What happened
Shares of Kratos Defense and Security Solutions (KTOS 2.33%) traded down nearly 10% on Tuesday after the defense company was downgraded by J.P. Morgan. The stock has had a strong run over the past three months, and at least one analyst doesn't see it climbing much higher right now.
So what
Kratos, which specializes in drones and defense electronics, got a lift back in late July when online news service Dealreporter suggested it as a potential acquisition target for Lockheed Martin (LMT 1.71%). Lockheed CEO James Taiclet had made comments suggesting his company could look for "pure play" defense companies that line up well with its existing capabilities, and Kratos would seem a natural fit.
Kratos' XQ-58A Valkyrie demonstrator drone. Image source: Kratos.
The shares were up 21% over the past three months coming into Tuesday trading, making Kratos one of the top-performing defense stocks of the summer. But in a note Tuesday, J.P. Morgan analyst Seth Seifman questioned how much higher it could go, saying after the recent run-up he sees a less favorable risk/reward proposition in Kratos.
Seifman downgraded the shares to neutral from overweight, but kept his $20 price target. Kratos shares as of noon Tuesday traded at around $18.
Now what
Kratos has long been the rare high-risk, high-reward stock among the mostly staid defense contractors, with great potential in its drone projects but also trading at a sky-high 3.3 times sales and more than 300 times earnings. There is a potential catalyst in the quarters to come, as Kratos hopes to win a production contract from the Air Force for its XQ-58A Valkyrie drone, but that deal is arguably already priced into the shares.
I'm bullish on Kratos for the long run, but agree with Seifman that it is going to take time for Kratos to grow into its valuation. I wouldn't sell off based on the downgrade, but even with the shares lower on Tuesday, I think there are more-attractive defense stocks to buy right now.
