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Kratos Defense Stock Upgraded: What You Need to Know

By Rich Smith – Aug 16, 2019 at 2:57PM

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Kratos shares just got much cheaper. That still doesn't make them cheap.

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...

Stock markets have had a rough summer of 2019, no doubt. The S&P 500 is off nearly 5% from its July highs, and individual growth stocks have done even worse.

In some cases, much worse. Fast-growing small-cap stock Kratos Defense and Security Solutions (KTOS -0.67%), for example, is up 42% over the past year, but down 23% for the month of August! And yet, according to one analyst, this sell-off in Kratos shares provides investors an opportunity to buy a high-quality growth stock at an attractive price.

Here's what you need to know.

Kratos Valkyrie UAV in flight

Image source: Getty Images.

Upgrading Kratos Defense

This morning, investment banker Goldman Sachs announced it is upgrading Kratos Defense & Security stock on the theory that the maker of combat drones for the military is set to enjoy "multi-year, multi-program, strong long-term growth."

Indeed, as Goldman argues in a note covered on TheFly.com, as early as 2020 we could see "substantial" growth in Kratos' unmanned aerial vehicles business -- and the company could continue growing sales at rates of anywhere from 23% to 30% annually through 2023.

Result: Not only does Goldman Sachs think we will soon see Kratos return to its recent high of $24.65 per share, the analyst even believes Kratos could fly higher -- hitting perhaps $26 within a year, and delivering as much as a 36% profit to investors who buy today.

Why Kratos crashed

And yet, this clearly raises the question: If Goldman Sachs is so positive about Kratos, then why does the rest of the market seem to be taking such a dim view of this defense stock?

The answer can be found in Kratos' earnings report -- or more precisely, in the guidance it contained.  

Just before Kratos suffered its big decline in stock price, you see, the company also reported its fiscal Q2 2019 earnings -- and this timing is no coincidence. In Q2, Kratos earned $0.04 per share as reported under generally accepted accounting principles (GAAP). Adjusted earnings of $0.08 per share beat analyst targets. Sales also came in ahead of expectations at $187.9 million, up 24% year over year.

And yet, as my Fool.com colleague Lou Whiteman pointed out at the time, it wasn't Kratos' earnings that had investors worried -- not at all! Instead, it was what the company said about the future that shook investor confidence.

Turns out, part of the reason that Kratos beat earnings in Q2 was that certain contracts it expected to close in Q3 actually closed a bit ahead of schedule, pumping up Q2 results. The downside to that success, however, is that Kratos now believes its Q3 sales will come in a bit short of consensus -- somewhere between $175 million and $185 million, versus the $194 million that Wall Street was looking for.

Result: Kratos may have beat sales guidance in Q2 by $8 million, but it looks like it could miss sales guidance for Q3 by $9 million!

What it means for investors

And this, in a nutshell, is why investors appear to have sold off Kratos stock despite its earnings beat. But is it a good reason?

Maybe. Personally, I view the whole revenue-in-one-quarter-instead-of-the-other issue as of little more significance than "six on the one hand, a half dozen on the other." For the most part, the predicted revenue is still there -- just the timing got shifted by a few weeks. No big deal.

What worries me more about Kratos, though, is the valuation.

After running up so far over the past year, Kratos now has a market cap of $1.9 billion (and an enterprise value of $2.1 billion). Against that, the company has earned just $13.4 million in GAAP profit over the past year, and generated free cash flow of $13.7 million.

On the one hand, this is good news. It wasn't so long ago, after all, that Kratos wasn't earning any profit. Now it's not just GAAP profitable, but free-cash-flow positive to boot. That being said, with the stock selling for a valuation well into the triple digits now (156 times earnings, for example), I'm hard-pressed to justify Kratos' share price today.

Sure, management is promising to deliver $40 million to $50 million in free cash flow by the end of this year, and if it succeeds in doing that, I'll reserve the right to change my opinion. (Or not -- $2.1 billion is still 42 times even the company's most optimistic FCF forecast.)

For now, though, the verdict is much clearer: At 150-plus times both earnings and free cash flow, Kratos stock is still too expensive to buy -- and Goldman Sachs is pulling the trigger too early.

Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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