Acquisitive government services contractor Science Applications International Corp. (NYSE:SAIC) is back on the march, agreeing to buy the federal business of Unisys (NYSE:UIS) for $1.2 billion in cash.
The deal is opportunistic, with Unisys eager to raise funds to pay down its debt and reduce pension obligations, but also strategic. SAIC is expanding its cloud expertise at a time when cloud is growing in importance among government customers and adding scale in response to its competitors bulking up.
The deal is not without risk, but assuming SAIC can integrate Unisys successfully and pay down the debt it is taking on, the strategic rationale to the purchase is strong.
Head in the cloud
Unisys Federal has more than 2,000 employees, including 1,500 with cloud certification. It contracts with a range of civil and defense agencies, and has deep ties with Homeland Security and the IRS. The unit generated $690 million in revenue in the last 12 months.
SAIC said the purchase would enhance its capabilities in areas where it expects the government to spend, including IT modernization, security, and cloud migration. The buyer expects the Unisys business to generate 10% revenue growth and low double-digit margins in the year to come, helping to boost both growth and margins.
The deal comes just months after the Pentagon awarded a $10 billion Joint Enterprise Defense Infrastructure (JEDI) contract to Microsoft. JEDI is a multi-year push by the government to shift much of its IT infrastructure to the cloud, and it should ripple down through the agencies and their IT contractors. While the outcome of the contract is currently in dispute, the Pentagon seems certain to embrace the cloud regardless.
SAIC has already built a toehold in cloud migration, last month winning a $727 million contract to transition about 800 mission applications into the cloud. In buying the Unisys business, the company is bulking up its cloud expertise overnight, which should allow it to better coordinate with customers and other contractors on JEDI, and could help it win additional IT business from existing defense customers.
Scale and superiority
The deal is SAIC's second major purchase announced in the last 18 months, following its $2.5 billion acquisition of Engility Holdings, and continues the frenzied pace of consolidation among government services firms.
Industry leader Leidos Holdings has announced two deals worth a combined $2.65 billion since December, joining General Dynamics, CACI International, and Perspecta in buying up services businesses in the last few years.
There is a belief among defense contractors that the services business is ripe for commoditization because the government often goes for the lowest-cost bidders. The companies are attempting to differentiate by building specific expertise in areas where the government has particular needs. But in many cases, greater scale (and the pricing power that comes with it), is the best way to win.
In buying Unisys, SAIC should both add to its specific expertise, in this case cloud computing, while also gaining a significant number of highly trained employees and with them better economies of scale.
But that expertise is not coming cheap. The deal is priced at about 10.5 times expected 2020 EBITDA, adjusted for about $175 million worth of tax assets included in the deal. At close, SAIC's debt to EBITDA would jump from 3.2 times to about 4.5 times, but the company said it would move to de-lever to a target ratio of 3 times EBITDA as soon as possible.
By comparison, following its two deals, Leidos would have debt about 3.7 times EBITDA. SAIC said it hopes to return to what it calls "capital deployment flexibility" within two years.
SAIC shares have underperformed an index of defense stocks in recent years. It might be hard for the stock to move dramatically in the months to come as investors wait to see how the Unisys integration goes, but over time the company hopes the cloud will be a catalyst for growth.
Positioning to win
SAIC's move for Unisys should help it better compete for future contracts, and continues the long-term trend of reshaping the competitive landscape as companies become larger and more diverse. Expect the dealmaking to continue -- and perhaps, some would-be acquirers to turn into targets, should concerns grow that the Pentagon spending cycle is nearing a peak.
Perspecta, which just lost a contract that accounted for about 15% of total sales, seems likely to at least review both acquisition and sale options. ManTech International and even CACI are two other wild cards that arguably need to respond to competitors growing larger.
It's unwise to pick stocks based on the potential for M&A, but it is helpful to know the competitive landscape when choosing between companies in a field.
With the Pentagon seeking to get the most out of the dollars it is allocated, there is a strong case to be made that total spending on outsourcing will increase in the years to come, but it also seems likely the bulk of that spending will be split among a small number of large contractors.
SAIC, in buying the Unisys business, is trying to ensure that it is among the companies best-positioned win that business in the years to come.