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Ignore This Government Contractor's Cautious Guidance -- It's Set to Outperform

Lou Whiteman, The Motley Fool

Leidos Holdings (NYSE: LDOS) reported fourth-quarter earnings up more than 25% year over year and above analyst consensus, but the results were met with yawns from investors due to the company's tepid initial commentary on 2019.

The government services provider struck a cautious tone concerning both earnings and margins for 2019, perhaps giving rise to fears that Leidos shares, which are down slightly over the last 12 months, won't have a catalyst to propel them higher in the quarters to come.

I believe Leidos' outlook for 2019 is conservative and the company is set up well to exceed expectations, both in the second half of 2019 and into 2020. Here's a look at where things stand at Leidos.

Early-stage blues

Leidos reported fourth-quarter adjusted earnings per share of $1.10, $0.03 above consensus estimates and far better than the $0.87 per share in the prior-year quarter. The company recorded net bookings of $3.2 billion in the quarter and $13.7 billion in all of 2018, representing a book-to-bill ratio of 1.2 for the quarter and 1.3 for the year.

Aerial view of the Pentagon

Image source: Getty Images.

But despite the new business, Leidos put a damper on expectations. The company forecast 2019 adjusted earnings per share in the range of $4.25 to $4.60, well below consensus estimates for $4.76 per share, and said it expects adjusted EBITDA margins of 9.9% to 10.1% compared to 2018's 10.4% margin.

Company CFO James Reagan on a post-earnings call with investors said that a large influx of new business, including a contract to manage and support NASA's computers and networks, would lead to increased start-up expenses that will weigh on results in 2019.

"[A]s we've said in the past, there is a trade-off between margin and revenue growth, and the ramp-up of our new awards will drive slightly lower margin levels in the near term," Reagan said.

Leidos is expecting 2019 revenue of between $10.5 billion and $10.9 billion, at the midpoint a 5% increase over 2018. For reference, the company's revenue increased by just 0.2% last year.

Multiple ways to beat

Leidos last spring saw its shares drop nearly 10% after reporting first-quarter 2018 revenue that came in below consensus expectations and down 5% from a year prior, and it appears management wanted to make sure this time around the markets were not getting ahead of results. Reagan is likely correct in forecasting some margin pressure as large contracts come online, but it's possible Leidos will see a payoff faster than expected.

LDOS Chart

LDOS data by YCharts.

Reagan also admitted on the call that the company has been "pretty conservative" in setting profit expectations for early-stage contracts such as the one with NASA and a separate deal to manage networks for the Army Corps of Engineers, with estimates assuming some contingencies. That's a good way to minimize the risk of unanticipated added expenses, but if the rollouts go without hiccup, 2019 profitability should get a boost.

Leidos, the nation's largest government services vendor thanks to its 2016 merger with the IT arm of Lockheed Martin, also had more than $28 billion in outstanding bids awaiting decision as of year's end. The $2.9 billion NASA deal was included in that total, but there is still ample potential for more awards that could boost 2019 revenue and help contribute to earnings. Reagan on the call noted the company's recent success winning new business, conceding that if all goes to plan, the revenue guidance is likely conservative.

For the last year, we've been experiencing win rates that reflect, first, the very competitive cost position that is now showing up in the velocity of new awards. [Second], we have a well-defined set of technical differentiators that is probably more prominent in our win rates than the cost competitiveness. And third, the efficiency of our business development process is not only yielding great technical scores, but it is reducing the cost that we need to put into winning X dollars of new backlog. So, those three things are really bearing out what I think gives us the confidence of at least the midpoint of our revenue guide, if not a little bit more.

Leidos also expects operating cash flow of at least $725 million in 2019, plus the potential for some one-time cash gains from asset sales. Management appears content with its scale in its core government services business and doesn't seem eager to pull the trigger on an acquisition, likely leaving more than $500 million available for additional share repurchases.

The company on Feb. 21 announced an accelerated share-repurchase agreement to buy $200 million worth of its common shares, with the potential for more buybacks on the horizon. It's worth noting that Leidos' 2019 guidance appears to assume no reduction from year-end 2018 share count, so buybacks should boost per-share figures.

Worth the wait

Leidos, despite its impressive book-to-bill and massive pipeline, is trading at 16.4 times earnings, a discount to rivals including Booz Allen Hamilton's 18.68 multiple and CACI International 17.4. Leidos also boasts a dividend yield of 2.04%, one of the best among government services companies and higher than that of larger defense contractors Raytheon and Northrop Grumman.

Leidos also has a small but promising hardware business, including an autonomous-ship program currently being tested by the U.S. Navy. That platform is not going to be a meaningful contributor to the bottom line any time soon but adds to the long-term potential for the company.

At worst, investors today can get in at a reasonable price and, thanks to the dividend, can get paid to wait until 2020, when those orders will likely start converting to revenue and margins should improve. At best, those contributions come ahead of schedule, 2019 exceeds expectations, and the stock appreciates faster.

Either way, now could be a great time to buy into Leidos.

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Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.