Image Source: Maryland GovPics
“Lockheed Martin shareholders have a choice to make, but it may not be the one they are thinking about. We think the Leidos deal is largely a wash, and while we don’t dislike the company, we don’t think Leidos is a no-brainer particularly in light of its net debt load. The real question, in our opinion, is whether either of the two, Lockheed Martin or Leidos, are worthy of your investment dollars at present levels. One is overpriced, while the other looks like dead money.” – The Valuentum Team
Key Takeaways
1) We view the deal between Lockheed Martin and Leidos as largely a wash for both sets of shareholders.
2) We like that Lockheed Martin has the opportunity to receive fair value for an underperforming segment in IS&GS, and we see no further reason for shareholders to seek to own that division on a fundamental basis.
3) The primary question then is whether Lockheed Martin shareholders want to own the pre-deal Leidos assets and whether the synergies associated with its tying the knot with IS&GS are enough to create a value opportunity.
4) With proforma net debt expected at ~$3.4 billion, and Leidos trading at ~11 times the midpoint of its fiscal 2017 post-deal guidance, there’s not much to be excited about, unfortunately. If Leidos wasn’t to be buried under a mountain of debt, one might be able to justify a higher earnings multiple for the equity, however.
5) Lockheed Martin’s shares themselves aren’t cheap on the basis of our discounted cash-flow process, and the company, while it has had a fantastic run, may be ripe for profit taking. Neither Lockheed nor Leidos may be worth your investment dollars at present price levels.
By Kris Rosemann and Brian Nelson, CFA
Lockheed Martin (LMT) has been busy as of late. On January 26, 2016, the defense giant announced an agreement in which it expects to “free up” as much as $5 billion in enterprise value for its shareholders. Through a tax-efficient Reverse Morris Trust transaction, the defense contractor will separate its Information Systems & Global Solutions (IS&GS) business before merging it with national-security firm Leidos Holdings (LDOS). To facilitate the transaction, Lockheed will create Abacus Innovations Corp, which will hold the company’s IS&GS segment, which will then be combined with a subsidiary of Leidos to become a wholly-owned subsidiary of the latter firm.
As part of the deal, Lockheed Martin shareholders will receive 50.5% of Leidos’ equity, worth an estimated $2.59 billion, as calculated on an future ex-dividend basis on yesterday’s closing value of Leidos’ stock (or $47.31 less $13.64 pending Leidos dividend payment) and a one-time cash payment to Lockheed shareholders of $1.8 billion for a total consideration of ~$4.39 billion, by our estimates. The deal is consistent with Lockheed Martin’s portfolio-reshaping strategy that will allow the firm to focus on its core aerospace and defense businesses (“Aeronautics”) moving forward, which continue to experience robust revenue and backlog growth, though not without funding uncertainty.
Lockheed’s IS&GS business segment, which it is divesting to Leidos in this transaction, hasn’t been enjoying the best of times of late, with the division’s net sales falling steadily the past few years, to ~$5.6 billion in 2015 from north of $6.1 billion in 2013 (net sales are expected to fall by a high-single-digit rate in 2016). Most of the segment’s business comes from US government customers at ~90% of total sales, and it continues to face pressure for a number of reasons: weakening federal agencies’ IT budgets, re-competes on existing contracts with stiffer competition, and the fragmentation of larger contracts into more price-competitive smaller and short-duration ones.
The current environment hasn’t hurt the IS&GS division’s operating margin too much (~9% in 2015), but the 2016 level is expected to be lower than last year’s mark (the division’s operating profit is expected to drop at a higher percentage rate than its net sales decline in 2016). The ability to win renewals has also become a cause for concern at the segment, with some big recent losses noted and an ever-increasing competitive landscape cited; volume reductions on some of the division’s major contracts haven’t helped either. Backlog in Lockheed’s IS&GS segment stood at ~$4.8 billion at the end of 2015, for example, down considerably from the $6.3 billion mark in 2013.
Image Source: Lockheed’s 2015 Annual Report, page 45
We think it is a blessing that Lockheed has the opportunity to shed this declining business, but at what price? Let’s put a standalone valuation on the company’s IS&GS operations. A back-of-the-envelope calculation will have to suffice in light of the lack of granular information associated with the division, which can only be expected in a company that has five sprawling segments. IS&GS also happens to be the defense giant’s smallest segment. Assuming that:
1) 2016 operating profit at IS&GS comes in at ~$450 million, which reflects a low double-digit decline from 2015 levels as guided to in management’s 2015 annual report,
2) the pre-tax annual recurring synergies related to the deal as measured by expected +150 basis point improvement in its adjusted EBITDA margin from 2016 to 2019 on a proforma $10-11 billion revenue stream are assumed to be ~$150 million,
3) the tax-effected ongoing segment EBI (earnings before interest) improvement to Leidos as a result of the IS&GS integration of $432 million ($600 x 0.72) at IS&GS is held at that level for the foreseeable future, despite a depleting segment backlog (Leidos’ 28% post-deal effective tax rate is used),
4) that a reasonable hurdle (discount) rate for Leidos’ projects is ~10%, and
5) that capital spending in the IS&GS division equals depreciation and working capital shifts are normalized,
On the basis of our analysis, we think an optimistic fair value for Lockheed’s IS&GS segment is ~$4.32 billion ($432 million/0.1), with perhaps $4-$4.64 billion being an appropriate range depending on future expected EBI growth (decline) rates and the discount rate applied. As outlined previously, in return, Lockheed will be receiving 76.96 million shares of Leidos’ common stock at its ex-dividend price (~$13.64 per share less than the price quoted August 8, for example), valued by the market on an ex-dividend basis at ~$2.59 billion and a $1.8 billion cash payment, or ~$4.39 billion, at the high end of what we would consider to be a fair value range for IS&GS on a standalone basis (or a very modest, perhaps inconsequential transactional value mismatch in favor of Lockheed).
