Leidos Holdings Continues to Deliver Despite Government Contract Cuts

Source: Thinkstock

Source: Thinkstock

Leidos Holdings Inc. (NYSE:LDOS) stock has lost 18 percent year-to-date. However, in this article, I will outline reasons why I believe the company’s performance has turned the corner despite significant cuts to government spending of which Leidos relies heavily upon and ultimately why I think the stock is a buy.

The company itself is involved in a lot of areas. Primarily it provides science and technology solutions.The company delivers solutions and services for data analytics, systems integration, and cybersecurity to the agencies of the U.S. Department of Defense, the intelligence community, and the U.S. Department of Homeland Security, as well as other U.S. Government civil agencies, state and local government agencies, foreign governments, and customers in a range of commercial markets. It implements and optimizes electronic health record (EHR) systems at commercial hospitals; and provides consulting and operational support services for ICD-10 transition, IT strategy, revenue cycle management, accountable care transformation, risk management, technology infrastructure, and project management.

The company also develops, fields, and maintains an EHR system and behavior health services; and offers life science research and development support services to the National Institute of Health, Army Medical Research community, commercial biotech companies, and the Frederick National Laboratory for Cancer Research in the areas of genetics and genomics, proteins and proteomics, biomedical computing and information technology, biopharmaceutical development and manufacturing, nanotechnology characterization, and clinical trials management. Further, the company offers technology, intelligence, and cybersecurity solutions and systems for the air, land, sea, space, and cyberspace applications. Given its numerous contracts with government, investors must carefully monitor government spending and keep an eye on contracts made by the company. Well, the company did see lower revenue due to less government spending.

Revenues for the first quarter of fiscal year 2015 were $1.32 billion, reflecting a revenue contraction of 17 percent, as compared to $1.60 billion in the prior year. Operating income from continuing operations for the first quarter was $89 million, up $13 million, as compared to operating income from continuing operations of $76 million in the prior year. Diluted earnings per share from continuing operations for the first quarter was $0.59 compared to $0.43 in the prior year. Non-GAAP diluted earnings per share from continuing operations for the first quarter was $0.60 compared to $0.57 in the prior year. The diluted share count for the quarter was 78 million, down 7 percent from 84 million in the prior year. An examination of the top revenue sources is warranted.

First the company’s “National Security Solutions” revenues for the first quarter of fiscal year 2015 decreased $133 million, or 12 percent, compared to the prior year. The revenue contraction was attributable to contract activities tied to the drawdown of overseas U.S. military forces and by overall reductions in defense and U.S. Government spending resulting from sequestration and budget cuts. National Security Solutions operating income margin for the first quarter was 8.2 percent, up from 6.6 percent in the prior year, with the increase primarily attributable to net favorable changes in contract estimates and an intangible asset impairment charge in the prior year period.

Next, the company’s “Health and Engineering” segment revenues for the first quarter of fiscal year 2015 decreased $141 million, or 27 percent, compared to the prior year. The revenue contraction reflects a decline in engineering services due to the completion of two energy design-build construction projects, lower sales volume in the non-intrusive inspection systems business due to timing of product shipments and lower sales volume in our federal and commercial health businesses. Health and Engineering operating income margin for the first quarter was 6.6 percent, down from 6.7 percent in the prior year. Operating income margin in the first quarter was primarily impacted by lower revenues from engineering products which typically generate higher margins and an operating loss for the Plainfield biomass power plant due to production short falls. The prior year quarter included an unfavorable change in contract estimates related to the Plainfield design-build construction project. The first quarter of fiscal year 2015 included a reserve adjustment following a favorable ruling on a legal matter and a year over year decrease in amortization expense of intangible assets.

Finally in the company’s “Corporate and Other” segment operating loss was $13 million for the first quarter of fiscal year 2015 compared to $30 million in the prior year. The first quarter loss included $1 million of separation transaction and restructuring expenses associated with the spin-off which was completed in fiscal year 2014. In the prior year, separation transaction and restructuring expenses totaled $14 million.

What about cash? Well the company’s cash flow used in operating activities of continuing operations for the first quarter of fiscal year 2015 was $8 million. During the first quarter of fiscal year 2015, the company also entered into a $200 million accelerated stock repurchase program and the company paid a cash dividend of $0.32 per share, which is a forward yield of approximately 3.4 percent. The company intends to continue paying dividends on a quarterly basis. As of May 2, 2014, the company had $183 million in cash and cash equivalents and $1.3 billion in long-term debt.

Now, it seems like things contracted. Well, they did, but it was expected to be much worse. The company actually beat the top and bottom line estimate. Further, the company’s backlog of signed business orders at the end of the first quarter of fiscal year 2015 was $8.84 billion, of which $3.11 billion was funded. As compared to the end of the first quarter of fiscal year 2014, total backlog decreased 6 percent and funded backlog increased 5 percent. Looking ahead, despite the cuts in government spending, the company affirmed its fiscal year 2015 guidance for revenues of $4.9 billion to $5.1 billion. They also expect to see non-GAAP diluted earnings per share from continuing operations of $2.35 to $2.55 and anticipate cash flows provided by operating activities from continuing operations at or above $350 million. All things considered, with the yield, the stock repurchase program and the company delivering analyst estimate beats despite cuts in government funding, I think the stock is a solid buy at current levels. It has down side protection and the stock is actually trading at reasonable levels on a forward earnings basis.

Disclosure: Christopher F. Davis holds no position in Leidos Holdings and has no intentions of initiating a position in the next 72 hours. He has a buy rating on the stock and a $45 price target.

More From Wall St. Cheat Sheet: