For defense contractors, all roads lead to, and most revenues come from, the Pentagon. Image source: Getty Images.

After broadly falling for five straight years, the U.S. defense budget finally ticked up a bit in fiscal 2016, rising to $585 billion. Now, Congress is contemplating an additional increase in 2017.

Military spending is already set to hit $602 billion based on the latest version of the 2017 National Defense Authorization Act, a level that the Senate signed off on last month. That number differs from the $583 billion approved by the House in April, however, and the two chambers have yet to agree on a final figure to send to the President for signing by their September 30 deadline.

For military contractors such as Kratos Defense & Security Solutions (NASDAQ:KTOS) and Leidos (NYSE:LDOS), the likely increase in defense spending is great news. But it still leaves us with two questions: Which defense contractors will reap the lion's share of the extra money? And most pertinently, which is the better stock to buy?

Let's take a look.

Kratos Defense & Security

Priced at more than 19.3 times trailing earnings today, with no free cash flow, no dividend, and $424 million net debt on the balance sheet, Kratos Defense stock doesn't look like much of a value at first glance. And the second glance isn't much better.

From one perspective, Kratos stock appears to be undervalued. Its price-to-sales ratio is a mere 0.4, which is far below the "one times sales" valuation that's historically prevailed in the defense industry. Problem is, Kratos doesn't earn a lot of profit on its sales. Up until last year, it had produced four straight years of negative earnings. And going forward, long-term growth-rate projections for Kratos average 3% annually, according to analysts polled on S&P Global Market Intelligence. That gives the stock a PEG ratio of 6.4 based on trailing results.


The situation at Leidos, a much larger, IT-focused defense contractor, is quite different. Thirteen times Kratos's size with its $3.6 billion market cap, Leidos usually does a much-better job translating its revenues into profits. With the exception of a big, writedown-related loss in 2015, Leidos has earned profits in each of the past five years. Average profit across the past five-year period is $138 million -- even counting the 2015 loss -- while trailing profit is twice that -- $272 million.

That works out to a trailing P/E ratio of 13 at Leidos -- much cheaper than at Kratos, and on a much-more consistently profitable company. Additionally, Leidos's profits appear to be of higher quality than what Kratos produces.

Free cash flow for the past 12 months amounted to $408 million over the past year -- 50% higher than reported net income. Valued on its free cash flow, the company sells for just an 8.7-times multiple to FCF (9.8 times, once debt is factored in to calculate an enterprise value).

An open-and-shut case

With analysts predicting that Leidos will grow earnings at about 10% annually over the next five years, the company's 8.7 times multiple to FCF suggests the stock is very cheap, indeed. Add in the company's respectable 2.6% dividend yield -- remember, Kratos pays no dividend -- and this is an open-and-shut case.

Leidos may not be the best-known name in defense. It may not be the "sexiest" military stock to own. But at today's prices, Leidos stock is a bargain. And it's a better buy than Kratos.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 284 out of more than 75,000 rated members.

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