Three things to watch in SAIC-Engility combo

The megadeal between Science Applications International Corp. and Engility hasn’t garnered the same level of "wow" response as it pertains to its $2.5 billion price.

Maybe that is because it is just the latest in a line of other government market megadeals. Maybe because both companies have large amounts of their business tied to more labor-focused technical services contracts, instead of the more profitable fixed-price type.

Engility has had struggles since it spun out from L3 Communications in 2012 to pursue lowest-price type contracts during the era of sequestration. Through the acquisitions of Dynamics Research Corp. and TASC, Engility been moving away from that strategy and seemed poised to start turning the corner.

Arguably SAIC has a similar history. This version of SAIC was created five years ago when "Old SAIC" split into Leidos and SAIC. Leidos took what was perceived as higher-end science and engineering work and SAIC took the technical services piece. (I’m painting broad generalities, I know.)

It could be said that both Engility and SAIC are kindred spirits as products of divestitures.

Both are publicly-traded companies and Wall Street's initial reaction hasn’t been positive. SAIC’s stock has dropped from about $90 to just over $78 per shere. Engility has gone from trading around $39.50 before the deal to just over $35. A lot of this drop probably has to do with the deal being an all-stock transaction, which dilutes the value of SAIC’s shares.

But the bigger question is how will these companies fit together and what comes next.

Here are a few things I’m watching.

INTEGRATION

Both Engility and SAIC made a point of saying that the integration will be straightforward. While always a challenge, they say integration can go quickly because of similar cultures and limited overlap between customers and capabilities. They didn’t use the specific word “easy” but that was the impression I got.

Analysts that watch both companies have flagged integration and execution as a main item to watch. In a Tuesday note for investors, Cowen & Co. analysts wrote that "integration of business development always is a challenge in defense services IT mergers."

Vertical Research Partners analysts caution that SAIC's lack of recent integration experience outside of Scitor three years ago "heightens concern on the ability to capture synergies and maintain market share."

Knowing whether an integration went well or not can be hard to track from the outside. Some signs to look for are workforce attrition, recompetes defended and new business won.

Combining business development operations will likely be the top priority for the newer, larger SAIC as it goes after new work and tries to cross-sell Engility capabilities to SAIC customers and vice versa.

NEW BUSINESS

It was interesting to me that SAIC CEO Tony Moraco and Engility CEO Lynn Dugle both spoke Monday afternoon about the need to move quickly to take advantage of the increases in federal budgets over these next two years.

That certainly was a driver for the deal. But they also spoke about 2020 and beyond and opportunities around space and intelligence that should be protected somewhat from the ups and downs of the budget after the current budget deal and its significant increases expires. SAIC's intelligence business will roughly double by adding Engility.

Dugle commented that whatever goes up must come down. She’s wise to think that way especially with recent government reports that the budget deficit for this fiscal year 2018 will be close to $793 billion, a more than 19-percent increase over fiscal 2017.

The deficit is expected to be near or above $1 trillion a year through at least 2022, according to noted budget guru Stan Collender.

To prepare for this, Moraco and Dugle said the new SAIC will be focusing on longer-term priority areas such as IT modernization, systems modernization and space. These areas should get funding even if other areas are cut.

The new SAIC also plans to ramp up investments in analytics as a path way to artificial intelligence and machine learning.

CHANGING CONTRACT MIX

One other challenge the new SAIC will have is getting more higher-margin, fixed-price contracts as opposed to the current cost-plus and time-and-material profile.

Integrating the businesses (the usual bugaboo of acquisitions) likely will be the easiest they need to do given both companies' similar operating structures.

Shifting away from the traditional labor-based work is harder and riskier. They have to change the kind of contracts they pursue and how they structure business development activities. It’ll also mean different kinds of partnerships and alliances as well as where they invest.

Both companies have been working independently to do this but some competitors have moved more quickly in that direction. CSRA's high number of fixed-price contracts was one of several points that made it attractive to its buyer General Dynamics.

Right now, the combined SAIC-Engility expects to earn 75 percent of its work from both cost-plus and time-and-materials. The other 25 percent is fixed-price.

If fixed-price starts to grow, that will be a big indicator of whether this deal was a good one. It’ll also help show if SAIC’s investments are paying off and translating to profits.

POSTSCRIPT

The deal won't close until early next year. I'll also be watching for how leadership roles change and who’s on the executive team and who are the two members that get added to SAIC’s board of directors.

There is also where Dugle ends up if she isn’t tapped to serve on the expanded SAIC board. She joked with reporters that she’d be sitting on a beach with a drink and an umbrella. But for some reason I doubt that.