Leidos: Not Enough Margin Of Safety Despite Creating Value In A Low Growth Sector

seekingalpha11-23

LDOS has consistently created shareholder value through a mix of organic growth and acquisitions.Despite improving operating and capital efficiencies, LDOS's returns have not shown an improving trend,...

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But I recommend waiting for a 15% price drop before buying.   DanielBendjy/iStock via Getty Images  Investment Thesis Over the past 8 years, Leidos Holdings, Inc. (NYSE:LDOS) delivered average returns greater than its cost of funds, implying shareholders' value creation. This was achieved via a combination of organic growth and acquisitions. Growth via acquisitions seems to be part of its DNA. Together with its sound financials, LDOS should be able to continue to grow profitably. Unfortunately, there is not enough margin of safety at the current market price. Background LDOS is a science, engineering, and technology company with products and services, primarily in the fields of defense, aviation, information technology, and biomedical research. For 2024, the company restructured its reporting structure into \"4 operating segments - National Security and Digital, Health & Civil, Commercial & International, and Defense Systems.\" Before this, from 2017 to 2023, the company reported its performance under 3 operating segments – Defense Solutions, Civil, and Health. Notwithstanding the changes in the reporting format, the company's main end customer is the US government, as illustrated in the left part of Chart 1. I projected that in 2024, the US government would account for about 87% of the company’s revenue, similar to that for 2023. “Our consolidated revenues are largely attributable to prime contracts or subcontracts with other contractors engaged in work for the U.S. government…” 2023 Form 10k. LDOS focuses on the US market. I projected that in 2024, the US would account for 92% of the revenue. Chart 1: Revenue profile (Author) Note to Chart 1: The 2024 profile was based on extrapolating the Sep 2024 YTD performance. In the context of LDOS’s revenue from the US government, slightly more than half came from the US Department of Defense and intelligence community. This suggests that LDOS growth is tied to not just the US Budget but in particular to the US defense budget. From this perspective, the sector LDOS serves is not a high-growth one. Based on Statista projections, I estimated that the US defense outlay would only grow at less the 2% CAGR over the next decade: “Defense outlays in the United States amounted to 891 billion U.S. dollars in 2023. The forecast predicts an increase in defense outlays up to 1.07 trillion U.S. dollars in 2034.” Statista I think LDOS is trying to address this low-growth sector by diversifying into the commercial sector as well as internationally. But there is still a long way to go. Operating trends Note that I started tracking the performance from 2017 to 2024 following the 2016 merger with a part of Lockheed Martin. Unless stated otherwise, the 2024 values were based on the LTM Sep 2024 performances. From 2017 to 2024, revenue grew at a CAGR of 6.9% via a combination of organic growth and acquisitions. To be fair, the revenue growth also took into account divestitures. The company did not provide a breakdown of the amount due to organic growth and that due to acquisitions. But you can get a sense of this by looking at the past 8 years' net CAPEX and net acquisition expenditures. From 2017 to 2024, the company spent USD 3.5 billion on acquisitions, compared to USD 0.9 billion on CAPEX. I think it is reasonable to posit that the bulk of the revenue growth came from acquisitions. Given the low growth rate in the US defense expenditure, this is a reasonable strategy. Growth needs to be funded and one metric for this is the Reinvestment rate, defined as Reinvestment/NOPAT. Reinvestment = CAPEX & Acquisition – Depreciation & Amortization + increase in Net Working Capital. From 2017 to 2024, LDOS had a 35% Reinvestment rate. I would consider this a good rate given the large acquisitions. It meant that there was 65% of NOPAT that could be used to reduce debt or returned to shareholders. Chart 2: Performance Index and Margins (Author) Profitability Generally, there was a profit uptrend from 2017 to 2024, although there was a drop in 2023. Refer to the left part of Chart 2. The main reason was the USD 596 million goodwill impairment charges in 2023. This is about 9% of the 2022 value of goodwill in its books. Without these impairment charges, the 2023 profits would be higher than that in 2022. The profit uptrend is due to a combination of improving gross profit margins and Selling, General, and Administration (SGA) margins as shown in the right part of Chart 2. Note that a declining SGA trend meant better cost control, i.e. improvements. Given the profit pattern, you should not be surprised that the ROE showed a large drop in 2023 followed by a projected recovery in 2024. But my main concern was the declining trend in the ROIC from 2017 to 2023, although there was a projected turnaround in 2024. Refer to the left part of Chart 3. To get a better understanding of the trend, I broke down the ROIC into the following components: ROIC = (1 – tax rate) X (Operating profit/Revenue) X (Revenue/Capital) = after-tax yield X operating profit margin X capital turnover. You can see from the right part of Chart 3 that the declining ROIC from 2017 to 2023 was because the improving operating profit margin was not sufficient to offset the decline in the:  Tax yield. This meant increasing tax rate. Although the 2024 tax yield seemed to suggest a turnaround, it is still lower than that in 2017. Capital turnover. To be fair, there has been a turnaround in the capital turnover since 2020.  