Wall Street's Buy List

Actions speak louder than words, as the old saying goes. So why does the media focus so much attention on what Wall Street says about companies, instead of what it does with them?

Once upon a time, we didn't know what the bankers were up to. Now, thanks to the folks at finviz.com, it's easy to keep tabs on the stocks that financial institutions buy and sell. And the 170,000-plus lay and professional investors on Motley Fool CAPS can lend us further insight into whether these decisions make sense.

Here's the latest edition of Wall Street's Buy List, alongside our investors' opinions of the companies involved.

Companies are selected based on past-three-month changes in institutional ownership, as reported on finviz.com. Recent price provided by Yahoo! Finance. CAPS ratings from Motley Fool CAPS.

Wall Street vs. Main Street
Up on Wall Street, the professionals think these five stocks are the greatest things since sliced bread. And by "bread," I mean money.

• They're defying the China-is-a-fraud crowd and snapping up cheap shares of Zhongpin and China Green Agriculture, selling for 7 and 4 times earnings, respectively.
• They're finding just as much value closer to home, where Atlas Pipeline is selling for the near-Chinese valuation of just 3.4 times earnings.
• And they're betting that executives know Abraxas Petroleum better than the rest of us and taking a cue from the insider buying going on there.

But perhaps Wall Street's strangest move this week is its sudden interest in Kratos Defense and Security. After all, the defense industry isn't exactly booming these days. Plus, the last time Kratos reported earnings, the news didn't inspire much confidence. Expected to report $0.11 in profits last quarter, Kratos instead announced a $0.17-per-share loss. So what is it about Kratos that has Wall Street so enthused -- and why is it that Fools are giving this stock five stars as well?

The bull case for Kratos Defense and Security
Excellent question. Problem is, the answer isn't quite clear. Not a single Fool in CAPS-land has written about the company in more than a year.

Way back in early 2010, CAPS member rdeep liked the company's acquisition of "Digital Fusion," pointing out that with it, Kratos "gained a very strong team that does engineering work for the U.S. Army." Around the same time, CAPS member tdigs79suggested that "there is a lot of speculation on a potential buyout" of Kratos -- but that hasn't happened. And aside from these comments, there really hasn't been much explanation of why 133 out of 141 Fools polled believe Kratos will outperform the market today. Let's see whether we can change that.

Kratos: buy the numbers?
Reviewing the company's financials, I see a lot to like about Kratos. The company's 6.4% operating margin is on par with what rivals such as CACI International (Nasdaq: CACI) and Computer Sciences (NYSE: CSC) generate. Surprisingly, though, the company sells for a much higher P/E ratio than those rivals -- about 16 times earnings.

Why the premium? Perhaps it's because most analysts expect Kratos to vastly outgrow its peers, improving earnings by 37% per year over the next five years. Or it could be because the company is much more profitable than it looks. Although net earnings are still nothing to write home about, Kratos generates considerably more free cash flow than its GAAP earnings let on. Over the past year, Kratos's free cash flow has hit $23.7 million, or more than twice reported earnings.

At today's prices, this means to you can by Kratos for roughly 11 times free cash flow -- not bad for a supposed 37% grower. Even considering the company's sizeable debt load, the price doesn't look too bad. Back out the company's $45 million in cash, and add its $516 million debt load, and you're left with an enterprise value-to-free cash flow ratio of 31 on the stock -- which, again, seems more than reasonable given the growth rate.

Foolish takeaway
Of course, this makes it all the more essential that Kratos live up to the growth expectations. Sure, 37% annual growth can cover up a multitude of valuation sins. But in a time of declining defense spending, I wouldn't advise taking predictions of "37% growth" for granted. Kratos certainly has potential, but Foolish investors will want to keep a close eye on the company to ensure that it's meeting expectations. One more miss like the one we saw last quarter, and this stock could fall off a cliff.

Disagree? Feel free. If you have an opinion of Kratos, tell us about it.