Buy This Defense Stock You Have Probably Never Heard of Before
Check out this name.

I have been getting a number of emails and tweets regarding Kratos Defense & Security (KTOS) since it started falling out of bed. Perhaps because I am a known long. Perhaps because I have backed the stock in the past on more than one national financial news network. That does not mean that I don't trade around my core position. However, you don't care about that. I understand. You contact me because you are nervous.

Last week noted short-seller Ben Axler of Spruce Point Capital made his case for a 40% to 70% decline in the share price of Kratos. The stock was trading in the area of $10.25 at the time. Axler is good, by the way. No dope. His case is that the firm does not deserve it's 28 times forward looking earnings valuation. I think the Kratos is heading in the right direction, however. Together, let's take a look.

Fundamentally, Kratos reported fourth-quarter earnings in late February where it beat consensus for both earnings per share and revenue. From Q3 2016 through Q3 2017, profit margin widened to 25% from 17%, cash on hand (and cash equivalents) grew from minuscule to $231 million, and total debt declined to $369 million from $445 million.

The company's current ratio runs at 2.49, and the quick ratio (less inventories) stands at nearly the same level (2.43). What this means is that Kratos, while maybe not such an efficient debt manager, should have no problem whatsoever in meeting short-to medium- term obligations.

The firm has landed $270 million in Department of Defense contracts over recent months, and has received permission form the State Department to market its MAKO drones to U.S. allies.

Expectations are for Kratos to earn $0.18 per share on $646 million in revenues in 2018, and $0.34 on $714 million in 2019.

Looking at the chart, one easily sees the impact that Axler had on both the share price and the trading volume on the day that he made his case -- not to mention Relative Strength, and Money Flow.

The $9.60 area is important from a technical perspective as that spot stands as a 61.8% re-tracement of the 2017 range. Since last week, the spot has been regained but just barely, and remains pivotal. I have added to my long position on this weakness.

Trade Idea

November 12.50 Kratos calls went out last night at $1.00. The stock itself closed last night at $9.71. I will use these prices for my example, though they will obviously fluctuate between now and the time you read this. A retail investor who buys 100 shares of the equity, and writes a covered November 12.50 call against the position will have reduced his or her basis on the trade to 8.71. Simple? yes, but extremely smart people tell me all the time that they are not ready for options, so bear with me.

Do you understand that this allows this investor to, in essence, purchase the stock at a 10.3% discount, while not increasing the downside risk one bit. The only risk associated with writing a covered call is the limitation of profit. In this example that means that any rise in the stock above $12.50 by November will not be yours to keep. What would be yours to keep if the stock went higher would be everything between $8.71 and $12.50. How does 43.5% on your money sound? Good enough? Want to go out to January on this? That one last paid $1.25.

It appears that if the stock does break down, there is some legacy support in the $8.50 area. First-line resistance on a technical bounce shows up around $10.40. Just remember if you implement this trade, and then sell the equity, you also need to cover the call option that you would now be short in order to keep the risk in check.

At the time of publication, Guilfoyle was long KTOS equity.

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