Responding to changing market conditions and relatively new conflict of interest rules, L-3 Communications [LLL] yesterday said it will spin-off the majority of its Government Services segment into a $2 billion, independent, publicly traded firm that will focus on systems engineering and technical assistance (SETA), training and operational support to the Defense Department and other customers.
The spin-off of the new company, to be called Engility, follows a year-long strategic review across all of L-3’s businesses that has resulted in a number of consolidations and a small divestiture. But Michael Strianese, L-3’s chairman, president and CEO, said that Government Services has some business areas that align well with L-3 and others that are manpower and management related that don’t.
Moreover, competition between government services providers is becoming more cost sensitive as the federal government shifts to new types of contracts, thereby allowing smaller contractors to compete with larger ones and “take market share,” Strianese said during a call to discuss the spin-off and L-3’s second quarter financial results. On top of that are the new Organizational Conflict of Interest (OCI) rules that have been issued by the federal government that make it harder for a company to bid on projects that another arm of the company may be helping the government on with SETA assistance.
Strianese also said that as the United States’ operations in Iraq and Afghanistan wind down, there has been margin pressure on Government Services. Now priorities are shifting toward cyber security and intelligence, Strianese said, two areas of Government Services that L-3 will retain.
For Engility, going its own way will enable it to get out from L-3 and not be restricted from potential OCI issues and “be able to pursue businesses that are outside of L-3’s area of strategic focus,” Strianese said. “It will expand its opportunities in the marketplace by leveraging its existing capabilities and operating as a low cost provider of high quality services.”
The spin-off will not require shareholder approval but must still receive approval from the Internal Revenue Service and other regulatory authorities and is expected to be completed during the first half of 2012. L-3 said the spin-off will be tax free to itself and its shareholders.
Engility will be led by Tony Smeraglinolo who has served as executive vice president of L-3 Services Group since last December and has previously worked for L-3, Dyncorp International and Harris Corp. [HRS].
Engility will have about 10,000 employees and $179 million in operating income this year. Strianese said Engility will have between $500 million and $650 million of debt at the time of the spin-off and said that its margins would exceed the average of its peers.
The Army will be Engility’s largest customer, accounting for 43 percent of sales, followed by the Navy and Marine Corps with 26 percent with intelligence agencies and other U.S. government customers accounting for 25 percent, according to L-3 briefing charts. SETA work accounts for 41 percent of Engility’s sales, training 31 percent and operational support 28 percent.
L-3 will retain several areas of business from its Government Services sector, including cyber, intelligence and security solutions. The new National Security Solutions segment is expected to have sales of about $1.7 billion this year, operating income of $108 million and 6,000 employees. The business will be led by Steven Kantor, who is currently president of L-3 Services Group.
The planned Engility divestiture follows major divestitures by Northrop Grumman [NOC] in the past 18 months of its former SETA business, TASC, Inc., and its shipbuilding unit, as well as one by Lockheed Martin [LMT] to avoid OCI issues.
J.P. Morgan aerospace and defense analyst Joseph Nadol said L-3’s news has several positive takeaways, including a “proactive” effort by the company to boost value in the eyes of investors, the possibility of further benefits down the road depending on how well Engility’s stock trades, potential for stock repurchases, and the possibility of future divestitures.
Strianese noted that further consolidations within L-3 are ahead but said these would be smaller than have occurred the past year. Under Strianese, L-3 has been streamlining and integrating its business units, which for years have operated fairly independently, both for greater efficiency and to take better advantage of the company’s wide-ranging capabilities so that it can bid for work more often as a systems integrator with turnkey solutions.
Separately, yesterday, L-3 reported second quarter results that beat consensus earnings estimates. Net income increased 7 percent to $243 million, $2.26 earnings per share (EPS), from $228 million ($1.95 EPS). Earnings per share also benefited from a lower share count as L-3 continued buying back its stock. Analysts expected earnings to be $2.12 EPS.
The company’s earnings were up due to non-operational matters, including lower interest expense and a tax benefit. Operating margins declined on a drop in operating income as well as 5 percent dip in sales to $3.8 billion from $4 billion, due to fewer revenues in its Aircraft Modernization and Maintenance, Government Services and Electronic Systems segments.
Bookings were a solid $3.8 billion. Funded backlog has declined $200 million this year and stood at $10.9 billion at the start of the third quarter.
As a result of the tax benefit, L-3 raised its earnings guidance by 15 cents to between $8.65 to $8.75 EPS for the year.