Leidos Holdings (LDOS 0.88%) is already a dominant player in the defense subsector known as government services thanks to a 2016 merger with the IT arm of Lockheed Martin, which provided Leidos with the scale needed to chase ever-bigger contract awards.
Shares of Leidos have been on a roll through much of 2019, fueled by a surge in government IT spending, but new competition is on the company's heels. In the years since the Lockheed Martin deal, consolidation among rivals has created several bulked-up entities better positioned to compete.
Leidos has easily outperformed the S&P 500 so far in 2019. Data by YCharts.
Leidos' recent results provide little evidence of a company slowing down, and management, in post-earnings comments, laid out its strategy for continued growth. Here's a look at Leidos' recent completed quarter and where management sees the company headed in the quarters to come.
Strong sales, big wins
Leidos earned $1.16 per share in the second quarter on revenue of $2.73 billion, surpassing analyst expectations for $1.11 per share in earnings on $2.65 billion in sales. The company recorded net bookings of $3 billion in the quarter for a book-to-bill ratio of 1.1.
Operating income for the quarter was $210 million, compared to $199 million during the same three months of 2018. Revenue was up $200 million year over year, from $2.53 billion. Leidos also increased its quarterly dividend by 6% to $0.34 per share.
The company also raised its full-year guidance to $4.50 to $4.70 per share in earnings on revenue of between $10.65 billion and $10.95 billion. It had previously forecasted $4.30 to $4.65 per share in earnings on $10.5 billion to $10.9 billion in sales. Analysts had been expecting earnings of $4.61 per share and $10.7 billion in revenue.
Image source: Leidos Holdings.
Leidos received a number of large new awards during the quarter, including a contract to provide IT services to the National Aeronautics and Space Administration that's potentially worth $2.9 billion, a $900 million deal to provide intelligence and reconnaissance support to the U.S. Air Force, and a $392 million contract in support of the U.S. intelligence community. In total, Leidos ended the quarter with a backlog of $21.7 billion, a new company high.
"Our growth momentum continues to accelerate through the second quarter, with nearly 9% organic revenue growth, a record backlog position and strong win rates," CEO Roger A. Krone said during a post-earnings call with investors. "Our success in executing against our pipeline and driving growth across all segments of our business, enables us to raise our full year guidance for both revenue and earnings."
Time to bulk up again?
Leidos was formed on the proposition that in the IT outsourcing business, scale matters. The company is the largest government services firm by revenue, allowing it to better compete on price and to have access to a greater number of employees with the clearances needed to do specialized government work.
The strategy seems to be working. Takeaways and new business -- as opposed to contract renewals -- represented nearly 70% of Leidos' bookings in the quarter and more than 60% of bookings year to date. Leidos is also using its scale to penetrate markets adjacent to defense, reporting 11% revenue growth from both its civil government division and its health group.
Leidos is also using its technological know-how to creep toward military hardware, supplying the brains and electronics on a large autonomous ship that made history last year by traveling from San Diego to Hawaii and back without crew.
Leidos' Sea Hunter autonomous vessel. Image source: U.S. Navy photo by John F. Williams.
Alas, Leidos' size advantage has shrunk over the last year and a half. In 2018, General Dynamics spent $9.6 billion to acquire CSRA, creating an IT business comparable to Leidos in terms of revenue. Earlier this year, Science Applications International spent $2.5 billion for Engility, moving it within range of the leaders in terms of sales.
These companies are increasingly vying for the same sorts of large opportunities Leidos likes to target. Last month, General Dynamics mentioned a surge in IT proposal submissions, often for increasingly larger, more complex deals, as a key driver of future growth. With competition in the wings, questions have arisen about whether it might be time for Leidos to ramp up the dealmaking machine again.
Leidos officials on the call stressed they want to be disciplined in how they allocate capital, and they are leery of deals that might look accretive today because of low-interest rates but won't age well in the portfolio. But CFO Jim Reagan said Leidos continues to consider options, adding that investors should not be surprised if Leidos makes a transaction announcement before year's end.
We've got a team of people that's evaluating opportunities and it is in a very disciplined fashion. And so, you don't mistake the lack of meaningful M&A announcements from the company, meaning that we're not actively looking and that you should not be surprised if you hear something from us in the coming six months on something that's strategic, it's meaningful, and it meets the financial criteria that we are going to continue to stick to before we undertake anything, any big transaction.
Invest in the leader
Leidos is a top defense stock to buy because the company is a leader in what figures to be a growing industry. The trend toward lower taxes and the need to shift an ever-growing percentage of government revenues to entitlement programs are forcing government agencies to do more with less funding, which should encourage additional outsourcing and more opportunities for services companies. Leidos, as the largest of those companies, should be a major beneficiary.
The work Leidos has already secured, coupled with just a fraction of the $30 billion in bids it has out there, should be enough to generate high-single-digit growth rates into the foreseeable future. The company has a respectable 1.5% dividend yield and the flexibility to boost the payout further: Leidos' $474 million in net cash from operations in the first half of the year has it well on its way to surpassing its target of $825 million for the year.
Leidos is profitable, growing, and generating cash even without an M&A boost. Given management's conservative approach to deals and its track record of successfully creating a larger, more powerful enterprise via consolidation, investors should be excited about the company's prospects with or without a deal announcement in the coming months.
Leidos is already a force to be reckoned with in government services, and its growth engines are just beginning to rev up.
