Better Buy: Kratos Defense & Security Solutions, Inc. vs. Leidos Holdings

Kratos Defense & Security Solutions (KTOS 6.50%) and Leidos Holdings (LDOS 1.04%) are two specialists serving separate parts of the U.S. defense market. Though they are chasing different business, both see opportunities for market-beating growth in the quarters to come.

Kratos, a one-time wireless infrastructure vendor who in recent years has pivoted to microwave electronics, satellite communications, and most recently drones, believes its latest offerings will play a major role in shaping how future aerial wars are fought. Leidos, meanwhile, is one of the largest companies competing to modernize U.S. government IT systems.

Data source: Yahoo! Finance. Data as of Aug. 30, 2018. TTM = Trailing 12 months. P/E = price-to-earnings. P/S = price-to=sales.

While neither is as well-known as defense titans such as Lockheed Martin, both Kratos and Leidos offer some of the same characteristics that make the bigger companies attractive investments. The Pentagon is a reliable bill payer with a growing appetite in the areas in which these companies operate.

Perhaps for that reason, both companies have also outpaced the market in recent years, with shares of both outperforming the S&P 500 over the past three years. Can that strong performance continue? Here's a close look at the two businesses to determine which is the better buy today.

LDOS, KTOS data by YCharts.

Drone warrior

Kratos has dabbled in a number of areas over the years, but following the sale of its public safety and security division for $70.7 million in cash earlier this year, the company is increasingly focused on its growing drone business. The majority of Kratos' current drone revenue comes from high-speed, jet-powered aircraft used as target practice by the military, but the company is in the process of developing high-tech platforms that it hopes will one day fly alongside crewed aircraft to provide additional firepower and to act as a decoy to confuse anti-aircraft systems.

A Kratos-made BQM-167 target drone is moved into position. Image source: Kratos.

That's a long way off, and Kratos has an unsettling history of making promises about profitability that it couldn't deliver on, but the drone business is seemingly advancing at a good pace. Earlier this year, Kratos won U.S. State Department approval to market one of its next-generation platforms, its Mako drone, internationally. Kratos' Valkyrie drone, the combat specialist designed for the U.S. Air Force, could have a demonstration before year's end. If it is successful, Kratos hopes to receive an initial production order for the $3 million per unit aircraft in 2019.

The Gremlins program, a separate project involving Kratos-built drones, also has a planned demonstration in 2019.

Kratos has also scored a handful of new contracts, most notably a July Air Force order for more targeting drones valued at upward of $109 million, to keep revenue coming in while the new drones are refined.

The company has its share of skeptics, with short-seller Spruce Point Capital in March accusing management of "tremendous value" destruction and predicting that shares could fall by upward of 70%. Shares of the company are actually up by more than 40% since that initial warning, but Spruce Point in May reiterated its skepticism and called the company a "trust us" story.

Spruce Point's warnings should be taken seriously, as Kratos in the past has overpromised and underdelivered. While the company's recent successes do provide reason for hope that this time will be different, investors need to be careful not to get ahead of themselves.

IT stalwart

Leidos, formed from the 2016 merger between part of Science Applications International Corporation and the IT business of Lockheed Martin, provides system engineering, IT, and integration services for defense, intelligence, and civil agencies.

Following the Cold War, government IT was seen as the next big growth business for the defense sector, but that view led to a flood of new entrants who, over time, shrank margins in the sector and created a shortage of capable (and security cleared) employees. In the current market, economies of scale are vital, and Leidos, thanks to its merger with Lockheed, now ranks as the largest government IT vendor in terms of revenue.

Image source: Leidos Holdings.

Government IT was pushed to the back burner earlier in the decade as Washington spending was curtailed thanks to partisan budget battles, but a two-year deal reached in February opened the floodgates for the sector. Leidos CEO Roger Krone on a post-earnings call with investors in late July said that fiscal 2019 government IT spending levels will be "significantly higher" than 2017.

In the second quarter, Leidos booked $3.4 billion in net awards, a book-to-bill ratio of about 1.4, with new business accounting for about half of bookings. Bookings are expected to increase in the current quarter as the Pentagon and civil agencies spend the new money that was appropriated to them. Indeed, in the first few weeks of August, Leidos was awarded $639 million in task orders by the Social Security Administration, and up to $620 million for F-16 avionics integration services.

While Leidos is the largest government IT vendor, General Dynamics, following its $9.6 billion acquisition of CSRA, is right on its heels, and smaller rivals including CACI International have made growth a priority. Leidos might do additional deals as well, with Krone on the call saying, "we're always thinking about ways to reshape the portfolio through acquisitions." Leidos generated free cash flow of $258 million in the second quarter, giving it some firepower to deploy if it sees an opportunity to expand.

Government IT by its nature will likely continue to be a cyclical business, but Leidos is well positioned to take advantage of what figures to be an extended period of spending growth over the next few years.

The better buy is...

Kratos and Leidos are two very different companies and will likely appeal to two very different types of investors. For most, Leidos is the better buy. While the government IT sector can see year-to-year fluctuations in spending levels, as said above, the next few years will likely see spending increases, and Leidos should get a significant share of that new business. When the cycle inevitably turns, Leidos, thanks to its size and the large number of Pentagon and civil agencies it does business with, should hold up better than its smaller rivals.

Leidos also pays a dividend.

Kratos doesn't offer the same level of stability, but the company does offer a chance for significant growth and value creation should its next-generation drone programs go to plan. That growth is no sure thing, and there is real uncertainty in buying the shares now especially given how fast they have climbed in recent months, but a small position in Kratos does make sense for a risk-tolerant investor.

Leidos looks like a solid, steady performer over the next few years, while Kratos carries a lot more uncertainty but also offers more potential upside. Kratos, with each passing quarter, is looking more and more enticing, but for most investors, Leidos is the better buy.