General Dynamics [GD] on Monday said it has agreed to acquire CSRA, Inc. [CSRA] in a $9.6 billion cash deal that will make it the second largest provider of federal information technology (IT) services while adding new customers and capabilities.

There are more than 25 big opportunities in “our collective pipeline,” that the two companies combined will have a better chance of winning, Dan Johnson, executive vice president of GD’s Information Technology and Systems (IS&T) segment, said during a presentation to analysts to discuss the acquisition. Larry Prior, president and CEO of CSRA, said each of these “megadeals” is worth more than $500 million, so “scale does matter.”

GD also said the pending deal, which is expected to close in the first half of this year, will give it the opportunity to apply CSRA’s higher margin business strategy to its GDIT business portfolio. CSRA, which expects to have upward of $5.4 billion in sales in its current fiscal year that ends in March, has margins that exceed 15 percent while GDIT, which is a $4.5 billion business, has high single digit margins.

Amy Gilliland, president of General Dynamics' Information Technology unit, will lead the new GDIT segment after the deal for CSRA closes. Photo: General Dynamics
Amy Gilliland, president of General Dynamics’ Information Technology unit, will lead the new GDIT segment after the deal for CSRA closes. Photo: General Dynamics

The acquisition is expected to be accretive to earnings and free cash flow in 2019, with pre-tax cost saving synergies of 2 percent of the combined company’s sales by 2020. Jason Aiken, GD’s chief financial officer, said the deal would be accretive to earnings this year if transaction costs, which are estimated at over $100 million, were excluded.

Once the transaction closes, GD will separate GDIT from its S&T segment to create a new $9.9 billion segment, the company’s largest, accounting for a quarter of overall sales. Amy Gilliland, the current president of GDIT, will continue to lead the segment after the close.

Mission Systems, which is also part of IS&T, will become the company’s fifth operating segment, with 12 percent of overall revenue.

Leidos [LDOS] is currently the largest provider of federal IT services, and expects to have 2017 sales of between $10.1 billion and $10.4 billion. In 2016, Leidos acquired the information services business of Lockheed Martin [LMT] in a transaction that doubled its size to jump to the front of the pack in the government IT services space.

At the time of its deal for Lockheed’s IT business, Leidos said that size mattered and that scale would help it compete more effectively for contracts. CSRA’s Prior said that after a “bumpy” beginning for Leidos following the Lockheed deal, in the past two quarters the company has had “greater success” when bidding for larger contracts.

“The good news is both of our companies are known for execution and hopefully we’ll do better out of the gate” than Leidos, Prior said. Novakovic chimed in saying, “I have every expectation that we do. We know how to integrate companies. We’ve been doing it for a very, very long time. We’re good at it.”

Johnson, the head of IS&T, said that CSRA’s operating lanes mirror GDIT’s, which will make for an easier integration of the acquisition and pursuit of future opportunities, as well as “rapid realization of cost and capability synergies.”

Briefing slides used by GD in its analyst presentation show that 36 percent of GDIT’s future sales after the acquisition will come from serving federal customers in the health and civil space, one-third from customers in the intelligence community, and 31 percent in the defense market.

Johnson said that CSRA brings both customers and skillsets that GDIT doesn’t have.  For example, he said GDIT is “arguably” a leading provider of services to four of the five top intelligence agencies while CSRA is the leader with the fifth agency. He also said CSRA has a larger presence with the Department of Homeland Security, the Federal Aviation Administration, NASA, and Veterans Administration, adding that the customer portfolios of the two companies are complementary.

In the skills area, Johnson said GD is a leader in large-scale IT infrastructure programs while CSRA is a leader in cloud applications, data analytics, and managed services. Prior said that for CSRA, the deal brings it stronger enterprise IT skills, which will help give it a “competitive advantage” with its current customers.

GD said both companies have relatively equal lines of business in IT and professional services, and in cyber security, while GD IT is stronger in major IT infrastructure programs and CSRA in training related to intelligence and Defense Department missions.

Phebe Novokavic, GD’s chairman and CEO, said that while GD’s IT business has been “whipsawed” over the past six or seven years by funding uncertainty, notably through extended continuing resolutions and the threat of budget sequestration, the outlook for defense spending is strong.

Jefferies defense analyst Sheila Kahyaoglu said in a client note that she sees the combination of the two companies allowing them to “be able to leverage common customers, better compete for contracts, and leverage scale to boost profitability.” On the downside, she cautioned, is “recompete risk” for some CSRA contracts in the 2019 and 2020 timeframe, as well as “government migration to the cloud.”

After Leidos and GD, the third largest federal IT services provider will be Booz Allen [BAH] with $6.4 billion in estimated sales this year followed by CACI International [CACI] and the U.S. public sector business of DXC Technology [DXC], with $4.5 billion, according to one of GD’s briefing slides. DXC is spinning out its federal business to its shareholders.

GD said it will still have a strong balance sheet after the transaction, which will be funded with cash on hand and new debt. Aiken said there are no changes with respect to capital deployment priorities, with internal investment to grow the company at the top, followed by predictable dividends, and “tactical” share repurchases.

GD’s financial adviser on the deal is Stone Key Group. Evercore and Macquarie Capital are CSRA’s financial advisers.

Terms of the deal include GD assuming $2.8 billion in CSRA debt. GD is paying $40.75 per share for CSRA.