CACI International (CACI 0.23%) dropped a bomb on General Dynamics' (GD 0.81%) planned $9.6 billion acquisition of CSRA (CSRA), going public with a rival cash-and-stock offer that is nearly 8% higher. Despite the premium, CACI is unlikely to win CSRA. But the company's bold move says a lot about the state of play in the government IT sector, and telegraphs what the future might hold for CACI and other mid-tier players.
CACI is offering $44 per share in cash and stock for CSRA, or about $10.1 billion all-in including assumed debt, attempting to break up General Dynamics' $40.75-per-share all-cash bid. CACI and CSRA are both so-called Beltway Bandits, providing IT services and consulting work for military and civilian government agencies, a sector that many defense primes have abandoned in recent years but which General Dynamics is set to double down on.
General Dynamics and others in the industry are predicting significant jumps in government IT spending in the years to come, as federal agencies seek to modernize aging systems. Much of that work was put on hold during congressional budget battles that led to short-term funding deals, but with a longer-term budget agreement finally near, there is reason for optimism that IT spending will increase.
Daniel Johnson, head of General Dynamics' IT operations, in February said increasing defense budgets "gives us cause for optimism that the services market is going to come back to pre-2011 characteristics"; in that period, some IT contractors saw their businesses grow at a double-digit pace.
CACI is smaller than its target in terms of both market capitalization and proposed terms that would give CSRA shareholders 55% of the combination. CACI also expects to realize $165 million annually in net run-rate cost synergies, beating General Dynamics' cost estimates.
General Dynamics wins by showing up
General Dynamics might have the inferior bid, but CSRA is still its prize to lose. And GD might not even have to raise its offer much -- if at all -- to come out victorious. General Dynamics is nearly seven times the size of CACI in terms of sales, and it has a pristine balance sheet on which to borrow. CACI, meanwhile, is stretched thin as it is, with the bid as presented implying that the combination would carry net debt five times earnings before interest, taxes, depreciation, and amortization.
CACI's best chance to win would be if General Dynamics decided to walk away -- which the company already said it would not do -- or if regulators block a GD-CSRA pairing. But without knowing full details on the overlap of top-secret projects, it is unclear that CACI's overlap would be less than General Dynamics', so there is no reason to believe a CACI deal for CSRA would be approved if a General Dynamics bid were not.
CSRA in a Securities and Exchange Commission filing Monday said its advisers reviewed the CACI proposal and "strongly believes" General Dynamics' all-cash offer is the better deal. Advisers often value all-cash offers over a mix of cash and shares because of the certainty that comes with cash, but CACI is likely to argue that its bid would allow existing CSRA shareholders to benefit from any long-term upside from the offer.
The dealmaking is not done yet
If nothing else, CACI's rival bid is a clear indication that the ongoing merger bonanza involving government-services companies is far from over. CSRA in regulatory filings detailed a prolonged bidding war between two companies that eventually led to General Dynamics' swooping in to win the auction. Though the filing doesn't reveal who the initial bidders were, it is believed CACI and Science Applications International (SAIC 0.93%) were both involved.
CACI has been among the top consolidators in the field. In 2016 it bought the IT business of L3 Technologies for $550 million, and even though it took on significant debt to complete that deal, it appears to still be on the hunt. Government IT contracting is an area where scale is increasingly vital as the government seeks bidders to take on increasingly large and complex systems, and where economies of scale are essential to putting together competitive bids.
Should GD buy CSRA, its IT business would vault past CACI, SAIC, and others to the No. 2 spot in the government IT business in terms of sales, rivaling industry leader Leidos Holdings, itself the product of large-scale consolidation. CACI is thought to have also been a runner-up in the auction for the IT business of Lockheed Martin, which resulted in the creation of Leidos.
CACI, along with other similarly sized rivals including Booz Allen Hamilton, have stated they feel no pressure to do a deal to gain scale. But CACI's actions seem to suggest management believes it needs to bulk up to survive. They also show a willingness to be creative. The company seems likely to pursue alternatives should it fail to win CSRA, perhaps a merger-of-equals with similarly sized SAIC.
Expect more alphabet soup deal discussions ahead.