To an extent, Leidos prioritizing growth over margin

Leidos is in the middle of year three since its megamerger with the former Lockheed Martin IT services business that added significant scale past the $10 billion annual revenue mark.

Improved profitability was also part of the rationale for Leidos to undertake the deal and the company did meet its target on that front last year, but this year will bring some downward pressure to the bottom line.

That downward pressure on profit may partly be by design as Leidos is prioritizing growth on the top line, based on comments Tuesday from executives during their fourth quarter and year-end earnings call.

Here is what Reston, Virginia-based Leidos is seeing for this year. Revenue last year was flat at $10.2 billion, but should grow between 3 percent and 7 percent this year to $10.5 billion-$10.9 billion.

Underpinning that is a 2018 that saw Leidos book $13.7 billion in awards for a 1.3 book-to-bill ratio, which measures additions to the backlog versus drawdowns that become revenue. Leidos is also waiting to see if anyone protests a potential $2.9 billion NASA end-user IT services contract won earlier this month, whether that be from incumbent Perspecta or another bidder.

But its adjusted earnings before interest, taxes depreciation and amortization margin will come down to 9.9-10.1 percent for this year, down from the 10.4 percent figure for last year. Either way the company is in its post-merger targets of 3-percent revenue growth and 10-percent margins over three years.

“As 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,” Chief Financial Officer Jim Reagan said on the call Tuesday.

Part of that comes down to the nature of how many government services contracts work. Along with the so-called “NASA NEST” program, Leidos is also starting a separate large IT services job with the Army Corps of Engineers this year.

“We've got a number of programs… where the ramp up of those programs typically has lower margins than for the life of the program, and we've been historically pretty conservative in setting those profit take-up levels early in the program as we plan on some contingencies,” Reagan said.

This approach of emphasizing the top line is also partly down to the current budget outlook that has defense funding at elevated levels over prior years. The Defense Department has ramped up its purchases of big-ticket hardware items over the past two years but that also translates into more activity in the digital sphere, according to Leidos CEO Roger Krone.

“We're also seeing a bit of a shift in how I think the department views the threat… the virtual threat is becoming even more important,” Krone said on the call. “What's going on in cyberspace, some of the newer technologies, and that fits really well with where we are. We're not necessarily a company that builds tanks and big aircraft carriers and things like that. We are much more in the soft technologies -- software, cyber, areas like that, (and) electronic warfare and we see increased spending in those areas.”

Joey Cresta, public sector IT market analyst at Technology Business Research, said Leidos is entering what he calls the “payoff period” of its strategy to increase its competitive posture including cost structures since the deal with Lockheed closed.

“It is generally very hard to grow revenue and margins concurrently, and in this moment of increased investment by the federal government Leidos has pretty clearly selected growth,” Cresta wrote to me. “Leidos looks to be aiming to secure strategic positions on contracts and is willing to use its scale advantages to facilitate its strategy.”

Will another acquisition be a tool Leidos uses to facilitate that strategy? Reagan did not discount the possibility but repeated the company’s current thesis: product businesses are of more interest than another services company like themselves.

“We don't need more of what we've got. We can compete and expand the business that we have just fine on our own,” Reagan said. “The things that we're looking for to build the company inorganically would be the kind of company with both the services and a product differentiator that bolts in well with the kind of work that both the target company and we do.

A pure product company could also be of interest to us, although I would say that the ones that we've been interested in to this point tends to have some kind of service element to them,” he added. “I wouldn't say we'd shy away from a pure product business… if it fit our strategic criteria.”

This approach aligns with how “everyone in this space is trying to move away from pure services” and more toward platform-based managed services, Cresta told me.

CACI International is one peer that has increasingly gone in that direction: its pending acquisitions of LGS Innovations and Mastodon Design are examples. And as Cresta pointed out, Leidos already supports the Navy’s Sea Hunter autonomous surface vessel and other hardware programs, “so we can imagine M&A becoming more product-oriented to support this aspect of Leidos’ work.”