Please ensure Javascript is enabled for purposes of website accessibility

Is SAIC's Engility Purchase a Good Deal for Shareholders?

By Rich Smith - Sep 15, 2018 at 2:03PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Here's one hint: SAIC could earn less money with Engility than without it.

Don't look now, but the government contracting industry just got a little bit smaller.

On Monday, SAIC (SAIC 0.27%), which collected $4.4 billion in revenue last year providing engineering and IT services to various branches of the U.S. government, announced a "definitive agreement" to acquire fellow government IT contractor Engility (EGL) and its $1.9 billion revenue stream for $1.6 billion, plus $900 million in assumed debt. (And let's give credit where it's due -- Reuters predicted this acquisition, and Vertical Research upgraded Engility because of it, two months ago).

Expected or not, though, SAIC was promptly punished by investors for its move to acquire Engility, and SAIC stock fell more than 9% when the news was announced. Why?

A woman painting large yellow fish chasing smaller yellow fish on a gray wall

SAIC is eating Engility -- and it's causing SAIC shareholders heartburn. Image source: Getty Images.

Details, please

Let's briefly review the details. SAIC will be paying all stock for Engility. SAIC will exchange 0.45 SAIC shares for each Engility share outstanding, or $1.6 billion in all. SAIC will further first assume, and then pay off, Engility's $900 million in debt, taking out a $1.05 billion loan on its own for this purpose.

Thus, taken as a whole, SAIC is paying about 1.3 times Engility's annual sales for the company -- a steep premium given that SAIC's own stock currently costs only about 0.7 times sales.

Why Engility is going down on the news

On the date it was announced, this all valued Engility at $40.44 per share, or 11.6% more than Engility shares cost before the merger announcement -- a nice premium for owners of the acquired shares. So it's perhaps surprising that Engility shares have declined 3% or so since SAIC made its announcement.

The reason for this is that SAIC's shares fell once investors heard of the acquisition and its cost. And because Engility's buyout price is tied to the value of SAIC's shares, at Wednesday's closing share price of $78.38, 0.45 share of SAIC is now worth only $35.27 to Engility shareholders. That's only a small premium to Engility's current share price of $35.01 -- so it appears Engility investors won't be making out like bandits on this deal after all.

What it means for SAIC shareholders

But what about shareholders in the acquirer? According to the announcement, the merger of Engility with SAIC will yield a company with:

  • $6.5 billion in annual revenue (essentially equal to what the two companies, combined, generated over the past 12 months)
  • $375 million in annual free cash flow ($50 million more than the companies have generated separately)
  • and permitting cost savings ("synergies") of up to $75 million per year after the deal closes in fiscal Q4 2018 (which may explain the optimistic forecast for future free cash flow)

SAIC shareholders should hope that that last point especially turns out to be accurate, because over the past 12 months, Engility actually reported $31 million in losses. Absent cost savings, this deal would be expected to actually subtract from SAIC's own $192 million in trailing-12-month profits. It would result in a less profitable business, in which the whole is worth less than the sum of its parts.

How investors should look at SAIC today

For the time being, though, let's give SAIC management the benefit of the doubt. Let's assume that the cost savings emerge as promised and that, more importantly, the two firms combined can generate $375 million in annual cash profits on their $6.5 billion in combined revenue. Will this make SAIC stock a buy or not?

Here's how I look at it: Investors today value SAIC at $3.3 billion. The company carries $900 million in debt, and to pay off Engility's debt, SAIC will be adding a further $1.05 billion to its debt load. This implies that in about five months, post-merger, SAIC will have an enterprise value of $5.25 billion or thereabouts.

Divided by $375 million in free cash flow, this will give the new-and-improved SAIC an enterprise value-to-free cash flow ratio of 14. That may not sound expensive, but the company will look even more expensive when valued on GAAP earnings of $161 million (or $236 million if all the planned cost savings filter down to the bottom line). Moreover, analysts surveyed by S&P Global Market Intelligence have been forecasting no better than 5% annualized earnings growth for SAIC and Engility separately. I see no reason to expect faster growth for a combination of the two companies.

Even assuming SAIC continued paying its current 1.5% dividend yield to all shareholders after the merger, 5% growth doesn't seem fast enough to me to justify paying 14 times FCF for this company -- let alone the 22 or 32 times valuation the stock will carry when valued on GAAP earnings.

Long story short, I think the investors who sold off SAIC shares by 13% on this merger announcement are calling this one right. This is a dud of a merger, and a bad deal for SAIC shareholders.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Engility Holdings, Inc. Stock Quote
Engility Holdings, Inc.
Science Applications International Corporation Stock Quote
Science Applications International Corporation
$81.24 (0.27%) $0.22

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/22/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.