Stocks to Buy: This Defense Winner is in a Class of Its Own

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If you think the sequester has taken all defense companies off the "stocks to buy" list, think again.

Indeed, there has been a cloud over defense stocks for some time thanks to the automatic spending cuts. The Department of Defense has to reduce its budget by $47 billion by the end of the summer.

That is in addition to almost $500 billion of cuts over the next decade that was passed back in 2011. All of the budget proposals currently circling Capitol Hill include additional cuts to defense spending.

Companies that work with the military and other defense agencies are feeling the pinch and many of their stock prices have reflected that.

But the truth is, while cuts will be made to some of the bigger, flashier programs, the military will still be in the business of protecting the country. Not all companies will slow spending.

And any industry that sees the type of investor distaste that has swept over defense frequently sees a wave of consolidation and takeover activity that lifts the valuation of companies in the sector.

That means it's time to go hunting for some undervalued stocks in defense.

Here's one we like.

Stocks to Buy: A Winner in Defense

Kratos Defense and Security Solutions Inc. (Nasdaq: KTOS) is a company that may be depressed in the short term as a result of the sequester and other budget cuts, but has a very bright future.

Kratos offers engineering, manufacturing and systems integration to national security and defense agencies.

It works on many mission critical projects unlikely to feel the impact of spending cuts. Most of the company's work is actually done on secure military bases or other closed locations operated by government agencies.

The company is involved in a wide range of military and national security projects that will be ongoing and well-funded. It works in the drone programs, satellite security and its programs support almost every U.S. electronic warfare and attack platform. It is currently engaged in programs for unmanned surveillance systems, cyber warfare, and defense and weapon systems sustainment.

Kratos' products are also part of almost all U.S. and Israeli missile systems and related missile radar equipment.

While many defense companies that work on some of the larger flashier programs may see cuts as a result of budgetary battles, Kratos is involved will actually see increased spending. That's partly because of its involvement in cybersecurity. It is heavily involved in cybersecurity programs used to protect critical infrastructure such as refineries, nuclear plants, airports and mass transit systems.

The number of unmanned surveillance systems and other drone projects is increasing across almost all, military and homeland security agencies. Electronic warfare and attack programs are fully funded and will be for decades as cyber warfare is becoming one of the leading threats facing the United States. We will not cut spending to protect our critical infrastructure as attacks in these areas could cripple significant portions of the country.

The company is in a business with what Warren Buffett calls a "wide moat." The barriers to entry from a knowledge and expertise stand point, as well as the government clearance aspect, are very high. It has very limited competition and most of its contracts are single source contract award and not part of a multi-vendor project.

The company looks solid. It expects to report revenue of $950 to $975 million for 2012 with EBITDA of $111 million. The backlog right now stands at $1.3 billion and it has over $5 billion of potential work in the bid and proposal pipeline. It also has over $300 million in net operating loss carried forward that can be used to reduce taxes and enhance cash flow, and it doesn't expire until 2030.

In spite of the company's solid business and bright prospects the stock has lost value over the past year as all defense-related issues have faced selling pressure as a result of spending concerns. Institutions own just 56% of the outstanding shares as virtually all of Wall Street has eschewed these stocks.

This should change as Kratos delivers on the potential of high-moat business whose contracts will continue to be awarded and funded over the next few years.

Trading around $4.50 a share now, Kratos could easily head to double digits in a year.

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