Leidos: A Hidden Gem In An Overbought Defense Industry (NYSE:LDOS)

Investment Thesis

Background

Leidos Holdings, Inc. (NYSE:LDOS), a Fortune 500 company and leader in technology, engineering, and science, provides services and solutions in the defense, intelligence, civil, and health markets, both domestically and internationally.

The company is headquartered in Virginia, USA, and was founded in 1969. Tom Bell became the CEO in May 2023. He is an experienced leader with a vision for a bright future at Leidos. The company understands its strengths, weaknesses, and opportunities. I am impressed with the company overall, both as a product and service provider and as a stock.

Thesis

LDOS manages five of the largest Department of Defense networks in the world, as well as the five largest federal security operations centers. They have a greater than 98% user satisfaction “as a service” rating and continue to be awarded military contracts. Over 85% of revenues come from U.S. government contracts, and most recently, LDOS was awarded a $180 million Defense Health Agency contract.

Leidos operates through three diverse segments: Defense Solutions, Civil, and Health.

LDOS offers a wide range of defense products and services, sells aviation products and services, provides IT services, and develops pharmaceutical drugs and equipment. It has a 5-year compounded annual growth rate (CAGR) of over 8% for sales and a 9.2% CAGR for net income.

Growth was strong in Q2:

Analysts, including myself, believe that steady growth will continue on both the top and bottom lines.

Consistent growth, combined with management’s strategic decision-making regarding M&A and operational efficiency, leads me to believe that the stock should not be so cheap. At a forward P/E of 12.2x, I think the stock offers tremendous opportunity, given its 5-year average P/E of 15.7x. Just look at the stock compared to others in the industry on a 2023 P/E:

LDOS is cheap, analysts expect consistent sales and earnings growth, and the stock has a plus 6% free cash flow (FCF) yield, making the company a cash cow in the making. They have a 1.6% dividend yield with a 28% payout ratio, and they have increased their payout for 5 years in a row. After looking into it, LDOS may have become one of my top 5 favorite dividend appreciation stocks.

Management’s goal is to achieve operating (EBIT) margins above 10% and net income above 5%, which I believe is very reasonable. Improved margins and increasing sales will result in even better FCF down the road.

If Leidos can continue to strategically grow the company by offering new and improved products and services through advanced technology capabilities like AI, I believe this mid-sized company ($12 billion) is a hidden gem.

At $90 per share, my calculations show a 3.2x risk-to-reward ratio, with a base-case next-twelve-month (NTM) price target of $102.21 (13% discount) and a bull-case scenario of $125 (39% upside).

Regardless, at 12.2x next year’s earnings, a diverse portfolio of products and services in an extremely defensive and safe industry, I love LDOS at current prices and would highly recommend the stock.

Balance Sheet & Cash Flow

Leidos has $755 million in free cash flow (FCF), giving it a 6.07% FCF yield. For reference, L3Harris Technologies (LHX) has a 5.7% FCF yield, Lockheed Martin Corporation (LMT) has a 5.3% FCF yield, General Dynamics Corporation (GD) has a 4.7% FCF yield, and Raytheon (RTX) has a 4.7% FCF yield.

Management is focused on improving FCF and margins, which I think is just a matter of time before investors take notice. With its generated cash flow, Leidos does a great job of improving its balance sheet and returning capital to shareholders. The company has lowered total debt by $400 million since 2021 and expects to pay off an additional $200 million this quarter alone. It has also bought back 12 million shares, or 8% of shares outstanding, in the past 5 years.

The company’s Q2 results are shown below, and I believe Q3 numbers will be even more generous to shareholders and analyst expectations.

Management’s decision-making and control over the balance sheet and cash flow are crucial to the company’s growth and stock price. Leidos constantly uses mergers and acquisitions (M&A) to bolster its portfolio of products and services, having acquired 18 companies in its history and 7 in the past 5 years. It has bought pieces and parts of businesses from LMT and LHX that were moving on from certain industries but appealed to LDOS.

Ultimately, M&A has been a big part of Leidos’s strategic long-term growth plan, and it has worked out very well for the company. Management has done a good job of not over-leveraging the balance sheet.

Debt is at a reasonable level and coming down, cash will consistently come in through government-directed contracts, and margins will only improve with management’s main focus.

With management buying back shares, paying down debt, and an undervalued stock, I believe shareholders and buyers will receive market outperformance over the next twelve months at current levels.

Price Target

I was able to create a NTM price target scenario table for LDOS using historical valuations and analyst estimates. At $90 per share, I rate the stock a strong buy with a 3.2x risk-to-reward ratio (R:R). I see the stock trading at a base case 13% discount with 39% upside in my bull case scenario.

$125.82 would match the stock’s all-time high, but would make perfect sense as the next resistance level if the stock can break out of its 52-week high at $110. At $90 a share, the stock has a cheap valuation, and the chart shows support for low downside risk and supports our quality risk-to-reward ratio.

The stock chart below shows strong support at the $89-90 level, some support at $87, and worst-case support in the high $70s (13% move down). However, the stock has been consolidating in a pretty wide range over the past three years from $80 to $110 a share.

Currently, at the lower end of the trend, I see a great buying opportunity in LDOS, given its undervalued valuation and increasing demand for the best technology and services in the defense industry. I like LDOS at $90 per share, and if it dips even lower, I would continue to dollar-cost average into the stock. The risk-to-reward ratio can only get better if the stock continues to dip with the broader market. Value investors and dividend growth stock pickers should be aware of Leidos and the potential value it could bring to their portfolios.

Risk

The first risk I want to address is the high portion of revenue coming from government-appointed contracts. Yes, this is good because it provides recurring revenue, large contracts, long-term partnership agreements, and prestigious product and service offerings.

However, what happens when fiscal spending pulls back?

When the government isn’t spending as much on projects to help try lower inflation or directs the money to a different project?

My point is, US spending may be consistent now, but growth may come in spurts and be reliant on contract news. I would love to see the company and management diversify into helping bigger commercial customers. A nice balance between the two could help ease investors’ fears of a lack of government contracts.

The second risk I have already touched on a bit is the company’s profitability margins. I understand that material costs are not cheap and will not get any cheaper. Management still needs to continue to find a way to improve margins and make operations more efficient. I believe they are doing what they can to improve operations, and I think AI will help. The company has advanced technologies, millions invested in R&D, and partners with multiple companies like Amazon (AMZN) with AWS and Dell Technologies (DELL).

If margins continue to contract or stay put, the stock could continue to consolidate and stall, waiting for what investors want: improved profitability. If management does reach their goals and improves margins and ultimately makes more cash, expect the stock to make a strong move higher.

Conclusion

Leidos is a technology, engineering, and science company. Its customers include the Department of Defense, Homeland Security, and the Federal Aviation Administration (FAA). LDOS is a defensive stock and company that value and dividend growth investors should hold.

They have a diverse portfolio of products and services that cover a wide range of industries and sectors, from IT hardware and networks to plane maintenance to pharmaceutical equipment. LDOS has a low beta of 0.78x, a solid dividend of 1.6% or $1.44 per share, and signs of plenty of room for dividend growth (28% payout ratio).

At current prices, I love LDOS, an undervalued company in an overbought industry. This is a quality stock and company that is overlooked by the big names but is making a strong name for itself. At only a $12 billion market cap, I continue to think the stock is undervalued. With strong catalysts for increased defense spending and uncertain times in the stock market, I suggest taking a look at this hidden gem.