Rothschild & Co. Redburn analyst Maggie Schooley initiated coverage of U.S. defense stocks on Tuesday, focusing on companies that could benefit from the growing use of low-cost, AI-enabled technology on the battlefield.
"Military spending is increasing globally as forces adapt to changes in modern warfare," wrote Schooley. "This... is driving an acceleration in the modernization of exquisite systems, the replenishment of stockpiles, a race to secure space and a drive to introduce mass affordable systems."
Exquisite systems include modern fighter jets that cost tens of millions of dollars each and cost millions more to maintain. They are still necessary, but so are lower-cost drones enabled by improving electronics and software. Space is growing in importance, too. Recently, the Pentagon confirmed the existence of an offensive weapon in space, ushering in a new definition of military high ground.
"The U.S.... finds itself in need of developing rapidly and scaling the production of affordable mass munitions to counter the asymmetrical risks that modern warfare presents," added Schooley. "The demand for exquisite systems alongside affordable mass munitions, interoperable communications and data-sharing capabilities is driving the requirement for material investment."
She rates shares of Lockheed Martin, Northrop Grumman, and Kratos Defense & Security Solutions Buy. The first two make exquisite systems such as bombers and fighter jets, but both also supply missiles and space technologies. Kratos makes drones, propulsion systems, and space-based technologies, among other things.
Her price target for Lockheed is $650 a share. Lockheed stock was $506.77 in early trading on Tuesday, flat on the day, while the S&P 500 was up 0.7%.
Her target price for Northrop is $680. Shares were at $477.84 early Tuesday. Her Kratos target is $70. Kratos stock was $42.83 in early trading.
Schooley's Kratos target implies more than 60% upside. Part of the potential gain comes from the starting point. Coming into Tuesday trading, Kratos stock was down 50% since fighting started in Iran.
Rising conflict and the need for more drone technology should be good for Kratos and other defense stocks. Still, investors have grown nervous about U.S. defense spending levels heading into a contentious midterm election cycle.
Those fears have led to a collapse in Kratos's valuation multiple. At the start of the year, Kratos traded for 100 times earnings expected over the coming 12 months. Now, shares trade for 41 times. The multiple has dropped as earnings estimates have risen. Wall Street expects Kratos to earn $1.11 a share in 2027. At the start of the year, that estimate was $1.06.
Still, the military is moving forward. Recently, Defense Secretary Pete Hegseth announced "Project Meridian," which will study the future of warfare and the systems needed to maintain U.S. military dominance.
Former House Speaker Newt Gingrich, defense startup Anduril founder Palmer Luckey, and SpaceX CEO Elon Musk are leading the 120-day effort.
Studying technology with an eye to reforming military practices isn't unusual. Having current suppliers partly lead the effort is.
The project report could serve as a catalyst for defense stocks. So could midterm elections. Whatever the outcome, the election results will remove one source of uncertainty for defense investors.