Leidos Holdings, Inc. (NYSE:LDOS)

I was catching up on last month's Value Investor Insight this morning and I came across an interesting value investing idea in an interview with Sunjay Mishra of Tourbillon Capital Partners.

The firm likes the stock of Leidos (LDOS). There's a number of special situation aspects that attract me to this value story. The current iteration of Leidos was formed through a series of spinoffs. First back in 2013 Science Applications International Corporation or "SAIC" spun off its slower growing operations and changed the name of its remaining "good" assets to Leidos.

Flash forward to 2016 and Leidos agreed to merge through a Reverse Morris Trust with a spinoff of the Information Systems & Global Solutions division of Lockheed Martin (LMT).

There's lots of fancy investing tricks and trinkets going on here. That's the sort of thing that often leads to mispricing.

For more information on the recent merger, check out this short piece on it by the always excellent Clark Street Value:

Leidos Holdings: Reverse Morris Trust with Lockheed Martin

http://clarkstreetvalue.blogspot.com/2016/07/leidos-holdings...

LDOS' stock has sold off significantly over the past year, going from $59/share last November to its current $41 and change. Mishra believes that the recent selloff was a result of a number of reasons:

The deal spooked the market, which on the surface was understandable. It appeared Leidos paid a full multiple in an immediately dilutive transaction for a business declining at a mid-teens rate, and they went from net cash to 3.5x leverage to do so. On top of that, there was technical selling pressure from the upcoming special dividend and arb-related shorting of Leidos shares from Lockheed Martin shareholders looking to tender their stock for LDOS at a discount.

According to Clark Street, Leidos is trading at approximately 8.2x EBITDA, significantly lower than its peers despite the fact that the new merger should yield significant synergies that should help to improve Leidos' performance.

In fact, Tourbillon Capital believes that Mr. Market may be underestimating the obvious synergies associated with the recent LMT - LDOS transaction:

Through our diligence we gained comfort that the guided synergies were likely substantially understated, based on precedent transactions and our benchmarking and bottoms-up analysis of what the cost structure could be. We did a lot of background work on the CEO, who had a history of success at Boeing, and on the management team overall, which had incentives in place to underpromise and overdeliver.

Add to this the fact that almost every single analyst that I've seen talk about the defense sector expects government spending on it to increase during the next President's term in office, regardless of who wins.

Now that the theory that LDOS is current undervalued has been established, the question is...how much is the stock worth. Here's Tourbillon Capital's view on the subject:

With the stock trading at $43.90, how are you looking at valuation?

SM: We think the downside is mitigated by the fact that the shares are statistically cheap, trading at 13x consensus forward free cash flow. We consider the debt burden manageable, and the company pays the highest dividend in the peer group, approaching 3%.

Post synergies and with some growth from a cyclical uplift in defense spending, we believe Leidos can earn up to $5 per share in free cash flow in the not-distant future. At a peer multiple in the mid to high teens, that would make today’s share price an attractive entry point.

This is an interesting situation to follow. I am adding shares of LDOS in CAPS today, but do not yet own a real money position.

Jason
No position in LDOS