Leidos [LDOS] on Tuesday said it will pay $5 billion to combine with Lockheed Martin’s [LMT] government services business to create a roughly $10 billion information technology and services company that will be about twice the size of its nearest pure play competitor.
That scale means “we’ll be able to provide a more comprehensive and compelling range of solutions to address the needs of our customers in defense, intelligence, civil and commercial markets,” Roger Krone, chairman and CEO of Leidos, said during an analyst call to discuss the pending combination that is expected to close in the second half of 2016.
Leidos is paying $1.8 billion in cash and doling about $3.2 billion in stock to Lockheed Martin, which will give the nation’s largest defense company a 50.5 percent share in Leidos. Krone will continue to lead the company and Jim Reagan remains as chief financial officer.
Lockheed Martin will be entitled to designate three new directors to the current Leidos 10-member board. The senior managers at the Information Systems and Global Solutions (IS&TS) segment that Lockheed Martin is divesting are expected to join Leidos.
The transaction is structured as a Reverse Morris Trust, which allows Lockheed Martin to avoid paying taxes on any gains associated with divesting IS&GS. The company announced last July that it was conducting a strategic review of the business segment because it wants to focus on its core aerospace and defense businesses.
Krone said another strategic rationale for the combination are the complementary technical capabilities and customer sets between the two companies in the defense, civilian, government health, intelligence and cyber markets. He added that Leidos will be getting “mindshare” with IS&GS to address its customers “most critical needs.”
Leidos’ current $5 billion business gets about 40 percent of sales from Defense Department customers, 32 percent from the intelligence community and 28 percent from civil and commercial customers. Combined with IS&GS, civil and commercial markets will account for 45 percent of the business with most of that from federal civilian customers, defense about 35 percent, and the intelligence community 20 percent, according to briefing slides Leidos used with its investor presentation.
Reagan said that IS&GS beefs up Leidos’ presence in Europe and Australia and that once the transaction closes the company’s international sales will double to 6 percent of the business
Finally, Krone said, the deal has a number of synergies ranging from savings, expected to be about $120 million annually by late 2018, geographic footprint, operational resources, customer base, offerings and target markets. He said that the combined companies’ adjusted margins will reach between 9.5 and 10 percent versus 8 percent at Leidos now.
The deal is also expected to be “slightly accretive to earnings over the next several years,” Krone said. Once the deal closes, Leidos expects to pay a $1 billion special dividend to its stockholders. The transaction is subject to approval by Leidos shareholders and federal regulators.
Leidos said that after it brings aboard IS&GS, the closest pure play government services providers in terms of size would be Booz Allen Hamilton [BAH] and CSRA, Inc. [CSRA] at $5.3 billion annual sales apiece, Science Applications International Corp. [SAIC] at $4.4 billion, and CACI International [CACI] at $3.3 billion. CACI last December agreed to acquire the government services business of L-3 Communications [LLL] in a deal that is expected to close shortly and raise its annual revenue profile to around $4.3 billion.
Reagan said that the combination will provide Leidos with more cash, with the priority going to paying dividends followed by paying down debt.
Krone said the pending deal doesn’t change his company’s attitude toward portfolio shaping with no plans to accelerate or delay efforts to ensure “our businesses fit, if you will, our stated business purpose.”
Leidos’ financial adviser on the deal is Citigroup.