There are other terms of the deal, however. On July 11, Lockheed Martin announced that the firm’s offer gives its shareholders the opportunity to exchange common shares of Lockheed Martin for common shares of Abacus, which will convert into shares of Leidos common stock on a one-to-one basis when the merger is completed. Just under 77 million shares of Abacus (soon to be Leidos) are available to be exchanged for, and shareholders have the option to exchange all, some, or none of their shares before the offer expires on August 16 at 8:00 am EST. No actual shares of Abacus will be issued; Lockheed Martin shareholders who elect to participate in the offer will be issued shares of Leidos Holdings when the merger closes.
Lockheed Martin has designed the exchange offer in a way such that investors will be able to exchange their shares of Lockheed Martin for shares of Abacus that correspond to a 10% discount in value to the equivalent amount of Leidos shares. Participating Lockheed Martin shareholders are expected to receive roughly $111 in Abacus shares for every $100 in Lockheed Martin shares tendered. This discount is subject to an upper limit of 8.2136 shares of Abacus per share of Lockheed Martin, and if that upper limit is in effect, the exchange ratio will be fixed at that limit which will result in shareholders receiving less than the aforementioned discount rate. We think the 10% sweetener helps to “tie-up” the modest transactional value mismatch explained above, if there is one. Assumptions will vary.
The exchange ratio at which Lockheed Martin and Abacus shares are exchanged will be determined by a simple arithmetic average of the daily volume-weighted average prices of shares of Lockheed Martin and Leidos on three dates ending on the third trading day prior to the expiration of the exchange offer. As we have previously mentioned in quoting ex-dividend prices, the final evaluation of the value of Abacus shares, soon to be Leidos shares, will be reduced by $13.64 per share from current prices (on August 8, for example) in order to account for the ~$1 billion special dividend to be paid to Leidos shareholders of record before the merger in the transaction agreement. If Lockheed Martin does not distribute the full ~77 million Leidos shares via the exchange offering, it will distribute the remaining shares to its shareholders on a pro rata basis.
Though all of this sounds nice, we think Lockheed Martin investors are caught between a rock and a hard place. For one, shares of Lockheed Martin are currently trading at a substantial premium to the upper bound of our fair value range, or a lofty ~20 times expected 2017 earnings. This supports the idea of trading them in. After all, Leidos’ relative valuation is far more attractive than that of Lockheed Martin, with price-adjusted shares changing hands at just ~11 times earnings on proforma 2017 numbers. However, Leidos’ equity value will be weighed down considerably by the amount of net debt in its enterprise, so its shares aren’t necessary a bargain either, and the discount involved with the exchange offer shares may sound nice, but there’s no way to guarantee that this won’t be arbitraged away hours, weeks, or months after the transaction.
But what about the dividend? Well, Leidos may offer some upside as it relates to income generation, but the higher payout levels come with greater financial risk. There’s no such thing as a free lunch. Shares of Leidos are slated to yield ~3.5% on an ex-special dividend basis (post deal), and while its free cash flow (averaging $370 million in the last two fiscal years) has been sufficient to average annual cash dividend obligations (averaging less than $95 million in the last two fiscal years) by a wide margin, a doubling of shares outstanding will raise its dividend-obligation bar considerably in future years. Operating cash flow is targeted to meet or exceed $475 million on a 2017 proforma basis, and its business remains capital-light by most standards.
Unfortunately, it’s Leidos’ debt load that keeps us up at night. The firm expects to have ~$3.4 billion in net debt at the closing of the deal, compared to less than $425 million as of the end of the second quarter of 2016. Due to such a burden, management has indicated that it plans to use excess capital following the completion of the deal to reduce leverage–targeting a net debt to adjusted bank EBITDA ratio of less than 3.0x–and maintain the current dividend in the near term, with the potential for dividend growth over time. Given all the moving parts at Leidos, we think the risks and potential rewards may be evenly matched, particularly for a firm tied to competing government budget priorities. Generally speaking, slow-growing, debt-heavy, hefty dividend payers tend to turn into dead money.
Lockheed Martin currently yields ~2.5%, and the firm registers a Dividend Cushion ratio of ~1.1, not bad but not great either. Management has been buying back stock somewhat aggressively as of late, a move we view as somewhat “value-destructive” at current price levels based on our estimate of its intrinsic value, and debt on the books has ballooned recently due in part to the acquisition of Sikorsky in 2015. We wouldn’t be surprised to see the firm’s Dividend Cushion ratio weaken in coming periods. It’s hard not to like Lockheed’s fundamentals, however, and shedding an underperforming segment will work wonders on the direction of revenue and profits, but IS&GS is a high-ROIC proposition in light of its capital-light tendencies.
Of course we could be wrong. If Leidos is able to achieve its operating targets following the closing of the transaction and shares get bid up on the basis of its dividend yield, the company could enjoy nice capital appreciation in coming years while paying shareholders along the way! Tightening security measures as a result of terror attacks, record lines at US airports, a cyber directive issued by President Obama, and the world accelerating its transformation to digital are all expected to provide support to demand for Leidos’ offerings. As for Lockheed itself, well, it has been wrong to bet against this defense contractor the past few years, and there might not be a good reason to now either. We maintain that its shares are overpriced, but that view hasn’t mattered much in this overheated market. Multiples are expanding – and everyone looks like a genius.