Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

The U.S. defense industry had a tough time of things this past year. Hurt partly by a budget crisis in D.C., partly by peak profit margins driving too-high valuations on its stocks (I think), and partly by the fact that just about every stock in the universe sold off toward the end of 2018, shares of defense contractors like Lockheed Martin, Northrop Grumman, and General Dynamics are all down by double-digit percentages. One stock that bucked the tide, however, is tiny military drone maker AeroVironment (NASDAQ:AVAV).

And AeroVironment just got a buy rating on Wall Street.

Drone firing at a tank

William Blair strikes a bullish pose in favor of AeroVironment stock. Image source: Getty Images.

Initiating coverage on AeroVironment

Early this morning, StreetInsider.com (subscription required) reported that analysts at William Blair have initiated coverage of AeroVironment stock with an outperform rating. (TheFly.com clarifies that the rating actually came out last night.) As for a price target, Blair estimates that over the next 18 months, it sees shares rising at least 11% to $82. In the best case, Blair sees the stock shooting up to $105.

As the analyst explains, its reason for upgrading AeroVironment is simple:

Citing a report just out of the Center for the Study of the Drone at Bard College in New York, William Blair notes that "[a]nnual growth for the U.S. fiscal year drone budget allocation accelerated to 20%" in fiscal 2019, with funds allocated to drone warfare topping $8.9 billion. The analyst predicts further growth in drone funding of about 15% annually over the next five years.

Now, admittedly, not all of these funds will go to AeroVironment. To the contrary, there are multiple players involved in this industry with which the company must compete. And S&P Global Market Intelligence data show that last year, AeroVironment's sales totaled just $271 million.

Nevertheless, the company's sales over the last 12 months amounted to $322 million -- a 32.5% year-over-year increase -- which suggests that AeroVironment is benefiting disproportionately from the growth in spending on drones, growing its sales at more than twice the rate of the drone industry at large. Moreover, in William Blair's estimation, "defense budget drone spending growth [will] continue to exceed overall defense budget growth by a wide margin."

Translation: Not only in the pie growing, but AeroVironment is claiming ever bigger slices for itself.

AeroVironment's competitive advantage

How is the company succeeding in growing where its rivals arguably are not, or at least not as well? As William Blair explains, "AeroVironment is the industry leader in small unmanned aerial systems for military users."

As General Atomics focuses its efforts on building large, missile-toting Predator and Reaper drones, and Northrop Grumman builds even larger Global Hawks and Tritons, AeroVironment still has the small-drone space mostly to itself, having outcompeted essentially all comers who've tried to horn in on its market in the past. Admittedly, its small drones carry small price tags, and thus don't bring as much revenue with them with each incremental sale (as confirmed by its tiny revenue haul). But for a company with just a $1.8 billion market capitalization, William Blair seems to think the revenue opportunities are big enough, and growing fast enough, to justify AeroVironment's price.

Valuing AeroVironment stock

Is William Blair right about that? Let's consider:

AeroVironment has a $1.8 billion market capitalization, but no debt and nearly $290 million in cash on its books -- thus, an enterprise value of only $1.5 billion. Trailing net income comes to just under $52 million, so the company's enterprise value-to-earnings ratio is only about 30.

That doesn't seem too expensive if it can maintain its 30%-plus rate of sales growth from the past 12 months, and grow earnings at a similar speed. (In which regard, it's worth pointing out that AeroVironment's earnings growth rate over the last 12 months was 71%, while free cash flow more than tripled.)

Granted, such barn-burning growth rates in sales, earnings, and especially free cash flow probably won't be sustainable in the long term. But most analysts agree that AeroVironment can maintain an earnings growth rate of 22.5% (according to S&P Global projections). And if William Blair is to be believed, and the company continues outgrowing the broader drone industry, it might grow even faster than that.

In which case, I'd say Blair's outperform rating is not misplaced.

Check out the latest AeroVironment earnings call transcript.