Kratos Defense & Security Solutions (KTOS -0.43%) suffered a fearful fall yesterday. After reporting Q4 and full-year earnings 2019 Monday evening, investors punished the maker of target drones and jet-powered combat drones, selling off the stock by 22.3% on Tuesday.

So how bad was the news exactly?

Drone firing rockets at a tank

Image source: Getty Images.

Kratos by the numbers

At first glance ... actually, not all that bad.

Kratos reported Q4 revenue growth of 13% to $185.1 million (although its earnings declined 25% to just $0.03 per share). This was partially a consequence of Kratos having more shares outstanding. (The more shares, the more earnings dilution.) But input costs also rose faster than sales (up 15% year over year), and Kratos paid a bit more income tax this quarter than in last year's Q4 as well.

On the other hand, the year as a whole was a pretty clear win for Kratos. Sales climbed 16% in 2019 in comparison to 2018. Profits as calculated according to generally accepted accounting principles (GAAP) turned from negative to positive ($0.11 per diluted share). And Kratos even generated a bit of free cash flow for the first time since 2012 -- $2.6 million total, excluding the cost of its February acquisition of turbines-maker Florida Turbine Technologies. 

(Incidentally, but for that acquisition sales would have increased only 8% for the year.)

Unit by unit, Kratos's unmanned systems division (i.e. drones) drove growth in 2019, with revenue there rising 21% year over year, and positive operating income. Kratos government solutions grew more slowly -- up 15% -- helped largely by the influx of revenue from FTT, and profits there were even stronger.

First the good news, now the bad

Now for the bad news. Kratos's book-to-bill ratio for both the quarter and the year was only 1.0, indicating that new business isn't coming in any faster than old contracts are executed, which limits the prospects for sales growth in the year ahead.

Perhaps because of this, Kratos guided investors to expect no more than $170 million in first-quarter-2020 revenue. (Wall Street was hoping to see $190 million.) Full-year sales are not expected to exceed $780 million. (Wall Street wants more than $830 million.) Kratos also warned that after finally turning free cash flow positive again in 2019, there's a very real chance it will resume burning cash in 2020 -- with as much as $18 million in negative free cash flow for the year.

In short, while Q4 numbers weren't all bad, Wall Street is looking at Kratos' guidance and seeing nothing good. Is that a mistake?

Drones to the rescue?

Perhaps. One of the reasons Kratos guided to potentially negative free cash flow, for instance, is the fact that the company is anticipating spending $15 million to $17 million to build a fleet of 12 Valkyrie combat drones for the Pentagon ... before actually receiving an order for them.

Kratos could potentially make back that money and more from a "contribution from expected Valkyrie or other tactical drone production or system contracts," said management. However, since Kratos doesn't anticipate delivering the Valkyries before "early next year" (i.e. 2021), investors may have to wait another 12 months to see the cash. Additionally, Kratos will lay out an additional $5 million for "aerial target drone systems in preparation of fulfilling forecasted customer requirements."

This money, too, could be made back if the anticipated orders materialize, but Kratos didn't say when that might be.

It's also worth noting that Kratos has one order worth $50 million (which you'll notice is the difference between management's guidance for up to $780 million in sales and Wall Street's expectation for $830 million) that has been held up by a competitor's protest of the contract's award to Kratos. Assuming that protest is overturned, Kratos's "missing" revenue could pop right back up, enabling the company to meet expectations in 2020.

The upshot for investors

All this being said, it sounds like a lot of things might have to go right for Kratos to "make its numbers" this year. With Kratos' stock still selling for a very rich 2.2 times sales valuation (the long-term historical average valuation for defense stocks is closer to 1.0), investors here are probably right to be taking a cautious approach to the company.