Leidos: Well-Positioned IT Play Operating In The Defense Space (NYSE:LDOS)

Leidos (NYSE:LDOS) which operates in the defense sector, has recently realigned its business into four reportable segments to focus on services like cybersecurity, analytics, and digital transformation to better serve its customer base as well as expand internationally. This thesis aims to show how this repositioning puts it in a strong posture to benefit from how the DoD (Department of Defense) spends its money.

With a price tag of $131 at the time of writing as charted below, I will show that it deserves better, both through a sector comparison and considering the IT revenues it generates.

To set the ball rolling, navigating through global conflicts on the one hand, and facing budgetary constraints on the other, there has been an alteration in the way budgeting is done, which appears to currently favor companies specializing in IT for defense purposes.

The new Military spending Paradigm favors Tech-Oriented Companies

First, the DoD’s budget for fiscal 2024 was approved by Congress only last week after months of delay in light of debates concerning priorities without forgetting the Fiscal Responsibility Act of 2023. Now, with a possible change in the political leadership after the November elections, there is no guarantee that the $895 billion requested for 2025 will be approved in its current form. Still, it provides an idea as to where the U.S. military intends to allocate capital and this is unlikely to change drastically unless there is another war.

Diving into the budget, one of the measures, according to Seeking Alpha News calls for a 2% increase in operational expenses, namely for personnel and maintenance purposes, but this could be at the detriment of certain modernization projects and instead favor technology-oriented companies like Leidos. Others include Booz Allen Hamilton Holding (BAH), and CACI International (CACI). These three do not seem likely to be impacted by a spending cap to the same degree as prominent defense contractors like Lockheed Martin (LMT) and RTX (RTX) who could suffer from the F-35 fighter jet program being trimmed down by 9% unless they can bag international contracts to offset the shortfall in sales.

Looking deeper, as hinted in the summarization in the table below, the DoD’s objective seems to increase capabilities in CCCCI (Command Control Communications Computers, and Intelligence) through investments in IT or digital modernization. Related projects range from cybersecurity, digital health transformation, data integration, and software insurance, together with advanced analytics or artificial intelligence-related tools.

Now, for the fiscal year 2024 which started in January, Leidos is operating in four reportable segments, one of which is Defense Systems including advanced space programs, aerial, surface, and sub-surface systems, both for manned and unmanned missions. Based on a recast of the segment information, Defense made up $1.88 billion of revenues in 2023 as tabled below.

Valuing Leidos as an IT play

In this respect, bearing in mind the services provided go beyond the military domain as it also serves the U.S. government and private companies, it can be viewed as more of an IT company operating in the defense space since its expertise goes beyond weapons made by the typical defense contractor. Rather, it can be considered as the brain behind these, making it possible for the intelligence networks to detect hypersonic missile launches even before they become threats, just as its software equips AI-driven robots to disarm bombs before they explode.

Looking further, Leidos’ largest segment is National Security and Digital which provides technology-enabled services including software, cybersecurity, logistics, and decision analytics, which are all key to the digital transformation program in force across U.S. federal agencies. As shown above, this segment is the largest as pictured above, and grew 7% year on year to reach $7.2 billion, out of overall revenues of $15.4 billion.

Interestingly, $7.2 billion for Leidos’ just one segment is only slightly less than Palo Alto’s (NASDAQ:PANW) total sales of $7.53 billion for one year. By the way, this is one of the largest cybersecurity companies with a market cap of more than $90 billion as tabled below. Extending the comparison, Leidos generates better sales than Palantir (PLTR), which also designs software for the intelligence community in the government.

In these circumstances, it is illogical for Leidos’ market capitalization to be only one-fifth of Palo Alto’s and one-third of Palantir’s. Looking for more appropriate valuations, its trailing price-to-sales is at least one-tenth of its two peers from the IT sector. Therefore, incrementing its multiple of 1.16x by 25% to 1.45x, I have a target of $163.75 (131 x1.25) based on the share price of $131.

This bullish position is further supported by the company’s trailing P/S trading at a discount of 24.15% relative to the median for the industrial sector, but the objective behind comparing with the two above companies is to show the high proportion of sales generated from IT for National Security and Digital.

Additionally, there is an IT component in the other segments too as exemplified by Defense Systems. In this case, revenues were up 7% YoY last year, driven primarily by digital modernization including NGEN (Next Generation Enterprise Network) in hypersonics weapon systems, where the speed of sound is exceeded by five times. NGEN is also used in the modernization of the Sentinel program which makes use of intercontinental ballistic missiles as a nuclear deterrent.

