Science Applications International Corp. (NYSE:SAIC) has joined the stampede of government services firms expanding via acquisition, agreeing Sept. 10 to acquire Engility Holdings (NYSE:EGL) for about $2.5 billion in stock and assumed debt.

There's sound logic behind this plan to create a one-stop shop for services including enterprise IT, high-performance computing, intelligence analysis, launch support, logistics, and training. The deal would move Science Applications International (SAIC) past Booz Allen Hamilton into second place among pure-play government services firms, trailing only Leidos Holdings in terms of annual sales. But the deal also creates near-term uncertainty around SAIC and could lead to further dealmaking in this rapidly consolidating sector.

Aerial view of the Pentagon

After SAIC's recent acquisition of Engility is complete, over half its business will come from the Pentagon. Image source: Getty Images.

Investors were skeptical, sending shares of SAIC down 9% following the deal announcement. Here's a look at why SAIC wants to buy Engility, and how investors should view the company and the rest of the government services sector following the announcement.

A bigger umbrella

SAIC officials said during a conference call with investors that the company's primary goal when considering mergers and acquisitions is to broaden its customer roster. Adding Engility would bring the company access to a range of new intelligence and space opportunities, much of them classified, and expand its cleared workforce by about 50%. Government services companies have complained in recent years that delays in getting security clearance for new workers have limited their ability to compete for new work, so adding the extra cleared workers should allow SAIC to go after bigger and more lucrative contracts.

On the conference call, CEO Anthony Moraco described intelligence as "a very tough market to grow organically" given the need for clearances and the specialized requirements that many of those contracts demand.

Post-deal, the company would generate about 55% of total sales from the Pentagon, with an additional 16% from the intelligence community, and most of the rest from federal civilian agencies. Company officials said they expect the combined companies' adjusted EBITDA margin to climb to near 9% (up from SAIC's current 7.2%), assuming its targeted $75 million in merger-related cost savings are achieved.

This isn't over

The deal is just the latest of several government-services mergers as companies race to gain the scale and resources needed to handle growing demand. In 2016, Leidos catapulted to the top spot with a $4.6 billion deal for Lockheed Martin's services unit. Last April, General Dynamics spent $9.7 billion to buy CSRA, itself the product of a merger between SRA International and the government business of Computer Sciences Corp. And in June, a three-way deal among Vencore, KeyPoint, and parts of DXC Technology created Perspecta (NYSE:PRSP).

Engility had previously been a buyer, spending about $1 billion to acquire TASC in 2014.

In his remarks, Moraco said that he believes growing SAIC into a larger company will help protect it from future market swings. Government services has been a boom-bust business in recent years, punished in the early part of this decade as partisan Washington budget battles caused government agencies to put off big IT modernization projects. While the two-year compromise budget has provided some temporary clarity and should lead to a rush of new orders, lawmakers will have to come up with a new deal by fiscal 2020 to avoid another potential pullback in funding.

"With this diversification in our portfolio and the broad set of capabilities, it provides the downside protection from individual agencies, movement up or down, the priority shift from defense to domestic," Moraco said.

Revenue rankings of government services vendors

The government services competitive landscape after the SAIC-Engility deal. Numbers represent revenue in billions. Image source: SAIC investor presentation.

That reasoning has fueled the rush of consolidation and explains why we are likely to see further deals in the quarters to come. Specifically, there's CACI International (NYSE:CACI), the rumored runner-up for Engility. CACI also made an unsuccessful attempt to break up General Dynamics' deal for CSRA, and will now face a landscape with three pure-play companies -- plus a General Dynamics that is significantly larger than CACI -- and seems destined to act.

Perspecta and ManTech International (NASDAQ:MANT) also could face difficult choices. Perspecta is still integrating the three-way merger that created it, and only went public earlier this year. But like CACI, it also faces a more difficult competitive landscape. ManTech, meanwhile, is similarly sized to Engility and seems likely to either seek out a larger partner or do a large deal of its own.

Investors should be cautious

While I like what this deal does for SAIC over time, I would not rush in to buy shares even after the 10% decline. Merger integrations carry risk, and SAIC in recent years has struggled at times to win new business even without the distraction of a big deal. As Moraco said, this tends to be a cyclical industry, and even if SAIC will soon have the wherewithal to help better weather the next downturn, it is possible the company will not be fully integrated and ready to compete before the current surge ends.

After the deal is complete, private equity companies KKR and General Atlantic, which have been invested in Engility since its deal for TASC, will hold about a 7% stake in the new SAIC. While the firms are supporting the deal, there is some risk that should they decide to sell shares over time, it would put downward pressure on the stock.

Similarly, investors need to proceed cautiously when considering a company like CACI that seems determined to find a large deal. Given there are high-quality alternatives including Leidos and Booz Allen available to investors to take advantage of the government budget upswing, there's no reason to risk buying into these transformations right now.

I commend SAIC's move for Engility and believe time will show it to be the correct move. I just think there are better options for investors while that integration plays out.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.