What happened

Shares of Kratos Defense & Security (NASDAQ:KTOS) traded up 10% on Friday afternoon, part of a broader surge by defense stocks following news that the U.S. military had killed Iranian general Qassem Soleimani. While the long-term ramifications of the airstrike are hard to predict, the event will likely raise global tensions and make an election-year cutback in military spending less likely.

So what

Kratos has long been among the most volatile of defense companies, rising more than 300% over the past five years. But the company has been stuck in neutral of late as investors wait word about a potential Pentagon order for Kratos' promising Valkyrie wingman drone.

The Valkyrie in flight over the desert

Kratos' Valkyrie drone during a 2019 test flight. Image source: U.S. Air Force Photo by 2nd Lt. Randolph Abaya, 586 Flight Test Squadron.

The killing of a top Iranian leader is unlikely to directly lead to the Pentagon ordering the Valkyrie, but the strike, and Iran's promise to retaliate, has increased the odds of a conflict in the Middle East. Investors on Friday appear to be wagering that it will be difficult for lawmakers to cut military spending in such a climate, eliminating some of the election-year risk that usually impacts defense stocks.

The SPADE Defense Index gained 2% on Friday afternoon, a day when the S&P 500 index was off by more than 0.5%. Kratos tends to swing wider than most defense stocks due to its relatively small size, with a market cap of just $2.1 billion compared to Lockheed Martin's $117 billion market cap, and the still-speculative nature of key products like the Valkyrie.

Now what

Kratos fits a different profile than most of the staid, button-up defense contractors and tends to have more momentum traders interested in its shares compared to its defense brethren. The outlook for the company is bright, which is why I named it as one of the best buys among defense stocks, but investors need to be careful not to get ahead of themselves.

As noted, the Pentagon is unlikely to rush a decision on the Valkyrie due to this airstrike, and there is a risk that rising tensions will cause the U.S. Defense Department to focus on near-term weapons need and defer decisions on next-generation systems. The outlook for Kratos is unchanged from Thursday: The company has great promise, but still must navigate the slow Pentagon procurement process.

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