What happened

Shares of Kratos Defense & Security Solutions (KTOS 1.09%) fell 11.3% in February, according to data provided by S&P Global Market Intelligence, after the company reported quarterly results that came in below expectations and provided tepid 2020 guidance. Kratos is among the biggest risk/reward stocks in the otherwise staid defense sector, and reinforced that reputation with its latest results.

So what

On Feb. 24, Kratos reported fourth-quarter earnings of $0.09 per share on revenue of $185.1 million, falling short of analyst expectations for $0.10 per share in earnings on sales of $197.34 million. The company blamed the shortfall on unexpected delays to contract start times and other short-term issues, but the guidance provided additional reason for worry.

The Valkyrie flying over a desert landscape.

Kratos' Valkyrie on a test flight. Image source: Air Force Photo by 2nd Lt Randolph Abaya, 586 Flight Test Squadron.

Kratos forecasted first-quarter revenue of between $160 million and $170 million, well short of the $190 million current consensus. For full-year 2020 Kratos expects sales of $740 million to $780 million compared to analyst expectations of $832 million. Kratos also expects full-year capital expenditures of $43 million to $48 million, with free cash flow generation ranging from $7 million to negative $18 million.

The company makes unmanned systems and defense electronics, currently generating about 45% of its revenue from electronic warfare, communications, and intelligence projects, another 30% from space, and 25% from unmanned systems. But it is the drone business that has investors most excited. Kratos' XQ-58A Valkyrie loyal wingman drone is currently on trial with the Air Force, ahead of a potential order.

Some investors had been hoping that order would come in 2019, but an October mishap pushed back the timetable.

Now what

There is a lot to digest in the guidance. Kratos appears to be erring on the side of caution, backing out about $40 million in potential revenue from a contract with the Royal Saudi Navy while an award protest plays out. They also eliminated another $50 million award from their guidance because it is being protested by a competitor.

Kratos is also committing upwards of $17 million to begin production of 12 Valkyrie drones, despite not yet getting a contract from the Pentagon. Should that contract come, the cost would be transferred into a revenue-generating program and the cash impact would look significantly better.

"We are leaning forward here, ahead of the expected contract awards as we are highly confident that receipt of initial Valkyrie production contracts is not if, but when, based on the most recent information that we have," CEO Eric DeMarco said during the post-earnings call.

There are a lot of "ifs" here, but if Kratos can move forward on the awards under protest, and if a Valkyrie order does materialize, the company is well positioned to easily top its guidance. Kratos has been a volatile stock over the years and is likely to continue to fly through turbulence, but for investors looking for a company with growth stock-characteristics operating in the defense sector Kratos is an intriguing stock to follow.