Will SAIC's Plan To Break Itself Up Promote Value?

| About: Leidos Holdings, (LDOS)

At SAIC's (SAI) annual meeting of shareholders, one attendee raised the issue of the company being in a similar state to Rockwell -- offering a diverse product line that was hard to identify, and ultimately deciding to break itself up and sell its components -- and whether this figured into management's plans. A. Thomas Young, a member of the board, replied that "there's no question that the definition of the strategic direction for the future is important. And that's our responsibility, and that we are focusing on that."

That meeting was held on June 15 and less then three months later, along with the announcement of the company's results on Aug. 30, it was revealed that SAIC would break itself into two separate companies and sell off a small portion. The major reason provided for this move was to remove organizational conflicts of interest (OCI) and also allow the two new public traded companies "be more differentiated and more competitive in their own space," as the new CEO, former Air Force General John P. Jumper, described it.

The results for the second quarter of fiscal year 2013 ended July 31 were mixed. Despite its revenues increasing almost 10% year-to-year to $2.85 billion, SAIC's operating income fell by about $18 million. This was due to a charges related to a relocation of corporate headquarters and the efforts put into the new plan to separate the company, along with some increased indirect spending and a net unfavorable change in contract estimates. Bid and proposal costs were a good portion of the indirect charges increase, perhaps reflecting the tougher market the defense industry is facing with the potential for large cuts causing less work to be available in the future.

The two new companies created will be of differing sizes. One will contain the services business, which includes the core scientific, engineering, and technical assistance group that provides support to military acquisition offices, alongside the financial analysis and system engineering lines. This will have an estimated $4 billion in revenue. The second company is referred to as the "solutions focused business" and will have close to $7 billion in revenue. It is made up of SAIC's groups that do development and production for a variety of defense, government, and commercial customers. This includes software, energy industry, and health IT products.

Interestingly, the founder of the original SAIC -- which was employee-owned until 2006 -- wrote an op-ed in The Washington Post objecting to the move. As J. Robert Beyster put it, "[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. Splitting the company will reduce SAIC's ability to draw from its deep bench of talent and experience."

The part being sold to American Systems is SAIC's test arm. Under increasingly restrictive Pentagon rules, this would face OCI with other parts of the company attempting to market their products to different government agencies. The test people would either be unable to support their government customers or the product could not be sold. It is a similar move as the one made by Northrop Grumman (NYSE:NOC) back in 2009 to jettison its TASC component, also heavily involved in supporting military procurement.

The stock price saw a bump in early September after the plan was announced, and the slight rise has continued. It closed Tuesday at $12.42, or just about halfway between the stock's 52-week high and low. Even so, the shares remain several dollars below the IPO price and peak of about $21 in 2008. Prior to the breakup, analysts had been predicting full-year earnings in 2013 at $1.34, which is well above the 77 cents estimate for 2012 and the actual performance of -2 cents. Much of this may be laid at the feet of the settlement with New York City on the CityTime payroll system. This led to a $500 million settlement, deferring prosecution of a conspiracy to defraud the city. The core of the company performed well considering the difficult markets developing for defense contractors in the United States.

The plans for the division are still ongoing, but current shareholders would maintain their SAI shares, which would be for the solutions-focused part, and receive new shares for the smaller, technical services. The total dividend between the two portions would be equal to the current one, which is 48 cents a year.

The key questions around this move relate to whether it will generate more value for the shareholders. Is there that much OCI that it is preventing the two parts to grow at the rate the company wants? Will it lead to one or all of the two smaller companies being involved in M&A as the shareholder discussed? Some believe that part of the motivation for ITT's (NYSE:ITT) move into three parts was to allow the defense component, now Exelis, to be sold more easily. There has been some nibbling around the edges, but there have been no major defense M&As caused by the proposed billions in defense cuts starting in 2014. Similar to what happened in the 1990s when the market declined, there is a chance of those kinds of moves happening.

The effect of all this won't be seen in SAIC's stock, the market, or the industry as a whole for several more months. The planned sequestration of defense funding may change based on the upcoming presidential election, a deal between Congress and President Obama, or other events. Defense spending as a whole should decline as the fighting in Afghanistan ends, the U.S. moves to deal with its deficits, and threats change. SAIC, like many other defense industrial corporations, will continue to expand its business lines to include health IT, government services, and commercial markets. The split into two parts may aid that growth and provide value through the two stocks. It might lead to one of them disappearing, but providing cash to the shareholders. It seems like a dramatic move, but it might be what is needed for an industry facing dramatic change.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.