Leidos Holdings (NYSE:LDOS) continued its aggressive march into hardware and equipment on Feb. 4, announcing plans to buy the security detection and automation businesses of L3Harris Technologies (NYSE:LHX) for $1 billion in cash. The deal is Leidos' second large purchase announced since late December, and a clear indication of the company's ambitions to move beyond government services.
The businesses to be acquired manufacture checkpoint security products including CT scanners, people scanners, explosive trace detectors, checked-baggage screeners, and automated tray return systems. The businesses generate about $500 million in annual sales and have about 1,200 employees and a global service footprint of more than 20,000 systems deployed across more than 100 countries.
Here's a look at why Leidos is buying and L3Harris is selling, and what investors should think about the moves.
Leidos' transformation accelerates
The deal is the latest push by Leidos, the nation's largest provider of government IT services, into hardware and equipment. The company in late January completed a $1.65 billion purchase of privately owned Dynetics, adding a range of space, aviation, and missile capabilities to a hardware portfolio that also includes an autonomous ship that last year set records by traveling from San Diego to Hawaii and back with little human intervention.
CEO Roger Krone, in a statement announcing the latest purchase, said the additions "further our commitment to a diversified revenue stream by expanding our customer penetration into 75 additional countries." He said he expects the L3Harris assets to add to revenue and EBITDA margins immediately, and said the deal will increase Leidos' international revenue to 13% of total sales from 10% currently.
"The acquisition of these businesses will help accelerate our growth and innovation and enable us to offer the market a comprehensive security platform," Krone said. "This powerful portfolio of technology and the outstanding team of employees that support it complement the Leidos team well."
But the businesses are not coming cheap. Leidos is paying 13 times expected 2020 EBITDA, and it expects to generate only about $20 million in annual cost synergies from the deal.
Leidos believes it can grow the business by cross-selling the airport security equipment with the company's existing port and border security products, which also include some checked-baggage equipment. The company believes it can grow the acquired businesses' margins by nearly 400 basis points by 2021, bringing the margins within range of Leidos' security products, by focusing on services and maintaining the equipment in the field.
Leidos currently generates about 60% of its security revenue from services, compared with just 30% for the L3Harris businesses.
If Leidos can hit its 2021 EBITDA targets for the acquired businesses, the deal's valuation would be a more reasonable 9.4 times EBITDA. But that's a big "if," as Leidos' projections appear to be aggressive.
L3Harris streamlines post-merger
For L3Harris, the deal is part of a broader reshuffling of assets following the 2019 merger of Harris Corp. and L3 Technologies. The combined company is focused primarily on defense electronics, space, and cyber, and CEO William M. Brown said in a statement that the sale "provides a stable path forward" for the security business "while enabling L3Harris to focus its resources on core technologies."
The sale would carve a noticeable chunk out of L3Harris' $18 billion in annual revenue, and on the surface it seems likely to dilute earnings per share. L3Harris said that proceeds from the divestiture will be used to repurchase shares in an attempt to offset that dilution, but it is possible investors will see some short-term impact as the process plays out.
Over the longer term, the sale makes a lot of sense. L3Harris shares enjoyed a terrific first year in trading, with investors optimistic that post-deal the larger company will find it easier to make inroads into different corners of the Pentagon and compete for larger contracts that neither L3 nor Harris could hope to win on its own. But L3Harris has a large portfolio of assets demanding management attention and resources, and the company through this sale is monetizing businesses deemed non-core at an attractive valuation.
Simultaneously with announcing the sale, L3Harris said it earned $2.85 per share in the fourth quarter, up 28% year over year and $0.07 per share above consensus expectations on growing sales and a 240-basis-point year-over-year expansion of margins.
The company expects to grow revenue post-divestiture by 5% to 7% in 2020, to about $18.98 billion to $19.34 billion. Wall Street had been expecting revenue of about $19.26 billion in 2020, but that estimate included the $500 million security business.
Keep both companies on your radar
Leidos said it is funding the purchase through a combination of cash on hand and incremental debt, leaving the company with net debt about 3.7 times EBITDA. Of course, debt is cheap right now, and even if Leidos' growth estimates do prove to be overly ambitious the rationale of the deal makes sense, and expanding its screening and detection business is a good long-term move.
Krone on a conference call with investors admitted the timing of the deal, coming so soon after it announced Dynetics, puts a lot on the company's plate, but said, "Sometimes you have to take the deals as they come."
I wouldn't be surprised if all this dealmaking leads to some integration indigestion, which could trip up a future earnings report. But overall there is a lot to like about Leidos, including a core government IT business that is winning contracts away from competitors and a growing product business in high-value areas. And the company should be commended for attempting to move into areas primed for increased government spending.
L3 and Harris merged to elbow their way into the upper echelon of defense contractors. Leidos, via these acquisitions, is well on its way toward joining them. The next few quarters could be choppy, but investors should be excited about the long-term potential of both companies.