Leidos Holdings: Reverse Morris Trust with Lockheed Martin

Following the draw-down of U.S. troops in Iraq/Afghanistan and the 2013 budget sequestration we've seen many defense and consulting firms spinoff their headwinds facing government services businesses (EGL, VEC, CSRA to name a few) as a way to continue to show growth.  In 2013, Science Applications International Corporation or "SAIC" spunoff it's slower growth technical services and IT divisions, the parent company changed it's name to Leidos Holdings (LDOS) and the slower growth government services division kept the name SAIC.  The reason for that spinoff wasn't entirely clear to me at the time, and still isn't, especially now that Leidos Holdings is acquiring the Information Systems & Global Solutions business of Lockheed Martin (LMT) in a Reverse Morris Trust transaction that will close in mid-August.

However after the transaction closes, Leidos will be the largest pure-play IT and government services contractor in the U.S., about twice as big as CSC's government services business CSRA.  They will be broadly diversified across government agencies, and internationally, in fact they'll be one of the few businesses to touch all seven continents as Lockheed's contract to run the U.S. research base in Antarctica will move to Leidos.  This is an industry where scale matters, in today's budget environment more and more contracts are being put out to bid as "Lowest Price Technically Acceptable".  Prior to sequestration, agencies used the "Best Value" method for determining a winning bid, allowing agencies to balance the trade-off between quality and cost, greater value for a higher cost was still okay.  Now the award goes to the lowest price as long as the bid meets all the technical requirements of the contract, there's less judgment on the contracting agency's part.  By being able to spread your corporate overhead over a larger contracting base, those with significant scale will be in a better position to compete on price.

Once a contract is won, it's often difficult to unseat the incumbent in future re-competes as the incumbent has the advantage of not needing to shoulder start-up and implementation costs, putting them in an advantage on price.  If a contract is lost, many of the employees working on the contract end up with the new contractor, the cost model for these firms is more variable than other industries allowing them to experience revenue declines but maintain acceptable margins.

Reverse Morris Trust Transaction
Below is an Leidos investor relations' slide outlining the transaction.  Lockheed Martin's IS&GS business generates about $500MM in EBITDA, at the $5B headline price, LDOS paid 10x EBITDA.

Leidos will be making a special dividend prior to the transaction closing to effectively true up the ownership bases of the two firms, in order for it to qualify as a Reverse Morris Trust and be tax free, Lockheed Martin shareholders need to own more than 50% of the combined company.  RMTs have been interesting to me recently because they pair the effects of a spinoff, but with immediate/improved scale and an in-place management team.

Valuation
There will be approximately 151 million diluted shares outstanding after the transaction is complete, the Leidos special dividend will be $13.64 adjusting the pro-forma stock price down to $34.95 for a $5.3B market cap company.  Per the prospectus, the combined pro-forma EBITDA is $1.05B without any cost synergies which are expected to equal $120MM by 2018.

I have pro-forma Leidos trading for 8.2x EBITDA, 1-3 turns below most of their peers despite the company's new scale which should make them more competitive and lead to an increased win rate.  While 8x EBITDA might not be absolutely cheap for a business like Leidos, consider the U.S. Federal government has a budget for the first time in years with all sectors of government including the Department of Defense seeing increased appropriations.  The economy is still sluggish and treasury rates are near record lows, fiscal spending is likely to increase in an attempt to spur growth as deficit concerns and the risk of sequestration lessen.

Exchange Offer
There's a cheaper way to buy LDOS shares being offered right now.  Instead of spinning off LDOS shares directly to shareholders, Lockheed Martin is conducting an exchange offer where LMT shareholders can select to exchange their LMT shares for LDOS shares at a 10% discount rate (subject to an upper limit).  Even without the exchange offer this is an attractive deal and LDOS should be worth ~$44 per share (adjusted for the $13.64 special dividend) or 9.5x EBITDA.

Disclosure: I own shares of LMT (will be exchanging for LDOS) and CSRA