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...

Kratos Defense & Security (KTOS -1.18%) stock has fallen off a cliff -- not just once, but twice in two months.

The first drop came in August, after Kratos reported a sizable earnings beat, but a guidance miss, warning that sales booked ahead of schedule in Q2 would subtract from Q3 expectations and leave the company woefully short of Wall Street estimates in the current quarter. Kratos shares plummeted as much as 28% in the two weeks following this news -- but the pain wasn't over yet.

By the middle of last month, Kratos stock had recovered about half its losses from the post-earnings crash. But the second shoe dropped on Sept. 20: The Department of Defense announced the winner of a massive $1.12 billion contract to supply "threat-representative subscale targets with simple and complex reentry vehicles" for the U.S. Missile Defense Agency...and the winner wasn't Kratos. (Instead, it was Northrop Grumman.) That news sent Kratos stock sliding once again, ultimately ending up down 17% as of yesterday's close.

But then, a miracle happened.

Five dice labeled buy and sell on top of an LCD screen showing charts and numbers

Image source: Getty Images.

Upgrading Kratos Defense

This morning, boutique investment banker Noble Capital announced it is upgrading Kratos Defense from market perform to outperform and assigning a $23 price target that's very near the stock's highs of July, as reported by StreetInsider.com.  

"[I]t was disappointing the company did not win a recent Missile Defense Agency award," the analyst said. Regardless, "there remains plenty of opportunity going forward" and "Kratos's opportunity set remains large."

In short, Kratos, which according to data from S&P Global Market Intelligence has successfully returned to GAAP profitability over the past four quarters and is expected to report a profit this year as well, could still very well fulfill the hopes that investors have for it.

One (big) loss, many (smaller) wins

Indeed, if you scan the newsfeeds over the past couple of weeks alone, there's no lack of evidence that Kratos Defense is continuing to get work from the Pentagon:

  • $35 million won in a sole-source U.S. Air Force contract for "Subscale Aerial Target peculiar spares."
  • $17.6 million for research and development into new jet-powered drones.
  • $7.5 million to upgrade "Enterprise Management & Control" architecture used by MILSATCOM and commercial SATCOM networks.
  • And just this morning, a $5 million contract "for mission system integration and test work associated with its high performance tactical jet drone systems."

Granted, all of these contracts pale in comparison to the $1.2 billion Missile Defense Agency award that Kratos did not win last month. That was a big disappointment. That single contract, if won, would have given the company nearly twice the amount of revenue it ordinarily books in a year from all its other activities combined. And shortly after the award was announced, investment banker R.W. Baird, which actively follows Kratos, opined that the contract had been winnable for Kratos.

Still, for the most part, analysts hadn't actually counted on Kratos winning, and Baird noted that the loss of the contract would not impact its estimates for Kratos' profits going forward.  

What it means for investors

Speaking of which, what are Wall Street analysts forecasting for Kratos?

According to estimates gathered by S&P Global, analysts believe the company will wrap up this year with GAAP profits of $0.17 per share, then more than double that number to earn $0.36 per share in 2020, ultimately earning $0.55 per share in 2021.

Currently, Kratos' quality of earnings looks quite good, with $13.7 million in trailing free cash flow actually running a bit ahead of reported earnings of $13.4 million. And estimates suggest that over the next few years, free cash flow will continue to track reported net income pretty closely, indicating continued high quality of earnings for this defense stock.

Admittedly, Kratos shares do still sell for a very rich valuation today -- more than 100 times this year's estimated earnings, in fact. But if all goes as planned and Kratos succeeds in earning $0.55 per share a couple years from now, well, a $17.35 stock price is only about 31.5 times that estimate.

Long story short: Even if I hesitate to recommend Kratos based on its current valuation, I still see a path to the stock growing into its valuation in the not-too-distant future.