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Kratos Defense Stock Upgraded: Not Too Late to Catch This Train?

Rich Smith, The Motley Fool

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...

Jet-powered combat drone maker Kratos Defense and Security (NASDAQ: KTOS) had a terrific first quarter. It beat on sales and earnings and posted its third straight quarter of GAAP profitability alongside positive free cash flow. To top it off, management indicated that its new XQ-58A "loyal wingman" military drone is enjoying "considerable bipartisan support" on Capitol Hill.

Today, Kratos got its reward for all the above -- in the form of an upgrade from JPMorgan.

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

Image source: Getty Images.

Upgrading Kratos

"Kratos is making good progress on several fronts," observes JPMorgan this morning in a note covered on StreetInsider.com (subscription required).

Sales growth in the fiscal first quarter was a respectable 12%, and an acceleration from the 3% growth pace set for all of 2018. Profits were rather modest -- just $3.1 million for the quarter -- but free cash flow came in at a robust $12 million, which is more cash profit than Kratos has produced in a single quarter since late 2014. The second time Kratos has achieved positive free cash flow in the past year, Q1 lifted the company into positive territory for FCF over its trailing 12 months -- $3.4 million -- finally delivering on management's long-standing promise to become FCF positive.

What really gets JPMorgan excited about Kratos, though, is its "Valkyrie tactical drone, which has gained the attention of Air Force brass," says the analyst, and is the primary reason it's upgrading Kratos stock to overweight, with a $24 price target.

Caveats, provisos, and...

Admittedly, even JPMorgan acknowledges that Valkyrie will not bring "an earnings windfall" for Kratos in the "near term." But as the company explained earlier this year, it does expect to begin receiving at least "initial" orders for the drone from the Pentagon later this year -- and importantly, Valkyrie is only one of a whole series of jet-powered, combat drone programs that it has in the works.

Gremlins. Thanatos. Aethon ISR. Project Spartan. "Program F." These are just a small sampling of the multiple drone programs that Kratos expects to begin bearing financial fruit over the next year or two. And in the meantime, JPMorgan notes that milestone payments as the company progresses from concept to development to production should help to keep its profits above water.

In short, JPMorgan says, it's been keeping Kratos at arm's length up till now over fears that the company might crash into what the analyst calls the "Valley of Death" -- the period between when a company has invested heavily in developing a working prototype product for the military, and the time the Pentagon finally signs on the dotted line and begins ordering large numbers of the product, generating the revenue that will repay a company for its investment.

With Valkyrie (at least) having performed its first demonstration flight already this year, and management confident that orders are in the offing, JP seems to feel it can wait no more to recommend this stock.

...a belated buy

That being said, deciding to pull the trigger today couldn't have been an easy decision for JPMorgan. Up more than 50% since the year began, and up by twice over the past year, Kratos now sports a $2.3 billion market capitalization and a price-to-earnings ratio of 1,225. (Hint: That's a bit rich for a stock that most analysts think will grow earnings at less than 14% annually over the next five years, according to data from S&P Global Market Intelligence.)

And even JPMorgan admits, "Obviously, we wish we had done this prior to earnings," before Kratos experienced its latest 20% run-up in share price. Nevertheless, the analyst is today staking its reputation on a belief that Kratos is just getting started on its growth path, that investors still have a chance to profit from this growth, and that no, in fact, it's not too late to catch this train.

I wish them luck with that bet. For my money, though, the valuation today looks far too expensive to try and hitch a ride.

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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.