Kratos' Stock Rally Crashes: What You Need to Know

Since reporting earnings three weeks ago, shares of Kratos Defense & Security Solutions (NASDAQ: KTOS) have soared 66% in 24 days. This was an amazing performance for a stock that actually lost money for the quarter -- but the rally also had its basis in a number of encouraging facts. For one thing, Kratos' losses were less severe than expected. For another, the company made some significant promises of greater revenue, and profits, in years to come.

Promises notwithstanding, analysts at KeyBanc this morning announced they are downgradingKratos stock (from overweight to sector weight) on fears it has risen too far, too fast. Investors aren't happy with the news, and Kratos shares are off 5% in early trading. Today we're going to dig into what lay behind the stock's enormous surge -- and its recent relapse -- and examine whether KeyBanc is right that the rally has finally come to an end.

Here are three things you need to know.

Drones are the future -- or so Kratos hopes. Image source: Getty Images.

1. "Solid results"

Running down the list of the main factors that resulted in Kratos's stock surge, KeyBanc begins at the beginning: "Solid results" reported in Q2.

"Solid," mind you, does not mean "great." But Kratos reported 5% revenue gains in a not particularly strong defense spending environment, and reduced net losses by 31% compared to last year's Q2 results. The company even reported a "pro forma" profit of $0.01 per share. And when you add all those together, then yes, the quarter went significantly better than most analysts had expected.

2. "A guidance lift"

As a result, Kratos stock has now accumulated profits of $18.5 million, GAAP, over the past four reported quarters, according to data from S&P Global Market Intelligence. Management is guiding toward positive EBITDAthis year. If all goes well, the company might even report a second straight year of GAAP profitability (although management hasn't promised this, and analysts still thinkthat unlikely).

3. "Increased optimism"

What management has told investors to expect, though, is the possibility that the three military drone contracts it has recently won could grow in size. And in particular, management is targeting a new market in "unmanned ... high-performance jets, which have been specifically designed with jet strike fighter aircraftcapability and performance in mind."

This is a capability that even larger defense contractors such as Lockheed Martin and Boeing have yet to demonstrate, and Kratos is self-funding a program to build a new combat drone called the UTAP-22 Tornado to capture this market before competition arrives. According to the company, combat drones could sell for as much as $300,000 to $5 million each. If it's right about that, each Tornado unit sold could be equivalent in value to almost the entire value of some of the entire drone programs it's already won contracts for. Management envisions a day, not far off, when it could be selling "hundreds or thousands" of Tornado and other combat drones to the military -- and raking in hundreds of millions of dollars, or even billions, in new drones revenue.

The most important thing: Not promises, but results

All of these expectations, says KeyBanc, are providing "much needed momentum" for Kratos stock. But at the same time, we're still talking mostly about expectations today, and not yet results.

The drone contracts Kratos has won to date, after all, have been valued only in the single-digit millions, while the hoped-for big Tornado contract remains to be signed. And as KeyBanc notes, in a comment related by, what this means is that Kratos "entering a 'show me' period as execution on key contract wins, expense spending, EBITDA generation, and overall execution will be paramount."

Simply put, Kratos must now do three more things to justify investors' optimism about its stock: First, it needs to win the combat drone contract that it's been trying to land for over a year. Second, that contract needs to be a big one, valued not in the millions, but tens or hundreds of millions. Third and finally, Kratos needs to show that it can convert that revenue into profits.

If Kratos can succeed in achieving all three aims, its astounding August rise could be just the beginning of a much bigger story. If any one of these things fails to happen, though, Kratos stock will fall back to earth.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 295 out of more than 75,000 rated members.

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