Long division

McLean-based SAIC doesn’t seem like a company that needs to come apart. With revenues last year of $10.6 billion and 41,000 employees nationwide, it’s the fifth-largest defense contractor in the country, and it’s hard-wired into the U.S. government’s defense missions. After all, companies like SAIC got this big (No. 245 in the Fortune 500 list) so they could bid on any contract. It expects revenues this year of at least $10.9 billion.

Amid cuts in federal spending and rising pressure from investors, though, a break up is coming for the contracting giant. The company plans to split itself in two. The separation, initially expected to occur as early as August, will take place sometime before the end of SAIC’s fiscal year, Jan. 31, 2014. There will be a new SAIC focused on IT and technical services for defense spending, and a second company called Leidos that will take the faster-growing engineering, health and national security sectors. Leidos — which takes its name from the word kaleidoscope — will be the bigger of the two: the revenues from its sectors were about $7 billion last year, compared with $4 billion for the sectors of the new SAIC.

The reason for the split, naturally, is the opportunity to boost the bottom line. The current SAIC, according to its corporate leaders, faces “organizational conflicts of interest” rules set by its federal clients. Those rules are supposed to keep a contractor from having an unfair advantage when bidding on other contracts, or from having what SAIC calls “undesirable economic incentives.”

Then there’s the impatience of investors, who increasingly think that dividing the company and creating more pure-play strategies will unlock value being smothered by the giant corporation. The downside of that position is the long-term risk in giving up the flexibility and strength that lets a bigger company weather market changes. But that’s a problem farther down the road while profits that could be had in the near term beckon.

“I think the investment community was growing long in the tooth” for a change “so part of the spin is driven by that,” says Michael Smith, a managing director with the Silverline Group, a McLean-based consulting firm. Smith has followed the defense contracting sector and SAIC for years. The company’s “value as a whole, as determined by the market, is less than the sum of those two parts. So there’s an inherent value for them splitting.”

Good news for NOVA
SAIC leaders announced the move in August 2012, six months after John Jumper, a former Air Force chief of staff, became CEO. Since then, company executives have been sorting out the separation, hiring new leadership and giving the companies a chance to anticipate how they’ll land once the split becomes final. The company has ruled out any chance of an August separation, but   SAIC had not announced any specific date by mid-July. Company executives were not available for comment for this story.

The SAIC split is good news for Northern Virginia. It gets two companies, presumably each with higher growth potential. Plus, one of them will need a new headquarters. In May SAIC announced plans to sell its current headquarters in McLean on SAIC Drive to Bethesda-based The Meridian Group and lease back one of the towers there for seven years. It will lease two other towers for a year. Meanwhile Leidos will relocate to a new site that will likely be somewhere in Northern Virginia, possibly the Reston area.

During a shareholder meeting June 7, Jumper talked about the move. Leidos needs to be in its own space, he said, and the current SAIC campus will always be SAIC turf. “I don’t care if General Motors moves into this building. This will always be SAIC Towers, like the Chrysler Building in New York or something,” Jumper said. “Leidos, in order to do what it needs to do, it needs to be separate.”

What Leidos needs is to keep gaining ground in markets where it’s done well. That’s a key reason behind this split. The new Leidos will have the sectors that are growing more quickly. The health and engineering business grew 9 percent in the first quarter, for example, while the tech services and IT segment (which will be under the new, smaller SAIC) saw revenue shrink by about 5 percent.

Executives say the split will open doors for more bidding opportunities for both companies. For example, Leidos will gain “unimpeded access” to about $37 billion annually in “new business opportunities that are not available to us today,” said COO Stuart Shea last year in announcing the split. The new SAIC, on the other hand, will have nearly $25 billion in new business opportunities through 2016 with the Department of Defense alone that the old SAIC wasn’t able to bid on because of conflicts of interest.

Executive teams named
In the past few months the senior executive team has taken shape: Tony Moraco, who has been leading SAIC’s Intelligence, Surveillance and Reconnaissance group, will be CEO of the new SAIC. Jumper will become CEO of Leidos where he will be joined by Shea serving as chief operating officer.

Lately SAIC has also been settling its issues with the U.S. Department of Justice regarding allegations of misconduct. In mid-June SAIC agreed to pay $11.75 million to settle allegations that it inflated charges for training services it provided in New Mexico. Then in early July, SAIC agreed to pay $5.75 million to settle allegations that SAIC personnel gave false information in the General Services Administration in order to win a contract. In both cases the Justice Department said there was no final determination of liability and that the settlement resolved the claim.

Amid the effects of sequestration and a general uncertainty about what direction federal spending cuts might take, the current SAIC has taken a hit. Its operating income in the first quarter was lower than a year ago, partly because of some reductions in defense and government projects. First-quarter results also reflected $40 million in costs related to the separation.

The coming separation “will yield two cost-conscious, high-performance companies that focus on driving value to our shareholders,” said Jumper in a June conference call with analysts.

A lot of the details about how that will be accomplished aren’t known. The company said in June that it would host investor conferences in mid-July in New York to explain “the capabilities and certain financial information” about Leidos and the new SAIC. In early July, however, the company announced it was postponing those events till a later date. It’s not known what caused the delay. SAIC says the split is still on schedule to happen this year.

Other spinoffs
SAIC’s solution isn’t new. Other companies, driven by defense budget cuts in recent years, have been selling off parts of their operations or splitting up to sharpen their game. In July 2012, for example, New York-based contractor L-3 Communications split off a new company, Engility, which took over L-3’s government services work. The company is based in Chantilly and has about 7,800 employees worldwide.

Another example is the 2011 split of New York-based ITT Corp., which divided into three freestanding businesses. One of them — ITT Exelis, a defense and government contractor — has its headquarters in McLean.

Back in the early 1990s, the defense and government contracting business saw a wave of consolidation in the wake of defense spending cuts. Today the wind is blowing the other way, says Smith of The Silverline Group. “Instead of consolidations, you’re seeing a disassembly. And it makes sense because with the [big firms] there’s only so much they can acquire before these organizational conflicts come into play,” he says. “So that’s kind of driving this disassembly, and the end result is going to be more pure-play companies.”

The Engility and L-3 split may be a precursor for SAIC and Leidos, Smith thinks. Before Engility split, investors were pressing for higher margins, “and [the L-3] side of the business couldn’t achieve that. Engility operating by itself can do the things they need to do without getting negative feedback from investors,” he says. “I think Engility has worked out really well. They’re giving bigger companies a run for their money.”

Founder not a fan
Nonetheless, the guy who founded SAIC in 1969 in San Diego and who was its CEO until late 2003 thinks the split is a bad idea. Robert Beyster, now retired, admits he’s got an old-school view of the industry but argues that the split will hurt the company in the long run.

“I think the great strength of SAIC is in its size, and in the diversity of talent and the synergy between all the various groups and sectors,” he wrote in a recent blog post. “Splitting the company will reduce SAIC’s ability to draw from its deep bench of talent and experience. SAIC works very well as an integrated company.”

The market, though, seems to see a company whose value has been less than it could be. So the split is coming, and if it’s done well the two firms “could land pretty well,” Smith says. It should make it easier for outsiders to judge. “If you have a company doing a million things like SAIC does, it’s really hard to say what this is and what it’s worth,” he says. “So [the split] starts to perk interest from investors that maybe were not paying attention.”

With defense and federal spending still trending downward, expect to see more spinoffs and split-ups in the sector, Smith says. “I don’t think this is finished.”