Science Applications International Corp. [SAIC] Monday morning said it has agreed to acquire fellow government technology services provider Engility Holdings [EGL] in a $2.5 billion stock deal that gives it more scale and complementary capabilities and customer sets, including expansion in the intelligence area and military space market.

SAIC said that once the deal closes, which is expected during the company’s fourth quarter that begins in November, it will have about $6.5 billion in annual sales, making it the second largest pure-play government services provider behind Leidos [LDOS], which is forecasting between $10.3 billion and $10.7 billion in sales this year. Earlier this year, General Dynamics [GD] acquired CSRA, and merged it into its GD Information Technology (IT) segment that now has about $9.9 billion in annual sales, making it the second largest provider of federal IT services.

GD, Leidos and SAIC have all cited scale and complementary capability and customers in making strategic acquisitions.

SAIC CEO Tony Moraco
SAIC CEO Tony Moraco

“Scale appears to be the name of the game,” Sheila Kahyaoglu, an aerospace and security analyst with the investment banking firm Jefferies, said in a note to clients with her analysis of the pending acquisition by SAIC. “Although scale does not always result in superior revenue growth, it does provide the labor force and security clearances which may be necessary in a growing market.”

Tony Moraco, SAIC’s CEO, said during a presentation for analysts that buying Engility will increase the percentage of SAIC’s workforce with security clearances by 50 percent, making it easier for the company to pursue more opportunities with the intelligence community as they become available. The intelligence arena is an area that SAIC is targeting to expand and Moraco said that his company currently does work with the National Reconnaissance Office and that Engility will provide additional three-letter agencies to the fold.

Currently, SAIC’s $4.6 billion in annual sales is comprised of 61 percent of business with the Defense Department, 30 percent in the federal civilian space, and 7 percent with the intelligence community. Combined with Engility, the company’s business mix will still be dominated by DoD, 55 percent, with the federal civilian portion dipping to 28 percent and the intelligence portfolio up to 16 percent, according to one of SAIC’s briefing slides from the presentation.

Moraco said that while Engility will help SAIC with its expansion into the intelligence community, the company also brings with it important work for DoD and other federal agencies.

SAIC also said that in addition to the classified intelligence work, Engility also provides SAIC with Air Force space business to go with its Army, Navy and NASA customers. As for complementary capabilities, Engility’s are in intelligence analysis, launch support for the space area, and high-performance computing, versus SAIC’s strengths in enterprise IT expertise, logistics, and training and simulation, SAIC said.

Moraco, on a separate call with media on Monday, pointed out that space has been another target area for SAIC in its acquisition strategy and that adding Engility’s work here means that SAIC will do about $1 billion in annual business in the space market.

SAIC said the acquisition will generate $75 million in annual cost savings synergies within two years of closing, thereby improving its competitive position due to lower costs. The company also said the deal will be immediately accretive to earnings, excluding acquisition and non-recurring costs, lead it to adjusted operating margin of around 9 percent versus its current 7.2 percent, and help it generate at least $375 million in annual free cash flow versus its current $207 million once the cost savings are realized.

Moraco said that overall SAIC’s long-term growth and margin expansion targets remain intact even with the deal. He said SAIC continues to see annual growth in the low single digits percentage wise and margin growth of around 10 to 20 basis points.

SAIC’s theme to the acquisition is “stronger together” and Moraco said on both calls that the diversified capability and customer portfolio the company will have with Engility will help it weather more challenging budget environments. Even though the federal spending outlook over the next two years is robust, once the two-year budget deal worked out by Congress earlier this year expires spending will flatten if not decline slightly, he said.

Lynn Dugle, Engility chairman, president and CEO, said on the media call that the common cultural and organizational fits between the two companies will make it easy for SAIC to integrate the new business and that SAIC won’t miss a beat in pursuing the business opportunities both service providers have on their plates. There were multiple suitors for Engility but the commonality with SAIC helped ensure it was the right buyer, Dugle said.

The acquisition will require shareholder approvals by both companies and regulatory clearance. With the all-stock transaction, SAIC shareholders will own 72 percent of the combined company and Engility shareholders the rest. The all-stock transaction preserves SAIC’s flexibility for further deals.

Moraco will remain CEO and Edward Sanderson will stay on as chairman. Engility will provide two board members to SAIC, increasing the number of directors to 11. Other senior management positions have yet to be determined.

Behind the combination of SAIC and Engility, other top pure-play government services providers include Booz Allen Hamilton [BAH] with $6.3 billion in sales, followed by CACI International [CACI] with $4.5 million, Perspecta [PRSP] with $4.2 billion and ManTech International [MANT] with $1.8 billion, according to one of SAIC’s briefing slides.  

SAIC’s financial advisers on the deal are Citigroup as lead and Stone Key Partners as co-adviser. Guggenheim Securities is the lead financial adviser to Engility and Morgan Stanley also provided financial advice.

With the acquisition announcement, SAIC also announced its second quarter financial results, which had been planned for release on Wednesday. Sales increased just over 3 percent to $1.1 billion, with all of the growth organic. Net income rose 36 percent to $49 million, $1.13 earnings per share (EPS), from $36 million (80 cents EPS) a year ago, topping consensus estimates by 14 cents per share.