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.
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.
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
I am going to play this too through the tender offer and drew similar conclusion like yours.ReplyDelete
It gives me additional comfort to see the performance of Leidos under Roger Krone in the past 2 years. LDOS should be trading somewhere between the multiples of BAH and CACI, but not at 8.2x EV/EBITDA.
I also read LMT's earnings statement about the IS&GS business. EBIT is up, but normalized EBIT and revenue are down slightly as several contracts are phasing out. It is not surprising to see that just before the transaction. I hope Leidos will do well after the deal closes.
If LMT stock price increases towards the date, does it make the discount of 10% less attractive...?ReplyDelete
I'm confused by the transaction dynamics of this one...For instance 99 shares of LMT @ $258 = $25542...so what do you get for this?
Hi - Sorry, I kept it high level since I wanted the focus to be on LDOS rather than simply the exchange arbitrage. Below is the link to the exchange offer, but LMT is going to take a weighted average of the stock price on 8/9-8/11 to determine the final exchange ratio. So one could wait until the exchange ratio is determined, however you risk it being capped at the upper limit and receiving less than a 10% discount. Otherwise if you don't want to be exposed to LMT, you could short LDOS or buy a put for fairly cheap.Delete
As of today, you'd get 8.0032 shares of LDOS (keep the special dividend in mind) for each share of LMT. Or $279.71 worth of LDOS shares for each LMT you exchange.
Thanks much appreciated. Just discovered your blog. So look forward to reading more :)Delete
MDC, what is the advantage of buying it now vs mid-august? If it hits upper limit, everyone will get capped - whether you bought it now or then - is my understanding. Is that not correct?Delete
If it hits the limit everyone will get capped, correct. But if it hits the limit its because LMT has gone up proportionately more than LDOS, so by buying now even if I'm capped I'll get the upside either from the full discount in the exchange or by LMT appreciating.Delete
That makes sense. I guess you also expose yourself to a fall in the share price of LMT shares before the conversion. thanks.Delete
That's true, but you can a buy puts (which I did) or short LDOS to protect the downside.Delete
May I please ask, what strike price you did you buy?Delete
I bought the Aug 18 $240 strike, basically just wanted to ensure that I don't lose money on the trade.Delete
The strike price was $240? The shares are trading at ~$48.Delete
The put I bought was on LMT, not LDOS, I'm mostly concerned with owning LMT into the exchange and losing money despite receiving the discount.Delete
Why did you do this? Wouldn't your LMT shares be converted into LDOS shares. Is your plan, assuming the exchange offer no longer looks profitable, to sell the option and your LMT shares thus breaking-even?Delete
Yeah it was more disaster insurance in case something really funky happened to LMT ahead of the exchange happening. If it went down by more than 10% from when I purchased and the exchange offer (assuming it wasn't capped like now) then I would have lost money. So by buying that put I ensured I'd make a profit on the exchange and basically didn't want to be exposed to LMT, a company I don't know well.Delete
Can you show me where the odd lot clause is? I can't find it and maybe there isn't an odd lot priority.ReplyDelete
Are there any tax implications? For example, I bought my shares of Lmt at 90 about 4 years ago, so I have significant gains - if I exchange for leidos, does it mean my strike price resets? Will those gains still be taxable? How will my equivalent buy price for leidos be determined by my brokerage? It would be great to use the exchange to reduce my capital gains taxes.ReplyDelete
In my experience your cost basis will simply shift over to LDOS if you choose to exchange, it shouldn't trigger a taxable event but it won't help you reduce your capital gains taxes either. But don't take my word for it 100%, I'm not a tax accountant. Thanks.Delete
Can you do an odd-lot transaction across multiple accounts? Ie buy 99 shares at etrade and fidelity and call each to do odd-lot?ReplyDelete
Thank you for the interesting find.ReplyDelete
The odd-lot exchange is appealing.
I know you are pure long LMT, so just curious on your view of the short-squeeze risk of LDOS pre-exchange. SLB rates are 17% at IBKR with a tiny amount available for shorting. In addition, it appears (I'm not an expert) if you enter the trade at close 254.84/50.54 that once the ratio drops below 7 (LMT decline of 10%), the tendering start losing money.
Would love to hear your thoughts.