Discussing the Problem of Slower Growth and higher Debt than IT sector Peers

Furthermore, as seen in the extract below, the company is an end-to-end provider of IT, ranging from cybersecurity to data centers, cloud services AI, and software development.

However, adopting some realism, unlike IT sector companies enjoying double-digit growth, the company grew by only 7.24% YoY in 2023 with analysts expecting only 3.79% for fiscal 2024.

One of the reasons for this deceleration is the Commercial & International segment grew by 12% YoY in 2023 but a significant percentage (5%) was due to the acquisition of Airborne Solutions in November 2022, allowing Leidos to gain access to the Australian aviation market for command and control systems and sensors for aircraft. Thus, without any contribution from inorganic sales, growth for this year will be lower.

Along the same lines, its SES (Security Enterprise Solutions) unit providing scanning technologies for airports is facing headwinds caused by the elongation of technology refresh cycles, but for Defense Systems which grew 4% YoY, it should see more of a “stable” growth in 2024 according to the management.

Now, there are two problems with this type of growth as seen by the financial performance during the last two years.

First, it may require an inorganic growth booster as with the Airborne Solutions acquisition mentioned earlier which cost $218 million and resulted in higher debt for fiscal year 2022 as pictured below.

Second, since Leidos had to resort to external financing, it does not generate the same amount of cash as IT companies, as evidenced by its much lower FCF margins of 5% which is six times lower than IT peers as shown in the comparison table above. This is caused by the relatively higher amount of Capex required when operating in the defense sector. Therefore, one of the risks in owning the stock is an acquisition that dangerously accentuates leverage. One way to monitor this is using its long-term debt-to-total capital ratio, which is currently 54%. This should not exceed the 60% mark as beyond this point, debt would significantly exceed equity.

Benefits from Stability and Niche Market as Spending Patterns Change in the Commercial Space

Shifting to a positive tone, first, there has been an improvement in the balance sheet as debt has been reduced by $286 million during FY-2023, while cash increased by $261 million. Second, as a tech-oriented company in the defense space, it operates in a niche market that is not within the reach of commercially focused IT providers. Third, viewed from the risk mitigation perspective, it is better to opt for a stable growth company in an uncertain macroeconomic climate. This stability factor can insulate it from the effects of new spending patterns emerging both because of high interest rates and giant cloud service providers now proposing bundled products which can pose risks to pure plays as I had highlighted in a recent piece.

Looking at growth opportunities, the Commercial and International segment is capitalizing on its engineering talent to rapidly extend several of its business lines to the rest of the world. Moreover, IT expertise in managing intelligence data and building digital systems could be required in Australia as part of the AUKUS nuclear-powered submarine-building partnership. Furthermore, an acceleration is expected for the Defense segment over a multi-year time horizon to be driven by demand for hypersonics where the company is “in deep dialogue” with U.S. customers. Now, Commercial and Defense together constitute more than 25% of the business. Then for Health and Civil, which makes up another 25%, a $180 million contract was awarded in October last year.

Talking competition, it has outclassed General Dynamics (GD) for a $7.9 billion contract awarded in September 2023. This spans over ten years and aims to provide the U.S. Army with rapid procurement of IT hardware solutions. One of the reasons for having been selected is superior supply chain management and logistics capabilities made possible by the Leidos Intelligence Logistics Platform.

As an Under-the-Radar Stock, Leidos is a Buy

In conclusion, this thesis has made the case for an investment in Leidos, as its new structure appears aligned with the DoD tech-focused approach. Also, as I elaborated in another piece, the persistent nature of the cyber attack impacting Microsoft (NASDAQ:MSFT) shows that hackers are not only becoming more sophisticated but they are devoting more resources to hacking, somewhat similar to adversaries putting in more resources (troops and military hardware) in the war theatre to increase its chances of prevailing.

As a solution, it is more likely for corporations to choose tech-focused companies like Leidos with cybersecurity capabilities and driven by a defense-type mindset. To this end, as part of the realignment exercise, Leidos is investing money in reskilling its staff around the themes of AI and cybersecurity just to mention a few. This puts it in a position of strength to harvest opportunities in the global cyber security market sized $172 billion in 2023 and projected to reach $425 billion in 2030.

The underlying theme of this thesis is that instead of opting for stocks that provide exposure to well-publicized and cutting-edge weaponry, it is preferable to choose tech-oriented ones that play more of a backstage role but are still key to advancing the capabilities of the U.S. military. At the same time, Leidos’ classification as an industrial sector play makes it less visible for investors looking for IT stocks. Both these two factors account for its undervaluation, but, ending with caution, one item to closely watch out for is debt.