SAIC Spinoff Filing Is A Scary Read For Investors

Last August, the board of Science Applications International Corporation (SAIC) voted to split the company into two separate businesses, spinning off much of its government-services work. Management argues that organizational conflict-of-interest rules in the Federal Acquisition Regulation have made it too hard for SAIC’s diverse businesses to achieve their full potential while part of the same entity. It also contends that the spinoff — which retains the SAIC name — will function more efficiently if the focus of its strategy is narrowed to emphasize government-related information technology, engineering, and technical services.

Those arguments make sense. Under pressure from activist investors, defense conglomerate L3 spun off its own government-services unit last year into an entity called Engility, and the new company has been taking market share from competitors ever since with its slimmed-down cost structure and focused strategy. Michael Lewis of the Silverline Group suggests that complicated military contractors may need to be dis-assembled into more manageable pieces before the defense sector can be rationalized in response to falling demand. However, a perusal of the Securities and Exchange Commission filing that the new “SAIC Gemini” submitted last month in preparation for the issuance of stock is enough to scare off many defense investors.

The SEC requires companies that are registering stocks for the first time to submit detailed disclosures concerning their future prospects and problems — including a discussion of “risk factors.” Nobody will ever accuse the people managing SAIC Gemini’s stock debut of sugar-coating the challenges it faces. In 17 dense pages of SEC Form 10, they describe just about every difficulty that might arise for the new entity except an asteroid hit. For instance, under the rubric of “risks relating to our business,” they cite: damage to their reputation; a decline in defense spending; contract delays; failure to comply with regulations; new contracting rules; adverse outcomes to audits; government investigations; employee misconduct; harsh competitive conditions; premature contract terminations; inability to retain key employees; backlog uncertainties; cost overruns; cyber threats; internal process deficiencies; legal disputes; under-performing acquisitions; unreliable team-mates; inadequate insurance; loss of intellectual property; and natural disasters.

And that’s just the risks inherent in being a technical-services provider to the government. A dozen other potential problems are cited concerning the planned spinoff and common-stock offering. For instance, the new entity will carry a heavy debt load, which means it expects to incur higher debt-servicing costs than it would have as part of the old SAIC. This is a fancy way of saying the business will have to issue junk bonds. Similarly, its shares may be less appealing to investors than the equity previously issued by the parent company — which itself has proven to be no prize for investors since the initial public offering in 2006. There are so many real and potential liabilities associated with the spinoff that it seems likely the new SAIC may soon end up in the hands of private equity, just the way recent spinoffs from Lockheed Martin, Northrop Grumman and Booz Allen did.