Hi - I didn't fully investigate shorting LDOS, didn't realize the rates were that high, but I would imagine the risk of a short squeeze is rather low. They've reported earnings, had their investor day yesterday, I don't believe any corporate news would trigger a short squeeze in the meantime. And if the borrow rate is high because people are hedging the exchange then those shares should cancel out once the exchange is finalized and there's no need for shorts to cover their shares.Delete
You have it about right on the risk of LMT losing more than 10%, I've hedged it by buying a put at $240, that's probably not the more precise way to do this, others could have more efficient ways to limit your downside risk. Or simply wait until we're closer to the exchange deadline and only be exposed to LMT for a few days, that's likely the best route.
As you can see from todays price action, these can be very tricky to trade in advance of knowing the final ratio. There are some things that can be done to lock in a profit weeks out, but they are expensive and eat into the return.Delete
Waiting till late in the process is the 'easiest' route to take, BUT exposes you to the possibility of the prices diverging so much that you lose a big chunk of the 10% by having waited. Today's severe drop in LDOS and LMT popping 2 points put the prices just ABOVE the 8.2 limit.
Yes, that's true, but we're still below it based on the three day VWAP so we'll see where things settle out. If we do get capped a couple percentage points because LDOS is down in relation to LMT that's not the worst thing in the world, I'm effectively selling LMT high and buying LDOS low when I think LDOS is already a buy.Delete
LDOS has fallen and LMT has rose since you wrote the article. Is the investment today still worth while. Confused because if you buy LMT at $260 today, do you get 110% worth of LDOS?ReplyDelete
You'll get the discount on the average of the next three trading days (8/9-8/11) not when I wrote the post, it's current capped so if that holds you won't quite get the 10% discount. But I like LDOS either way, not just for the exchange arbitrage.Delete
LMT is trading at $260. So buying 99 shares, gives total investment of $25,740
The exchange ratio has been hit, so the max amount of LDOS shares you get is 8.216 x 99 = 813.1464
LDOS is trading at $47.36. but will pay a dividend of $13.64
So you will receive 813 shares of LDOS at $33.72 each = $27414.36
Profit of $1674.36
Is this math correct? Where does the 10% discount come...
Yes, that's correct, it's capped now as you mention. If you were to purchase LMT now at $260.35 and exchange, you'll get $278.19 worth of LDOS at current prices, or a 6.4% discount due to the cap. It was a little advantageous to buy LMT a couple weeks back instead of waiting if current prices hold.Delete
Hey MDC, I found another Reverse Morriss Trust deal. with Coty Inc. https://www.coty.com/news/coty-inc-announces-update-transaction-pg-beauty-brandsDelete
Do you know if this the same set up as the LDOS/LMT?
They haven't announced the structure yet but P&G is hoping to do a split off. Hopefully they do something similar with the bump for those participating. Should hear in the next month or so.Delete
Thanks for the heads up. I'll have to see what the discount is as COTY appears pretty expensive at first glance so I'd strictly be interested in the exchange offer.Delete
Cool, Looks like a short squeeze in LDOS today...Delete
If the exchange ratio is capped, does the offer get extended for 3 business days?ReplyDelete
No, I don't believe so. I doubt they extend the offer unless the exchange ratio is so out of whack that they risk not being oversubscribed. Even capped the discount is 7-8% which is inline with other recent reverse morris trust split-off deals.Delete
When is the last date to participate in the exchange offer now?ReplyDelete
It expires at 8am on Tuesday (8/16), but I wouldn't wait until the last second to allow your broker's corporate action team time to process.Delete
Thanks, Just trying to see if LMT pulls back a bit...Delete
if we tender our lmt shares, when should we expect to get ldos shares post to our account?ReplyDelete
Could be a few days, could be two weeks. Lockheed will put out a press release finalizing the exchange, announce the pro-ration amount, and maybe give a timeline. It also depends on your broker, some move faster than others.Delete
Lockheed issued two press releases. Looks like shares could come early next week. If you didn't do odd lot looks like ~8% proration.
Thanks. Yeah this one has worked out surprisingly well, they don't all.Delete
Has a definitive date been announced for when we will receive the shares?ReplyDelete
It looks like the final exchange ratio was determined late yesterday, so I would guess shares will be distributed later this week or early next week. But with these tenders its all a little random and can depend on your broker too.Delete
Just got my shares. My broker is IB. Sold everything. Thank you MDC for the idea.Delete
Sure thing. I'm pleasantly surprised that LDOS has moved up since the exchange offer finalized, there's still probably a little meat on the bone up to that $44 range I targeted, but I don't fault anyone for taking profits.Delete
Great idea! Thank you. Have another go at it with the P&G/Coty deal.ReplyDelete