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Forget #1, Try #6

Written by Briton Ryle
Posted January 2, 2017 at 7:15PM

You've probably heard the names: Lockheed Martin (NYSE: LMT), Boeing NYSE: BA), Raytheon (NYSE: RTN), General Dynamics (NYSE: GD), and Northrop Grumman (NYSE: NOC). These are the Top 5 government contractors. No surprise they are defense companies, the U.S. spends ~$700 billion on defense every year, more than every other country on Earth, combined. 

You're probably also well aware that, in addition to making America great again, President-elect Trump has promised to make the U.S. military great again, too. So it's probably not surprising that the biggest military suppliers to the U.S. have seen their stock prices move higher since the election...

Lockheed Martin ran from $240 to $270 a share. Boeing jumped from $142 to as high as $160. Funny thing, though; both stocks ran higher on expectations that they would benefit from Trump's plans for more military spending. And both stocks sold off from recent highs after Trump attacked them for costs related to the F-35 and Air Force One. Oh the irony...

It's probably just a matter of time before we see Raytheon or Northrop in the Twitter crosshairs. But that's not why I don't want to own these stocks right now (though for the record, I've had Boeing in the Wealth Advisory portfolio since it was $62 a share.). The reason I'm not adding any of the Big 5 is valuation...

How To Get More Upside

As Warren Buffett says, price is what you pay, value is what you get. That's a roundabout way of saying that value is a function of price. That is, if you pay too much, you're not getting value. And right now, with P/E ratios in the 18s, there's not a lot of value among the big defense/contractor stocks.

But if we go out of the Top 5, to say, #6, the valuation formula changes radically. Because the sixth largest government contractor trades with a P/E ratio of just 13. On that measure, it's nearly 30% cheaper than its bigger rivals. And while the Top 5 are very near their 52-week highs, #6 is about 15% from its highs...

The company is Leidos Holdings (NYSE: LDOS). 

Leidos delivers solutions and services in the national security, health, and engineering markets in the United States and internationally. Through its national
security solutions and health and engineering segments, it counts the federal government, U.S. military, U.S. intelligence community, Department of Defense, numerous government agencies of U.S. allies abroad, and many commercial hospitals and industrial companies as customers.

In 2013, the U.S. government had obligations worth well over $6 billion with Leidos, and the company performed over 30,000 contract-related actions.

Leidos is an applied technologies company. That means it provides high-tech solutions to some of the toughest problems facing governments and commercial companies… solutions like biomedical research, explosives detection systems, cyber security, energy, infrastructure, and health.

And this company doesn’t just rely on the U.S. government for its revenues. Leidos counts most of the biggest oil companies in the world as customers. It also provides support for U.S. allies such as the UK and Canadian governments.

That means as oil companies come out of the trench caused by the drastic drop in oil prices, Leidos stands to benefit as well. With increased drilling, those
heavyweights will also have increased needs for the specialized services offered by companies like Leidos. We’re really talking about a company that’s perfectly positioned to profit from the U.S. election and the resurgence of oil prices.

Value is What you Get with Leidos

So, now that we’ve explored the revenue streams that will keep growing Leidos’ top line, let’s take a closer look at the stock itself.

For starters, Leidos pays a dividend. Not just any dividend, but one of the largest in the industry. It’s also an undervalued stock that trades at a price-to-book discount of 60% compared to the rest of the industry. If that’s not enough, the stock also trades at a substantial price-to-sales discount — 59% to be specific.

In addition to being undervalued and paying a great dividend, Leidos’ free cash flow has increased by two-thirds since 2013 (when it was making over $6 billion from the U.S. government alone).

And last quarter, it grew revenues year over year by more than 43%, helped by the acquisition of Lockheed-Martin's government services unit, IS&GS. That’s a figure that will jump even more as the Republicans reduce the federal workforce and the government has to rely more on contracting companies like Leidos for staffing solutions.

With everything going right for Leidos’ top line and an already attractive stock price, this little-known contractor is primed to make waves in the investing world as it capitalizes on all of the growing trends around it. I recommended Leidos common stock to my Wealth Advisory readers around $47. It's currently a little over $51, and I have a 12-month price target of $65. 

Until next time,

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Briton Ryle

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An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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