CACI turns up the heat with renewed bid for CSRA

UPDATE: General Dynamics announced Tuesday morning that it has increased its offer to $6.9 billion in cash.

CACI International’s renewed effort to beat out General Dynamics’ offer for CSRA brings what was once a private bidding war into the public sphere -- and showcases why even the largest services players see scale as the path to success in the government IT market.

The $7.2 billion cash-and-stock proposal from Arlington, Virginia-based CACI comes with a great deal of risk: Debt would skyrocket past the company’s peers; they would not have full ownership of a CACI-CSRA combination; and the bid has some dependence on CACI’s stock activity.

General Dynamics cited those three factors in its long public response released late Sunday night to CACI’s proposal. GD is continuing with its $6.8 billion all-cash tender offer for CSRA shares. First announced Feb. 12, the tender offer started March 5 and will expire April 3 but could be extended.

Then on Friday, March 16, CACI sent its latest offer letter signed by Executive Chairman Jack London and CEO Ken Asbury to CSRA that details the new proposal. They said should CACI be chosen to buy CSRA, the deal would close by July 31 of this year. General Dynamics is eyeing closure by the end of the first half of this year.

But if CACI’s latest push and other deal activity over the past year is any indication, the government IT and professional services market is increasingly rewarding those with scale, which if successfully attained translates to more resources to bid for more contracts across a wider base of potential customers.

That was the thesis behind Leidos’ merger two years ago with the former Lockheed Martin IT business, the creation of CSRA the year before that and the ongoing formation of “Perspecta” through the merger of DXC Technology’s U.S. government business with Vencore and KeyPoint Government Solutions.

Expectations of more defense spending and IT modernization are only amplifying that quest to grow the top line, lest they be left behind in the race to the top. Either combination of CACI-CSRA or that of General Dynamics’ IT services business with CSRA would result a new almost $10 billion entity -- just behind the government services market’s behemoth Leidos at $10.6 billion.

General Dynamics has also cited change in agency buying habits back to more “best-value” type contracting for large IT jobs versus the low-price technically acceptable approach that dominated the market over the past decade as defense spending wound down.

And as Chief Financial Officer Jason Aiken described it in late February, services contractors now "either have to consolidate or get consolidated out."

“This is yet another data point that confirms a new wave of consolidation that harkens back to the early-to-mid 2000s,” said Greg Woodford, senior managing director at The McLean Group. “It shows the impact of a growing defense budget and the opportunities that the tier-one contractors are seeing after years of stagnation, challenges with LPTA, and budget uncertainty.”

But perhaps we should not be surprised that CACI wants to step up its game from being a self-described strategic integrator through a series of deals -- 67 in its entire history -- to a larger consolidation move this time around.

As Woodford pointed out, CACI has gradually made larger deals such as the 2013 buy of Six3 Systems for $820 million and the 2016 acquisition of the former L-3 National Security Solutions business that cost $550 million. Six3 added $470 million in revenue and L-3 NSS brought almost $1 billion in new sales.

It is also reasonable to see that CSRA with its “next-generation IT” focus, network of commercial partners and industry-leading margins would be the subject of intense interest from buyers.

“CSRA might be the best positioned asset to capitalize on the spend” in government IT, said Joey Cresta, public sector IT market analyst at Technology Business Research. If the CSRA offer is not accepted, Cresta suggested to me that CACI could look to privately-held government IT assets as their means to climb up the scale food chain.

That in particular includes CSRA’s business in the defense and intelligence markets, where the company has made a pair of deals of its own and captured large contracts such as the $2.4 billion Greenway IT services contract with the National Security Agency and the $498 million milCloud 2.0 contract with the Defense Information Systems Agency.

“Where most initiatives are moving with cybersecurity, cloud transformation and modernization of legacy IT systems within government, all of those areas are places where CSRA has strong qualifications and capabilities,” said John Hagan, managing director of Raymond James’ aerospace, defense and government services practice.

Much of that highly-technical solutions-oriented work has helped CSRA carry earnings before interest, taxes, depreciation and amortization margins at or above 15 percent since the company’s launch in 2015. As Hagan pointed out to me, those margins help a prospective buyer with cost synergies to further help on the bottom line.

CACI’s second press statement issued Monday afternoon details its cost synergy targets: $165 million that equals 1.7 percent of what they see combined CACI-CSRA revenue to be. General Dynamics sees the combination of its IT services business with CSRA as generating net synergies of 2 percent of revenue.

CACI still faces financial hurdles in its quest to snatch away CSRA. General Dynamics’ market capitalization of roughly $66 billion outweighs CACI’s by almost 17 times. And General Dynamics’ offer is all-cash versus CACI’s of a cash and stock combination.

General Dynamics also cleared federal antitrust regulatory hurdles last week for the CSRA deal, which the latter said late Sunday its board of directors is still in favor of. The board is required to consider CACI’s latest proposal as CSRA is a public company.

One immediate risk factor CACI would have to address should its bid for CSRA succeed is how much this stretches the prospective buyer’s balance sheet.

When including the debt assumed from CSRA, analysts at Vertical Research Partners wrote in a research note that CACI would see its total long-term debt climb to almost $6 billion against $1.18 billion of combined earnings before interest, taxes, depreciation and amortization.

That means CACI’s ratio of debt-to-EBITDA would jump from 2.9x to what would be by far the market’s highest of at least 5.0x, according to analysts at investment bank Cowen and Company.

In its Monday afternoon statement, CACI said it estimates the gross debt-to-EBITDA ratio to be 4.8x after the acquisition of CSRA and is targeting a reduction to 4.0x within two years of closure.

Government services companies typically see their debt ratios go no higher than 3.5x, although CACI’s jumped to 4.2x from 3.2x after its 2016 deal for L-3 NSS.

Investors use debt-to-EBITDA as a measure of how many years it requires a company to pay down its debt if both sides of that measure hold constant.

There is also what a combined CACI-CSRA would look like. The structure of CACI’s offer would see CSRA shareholders own 55 percent of the stock in that entity based on the fixed exchange ratio proposed: 0.184 shares of CACI stock for each share in CSRA.

I have asked CACI for more details on that stockholder ownership aspect and will update this post if and when I hear back.

CACI shares traded almost 8 percent lower Monday afternoon but the stock is up almost 7 percent since the year started. Based on that intraday decline, CACI’s offer comes in slightly equal to that of General Dynamics but again in that combination of cash-and-stock versus GD’s all-cash proposal.

For CACI’s part, its offer letter to CSRA touts the stock as having outperformed the S&P 500 composite index on a one-year, three-year, five-year and 10-year basis.

This could also trigger General Dynamics to slightly sweeten its offer for CSRA with additional cash.

Analysts and investment bankers are not discounting this possibility. A research note from Loop Capital Markets suggested General Dynamics could add between 50 and 75 cents per share on top of its additional offer.

That translates to roughly $82 million-$122 million and is expected to be all cash.

That was the original thesis for why CSRA’s board of directors opted for General Dynamics’ offer instead of the cash-and-stock proposals from two other interested parties prior to the Feb. 12 announcement that it accepted GD’s bid.