Of course, the 2023 tax rate was high as it “was unfavorably impacted primarily by non-tax deductible goodwill impairments.” At the same time, the tax rates in 2017 and 2018 were unusually low due to the combination of tax reforms and specific tax benefits. Given these, I would think that “realistic and sustainable” returns for LDOS should ignore the 2017, 2018, and 2023 returns. On such a basis, this meant an average ROE of 19% and an average ROIC of 11%. These are good returns in the context of the current 8% cost of equity and 7% WACC. Chart 3: Returns and ROIC drivers (Author) Efficiencies With challenging revenue growth, I would have thought that LDOS focus should be on improving efficiencies. Unfortunately, I could not find any mention of improving efficiencies in its past 7 years' business plans as reported in the various Forms 10k. Notwithstanding this, there are signs of improving operating and capital efficiencies:  Gross profitability seems to be improving. Refer to the left part of Chart 2. SGA margin seems to be improving, i.e. trending lower, as shown in the right part of Chart 2. I have already mentioned the improving operating profit margin and turnaround in the capital turnover, as shown in the right part of Chart 3.  The combination of the SGA and operating profit margin led to an improving contribution margin as illustrated in Chart 4 from 2020 to 2024. This is an important period as in 2020, LDOS undertook several acquisitions that amounted to USD 2.7 billion.  These led to a 10.8% and 11.7% revenue growth in 2020 and 2021. Total assets increased from USD 9.4 billion in 2019 to USD 13.3 billion in 2021.  Despite these massive growths, fixed costs remained \"stable\" as shown in Chart 4. Notwithstanding some write-offs in 2023 for goodwill, the above suggests that LDOS did not overpay for the acquisitions and managed to have some “margin and cost” synergies. For a company where acquisition and divestiture are an important part of its growth strategy, this is important.   Chart 4: Operating Profit (Author) Note to Chart 4. I broke down the operating profits into fixed costs and variable costs.  Fixed cost = SGA, Depreciation & Amortization and Others. Variable cost = Cost of Sales – Depreciation & Amortization. Contribution = Revenue – Variable Cost. Contribution margin = Contribution/Revenue.  Peer comparison I compared LDOS with several companies that are focused on the defense sector, as listed in Table 1. You can see that LDOS is among the smaller ones in the peer group in terms of revenue. However, it delivered one of the better revenue growths from 2017 to 2023.   Table 1: Peer Revenue (Author) However, from an operating performance perspective, LDOS performance is among the worst compared to its peers.  LDOS had one of the lowest returns on capital and EBIT margin. Refer to Chart 5. LDOS had the best levered Free Cash Flow margin in 2020, but this has since deteriorated. Refer to the left part of Chart 6. LDOS EPS was among the worst, as shown in the right part of Chart 7.  As a defense contractor, LDOS's performance did not stand out. I am not sure whether this is because it was not dealing directly with the US government but rather as a supplier to the contractors or subcontractors. Chart 5: Peer Return on capital and EBIT margin (Author from Tikr.com)Chart 6: Peer Levered Free Cash Flow Margin and EPS (Author from Tikr.com) Financial position I would rate LDOS financially sound based on the following.  From 2017 to 2024, it delivered positive cash flow from operations every year. During this period, it generated USD 8.2 billion cash flow from operations, compared to its USD 5.1 billion net income. This is a very good cash conversion ratio. It had USD 1.2 billion in cash and short-term investments as of the end of Sep 2024. This was about 9% of its total assets. From 2017 to 2024, it had a Reinvestment rate of 35%. Excluding the acquisitions, it had a negative average Reinvestment rate. This meant that a big part of the NOPAT could be returned to shareholders. It had a good capital allocation plan as shown in Table 2. It is a cash cow where there were a lot of excess funds after CAPEX and acquisitions that were returned to shareholders.    Table 2: Sources and Uses of Funds 2017 to 2024. (Author) While it had a debt-capital ratio of 52% as of Sep 2024, this has decreased from its 2020 high of 57%. I would not worry too much about this debt level given its historical cash generation ability as illustrated in Table 2. Valuation I adopted the following picture in valuing LDOS. The company would continue to grow via acquisitions. In this context, I assumed that revenue would grow at 10% next year and this growth would proportionately decrease to the terminal growth rate of 4% in Year 6. Over this period, revenue would grow at an average 7% CAGR. This 7% is about its average CAGR over the past 8 years. The base revenue was the projected 2024 revenue based on the best fit line for the historical revenue. I used a log normal trend line for the best