Investors are feeling bearish about the defense industry these days and with good reason. Unless Congress acts soon, the sequester budget cuts will kick in on March 1st, 2013. This will reduce government spending by $85 billion, with half the cuts coming from military programs. Investors are particularly worried about small defense companies like Kratos Defense and Security Solutions Inc. (NASDAQ: KTOS). These companies only have a few product lines. If they lose key contracts because of these cuts, they will be in serious financial trouble. Multi-billion dollar firms like Lockheed Martin Corporation (NYSE: LMT) and the Ratheon Company (NYSE: RTN) are expected to fare much better because they are more diversified. Even if they lose some projects, they still have plenty more to fall back on.
In this current environment, why would anyone even think about investing in a micro-cap defense company, especially one that recently took a huge stock plunge like Kratos? When you dig a bit deeper, things don’t look quite as dire for Kratos Solutions. This company’s stock took about a 30 percent dive this past October, exactly the same time as Hurricane Sandy. Kratos is based out of the Northeast and most of its clients are in the same region. When Sandy shut down the region, Kratos saw its orders fall dramatically. Now that the Northeast has started to recover, Kratos is beginning to return to business as usual. Since this company specializes in IT and security systems, it could see a boost as companies continue to rebuild and repair damage from the storm.
Kratos’ share price still remains depressed because of fears about the sequester cuts. No doubt this is going to be a significant challenge. With less money, the military is going to have to cut a number of contracts. Several companies won’t survive but this will leave more market share for those that make it. Kratos should survive because it specializes in the military equipment of the future: cybersecurity and cyberwarfare technology. The battles of the future will not be fought with tanks and jets, but with computers. Just this week, 140 companies were hit with cyberattacks that seem linked to the Chinese military. America can’t afford not to invest in cybertechnology. As a result, demand for Kratos’ services won’t be going away anytime soon. Competitors like CPI Aerostructures Inc. (NYSE: CVU) and VSE Corporation (NASDAQ: VSEC) have more to worry about because they specialize in vehicle and aircraft production; two lines that should be in less demand as the wars in the Middle East wind down. A sign of this trend is that Kratos received another $12 million in bids just this February. At a time when military orders are slowing down to a crawl, Kratos is picking up new business.
It’s not going to be easy for Kratos going forward. The sequester cuts are going to be a problem for all defense companies. In addition, this company’s balance sheet is still in rough shape as it recovers from Hurricane Sandy. However, there is reason to believe Kratos will not only survive, but also do well in the near future. This gives this stock some speculative upside, especially right now. Waiting until after the sequester cuts before investing is another option. This is a less risky play, but then you might miss an immediate jump in share price should Kratos get hit less than expected. Either way, this stock could work out well as a speculative part of your portfolio.