Valkyrie and Mako drone platforms that it hopes will one day fly alongside crewed aircraft providing additional firepower and acting as decoys to distract anti-aircraft systems.

Kratos XQ-58A Valkyrie drone in a hanger
Kratos XQ-58A Valkyrie drone in a hanger

Kratos' XQ-58A Valkyrie drone, expected to fly in early 2019. Image source: U.S. Air Force Research Laboratories.

Fully autonomous combat systems are still a long way off, but the drone business does seem to be advancing at a good pace. Last year Kratos won U.S. State Department approval to market the Mako internationally. The higher-tech Valkyrie, meanwhile, is expected to have its first flight this year. And Kratos in the last year has rapidly expanded the number of unmanned air vehicles under development, revealing at least five other platforms.