fit line. I do not expect any further improvements in its operating or capital efficiencies. Accordingly, I assumed that the contribution margin and capital turnover to be the 2021 to 2024 average values. This is to account for the changes in the business profile following the large 2020 acquisitions. I assumed that its Reinvestment as measured by the Reinvestment margin followed the 2017 to 2024 average values. The tax rate would follow the average 2019 to 2022 and 2024 average tax rates. This would exclude the low rates in 2017/18 as well as the extraordinarily high 2023 tax rate. On such a basis, I obtained an intrinsic value of USD 185 per share compared to its market price of USD 162 per share (20 Nov 2024). There is only a 14% margin of safety. My target is at least a 30% margin of safety. I think this is an optimistic valuation, as the valuation model resulted in:  An average 14% ROIC in the terminal year, compared to the historical average of 11% stated earlier. A USD 0.12 EPS in the terminal year Sep 2024 LTM EPS of USD 0.09.  Valuation model I used a multi-stage Free Cash Flow to the Firm (FCFF) model where the EBIT was determined based on the following: FCFF = EBIT(1 – t) - Reinvestment. EBIT = Revenue X contribution margin – Fixed cost. This was based on the operating model as shown in Chart 4. The reinvestment rate was derived from the historical Reinvestment margin. Value of firm = FCFF X (1+g) / (WACC – g). Value of equity = Value of firm + cash + Other investments – Debt – Minority interests + excess Total capital employed. Table 3 illustrates the calculation. Table 3: Estimating the intrinsic value (Author) Notes to Table 3: a) Straight-line reduction. b) Pegged to growth rate. c) Assumed no improvement. d) Assumed growth at a terminal rate. e) Revenue X Margin and after accounting for Fixed costs. f) Assumed no improvement. g) b X f h) FCFF for each year = e - g j) Assumed constant D/E ratio. Refer to the WACC table. k) NPV for each year = (h X j) l) Terminal for the year discounted at terminal growth rate. m) 5 years NPV + terminal value. n) Inclusive of any excess TCE. Non-operating assets, MI and Debt. o) Based on the number of shares. The WACC was determined from the first page results of a Google search for “LDOS WACC” as illustrated in Table 4.   Table 4: Estimating the cost of funds (Various) Risks and limitations The key valuation challenge is LDOS's continuous acquisitions. Acquisitions would boost growth as well as require a higher Reinvestment rate. The DCF valuation model cannot handle such a situation, as it assumes a terminal stage where revenue growth would at best be at the long-term GDP growth rate. At the same time, the Reinvestment rate would “stabilize” to one reflecting the low terminal growth rate. In my valuation, I have assumed that there would be a “high” growth period of 5 years before revenue growth reaches the terminal stage. Such a model undervalues a company that has continuous high growth. In mitigation, you could argue that LDOS cannot continue to acquire companies forever. However, when you compare LDOS's size with the other defense companies, you can see that there is still a big acquisition potential. The only way to overcome this model limitation is to update the valuation periodically, especially when the company announces new acquisitions. But unless there is a drop in the market price, I am not sure whether this will be helpful. This is because I have used optimistic projections in my valuation. You can see this by comparing the projected values with the historical ones, as illustrated in Chart 7. Yet despite the optimistic projections, there is no margin of safety.  The left part of Chart 7 compared the projected revenue, costs, margin, and capital turnover with the historical ones. You can see the optimistic revenue projection. The right part compared the projected Free Cash Flow with the historical ones. Note that the dotted line is the best fit line based on a log normal trendline.  Chart 7: Projected values vs historical values (Author) Finally, to obtain a 30% margin of safety, the base revenue has to be 8% higher. Alternatively, I would obtain a 30% margin of safety if I assumed a 5% improvement in the contribution margin in the terminal years. But as can be seen from Chart 7, I have already assumed optimistic values for the various parameters. Conclusion I would consider LDOS a good company from an operating perspective.  Despite being focused on the low-growth defense sector, it has been able to deliver a 7% CAGR in revenue via organic growth and acquisitions. Despite the acquisitions, it has been able to achieve a sustainable Reinvestment rate. With the past 7 years' average returns higher than the current cost of funds, it created shareholders' value. It is financially sound and is a cash cow.  My main concern was that there was no improving trend in the returns. I suspect that until it focuses more on improving operating and capital efficiencies, we are unlikely to see this trend. But given returns that are greater than its cost of funds, I would not worry too much about this.  Unfortunately, my valuation shows that there is currently not enough margin of safety. You can understand why I would sit out on this one and wait for the price to come down by 15% before buying.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"-1","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485299502"}