Why Defense Contractor Leidos Is Spending $1.7 Billion for Dynetics

Leidos Holdings (LDOS 0.40%), which has used M&A to build the defense industry’s largest IT and services business, is on the warpath again, having agreed to buy privately owned Dynetics for $1.65 billion in cash. The deal should help Leidos keep pace with rivals who have been clawing closer in terms of revenue, and it opens intriguing new growth opportunities for the company.

The deal, priced at about 15 times EBITDA and more than 1.5 times sales, is not cheap, but Leidos is getting one of the crown jewels of defense R&D. Leidos, which in the last half decade has vaulted from the second tier of government services companies to an industry leader, is signaling to the markets that its ambitions go well beyond doing IT and engineering work.

A defense tech powerhouse

Dynetics was founded in the 1970s as a research shop focused on ballistic missile defense, and over the years has built out its capabilities to include intelligence, missiles, aviation, cyber, and space. The company is based in Huntsville, Alabama, not far from NASA’s massive George C. Marshall Space Flight Center and military assets including the Missile and Space Intelligence Center, and over the years has used those local connections to develop an expertise in space.

The company generates about 25% of its revenue from space, another 25% from intelligence and electronic warfare hardware, and 20% from unmanned systems. All these areas are projected to grow faster than the overall Pentagon budget over the next five to 10 years.

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Dynetics, despite its small size and low profile, has a seat at the table for some important futuristic Pentagon programs. The company and partner Lockheed Martin earlier this year won a contract to build and test a U.S. Army laser weapon. The company is also the lead contractor, working with Kratos Defense & Security, on the Defense Advanced Research Projects Agency’s (DARPA) Gremlins program, effectively an airborne, drone-launching aircraft carrier.

The company is a subcontractor on Boeing’s Space Launch System, a multibillion-dollar effort to return to the moon, and is supplying expertise and components on various contracts won by Lockheed Martin and Raytheon to develop hypersonic weapons able to travel five times the speed of sound. It also last year won a contract to develop two highly classified experimental satellites designed to provide tactical support to terrestrial operations, part of the Army’s Gunsmoke program.

Bigger than IT

Leidos moved to the forefront of the government services business via a 2016 merger with the IT business of Lockheed Martin, nearly doubling the size of the company overnight and giving it the scale needed to compete in a business known for its constant margin pressures.

But in the years since, some of its chief competitors have bulked up as well: General Dynamics spent $9.6 billion on CSRA, establishing itself as a clear number two behind Leidos in terms of revenue, and Science Applications International followed with a $2.5 billion deal to acquire Engility Holdings.

I wrote in August to expect Leidos to pull the trigger on another deal before long, and Dynetics is an ideal target because it adds to the company’s expert workforce, gives it exposure to a number of cutting-edge projects, and should open additional doors at important customers including NASA, DARPA, and the intelligence community.

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It is also a fresh sign that Leidos is not content to simply do systems engineering work and is instead looking to grow in areas where it has unique abilities and can command higher margins. Leidos has already dabbled with hardware: Earlier this year an autonomous ship designed by the company completed a trip from San Diego to Hawaii and back with little human intervention.

Leidos is betting it can improve profitability, and avoid pricing pressure, by offering high-tech capabilities the military can’t buy just anywhere.

Leidos is ready to accelerate

Leidos was already among the top defense stocks to buy as a leader in what figures to be a growing industry. Long-term trends including lower taxes and the need to shift an ever-growing percentage of future government revenues to entitlement programs are forcing federal agencies to do more with less funding, which should encourage additional outsourcing and more opportunities for Leidos and other services companies.

Nothing about that investment thesis has changed with Leidos buying Dynetics, but the deal does give the company more ways to win.

Through most of the history of the defense industry, the bulk of the revenue, and profits, went to the giant companies with the manufacturing expertise needed to build massive warships and advanced planes. Significant resources are needed to even compete for those programs, creating an effective barrier to entry for smaller companies and upstarts.

While the need for manufacturing knowhow and capital is not going to diminish, the role of advanced tech and electronics on modern war platforms is opening up new opportunities for specialists to compete. Leidos isn’t going to replace Lockheed Martin or General Dynamics anytime in the foreseeable future, but the portfolio of tech and intellectual property it is building will give the company more opportunities to get involved in bleeding-edge hardware development and to grab a bigger piece of the government procurement pie.

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Leidos’ deal for Dynetics gives a solid company even more potential.