When information-technology providers fight for U.S. government contracts, they're finding more and more that size matters.
They can either pull back from the business, as military contractors Lockheed Martin and Northrop Grumman did with sales of IT divisions over the past decade, or expand. That's the response General Dynamics chose with the $9.6 billion takeover of cybersecurity specialist CSRA, a deal that will make the combined company one of the biggest suppliers in the field.
"The strategy may be neatly summed up as 'bigger is better,'" Credit Suisse analyst Robert Spingarn said in a report. "We largely agree with that view." Leidos Holdings' success in integrating the IT business it purchased from Lockheed Martin for $4.6 billion shows the potential payoff for the move, he noted.
The deal positions Falls Church, Va.-based General Dynamics to take advantage of higher military spending under President Trump, who signed a government funding bill last week that calls for defense funding to rise to $700 billion this year and $716 billion in 2019.
“Recent events such as the newly-approved increase in budget, the realization that awarding to the lowest bidder has not worked and quality matters, all aligned at this point to make the combination of General Dynamics and CSRA a market-changing event,” said Dan Johnson, who heads the purchaser’s information technology and services business.
General Dynamics agreed to pay $6.8 billion for the company, a 27 percent premium to its four-week average share price, and take over its $2.8 billion debt. Afterward, CSRA – which specializes in fields from cybersecurity to building digital platforms – will be rolled into General Dynamics Information Technology, or GDIT.
“We believe in that information-technology service space,” General Dynamics CEO Phebe N. Novakovic said Monday. "We’re good at it. We know how to do it. We’re adding to our core."
The transaction creates the U.S. government’s second-biggest information-technology contractor, outranked only by Leidos, the renamed Science Applications International Corp. After adding CSRA’s $5 billion in revenue, the combined General Dynamics information-tech business will have roughly $9.5 billion in annual sales.
While larger companies are better able to compete for the bigger IT contracts the government is starting to favor, there are risks, said Krishna Sinha, an analyst with Vertical Research Partners. Integrating staff and operations after a buyout typically hurts a contractor's win rate for an extended period, he said, and CSRA's success at winning contract renewals has waned since its spinoff from Computer Sciences Corp in 2015.
"We did not see this particular deal coming," Sinha wrote, with most prime contractors moving away from federal information-technology work because they're not cost-competitive enough to win contracts.
While the field is ripe for consolidation, it makes more sense among companies that specialize in that industry alone than for major contractors like General Dynamics focused on equipment, he said.
"Investors will be confused as to why General Dynamics is deciding to lean in to the IT market at this juncture when its peers have decided to pull away from it, and furthermore why they are deciding to buy a company struggling with recompete risk," Sinha wrote.
Lockheed emphasized the need to focus on its core aerospace and defense businesses when selling its information-systems unit for $6 billion in 2016, while Northrop cited compliance with new conflict-of-interest laws when shedding its analytics business in 2009.
Prior to buying CSRA, General Dynamics' information systems business accounted for nearly a third of its $30.9 billion in annual revenue. It was the fastest-growing unit by revenue, with a gain of about 9.5 percent in the last three months of 2017, according to Credit Suisse's Spingarn.
The deal values CSRA at roughly 1.8 times estimated 2018 revenue, compared with a median multiple of 1.3 for similar transactions, according to data compiled by Bloomberg.
General Dynamics has slipped less than 1 percent to $211.81 in New York trading since announcing the deal, while rivals Northrop and Lockheed have climbed, as has the broader S&P 500.