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Leidos to Merge With Lockheed IT, Gov’t Services Segments in $5B Tax-Free Deal

acquisition,  mergerReston, Virginia-based contractor Leidos Holdings (NYSE: LDOS) has agreed to a merger with the government information technology and services businesses of Lockheed Martin (NYSE: LMT) under a $5 billion, tax-free Reverse Morris Trust transaction to create the government services industry’s largest publicly-traded contractor by revenue, the companies said Tuesday.

Both companies — two of 30 listed in Executive Mosaic’s GovCon Index — expect to close the deal in the fourth quarter of 2016 and Lockheed will continue to operate the businesses within its information systems and global solutions segment.

The agreement completes a six-month long process for Lockheed as the Bethesda, Md.-based defense contractor first announced in July 2015 it planned to either sell or spin off parts of its IS&GS segment in conjunction with the company’s $9 billion purchase of helicopter manufacturer Sikorsky Aircraft.

Programs subject to the review posted nearly $6 billion in 2015 revenue for Lockheed, which projects close to $5.65 billion in 2016 sales for IS&GS and the company will hold onto most of the defense and intelligence-related work from the segment.

Under a Reverse Morris Trust, a seller spins off assets it wants to sell into a new separate company that the buyer immediately acquires or merges with, then the acquirer issues shares in the combined entity to stockholders of the selling company.

Shareholders of the selling company must own more than half of the voting rights and economic value in the combined entity for the transaction to qualify as a Reverse Morris Trust, a type of transaction intended for the seller to avoid taxes on the deal’s income.

Lockheed will receive a one-time cash payment of $1.8 billion and its stockholders will own 50.5 percent of the shares in Leidos with that portion of the latter company’s stock worth around $3.2 billion as of Monday’s market close based on the five-day volume weighted average stock price of $55.22.

Leidos will pay its shareholders an approximate $1 billion special dividend upon the deal’s closure and will fund the payment through new borrowing and cash on hand.

James Reagan, Leidos’ chief financial officer, told investors in a subsequent call that the one-time payment and special dividend are intended to qualify the transaction under laws governing Reverse Morris Trusts and match up the equity values of both companies.

Leidos posted close to $5 billion in sales for its fiscal year ended Jan. 30, 2015 and expects the transaction to create a business with nearly $10 billion in annual revenue, which the company said in investor slides is almost double compared to its own current scale as well as twice that of consulting firm Booz Allen Hamilton and the technology services contractor CSRA (NYSE: CSRA) that launched in November.

The company known as Science Applications International Corp. prior to its Fall 2013 division into Leidos and a rebranded SAIC posted approximately $11.17 billion in sales for fiscal 2013, the pre-split contractor’s last full fiscal year.

According to the slides, the combined Leidos-Lockheed IS&GS company will have nearly 33, 000 employees with 45 percent of its business mix represented in the commercial and civil markets, 35 percent in defense and the remaining 20 percent in the intelligence community.

Roger Krone, Leidos chairman and CEO, told investors his company’s current portfolio evaluation process is unchanged with the ongoing deal.

Krone will continue to hold both titles at the combined company and Lockheed has the right to designate three new directors for the board, while a joint management team will lead the combined entity and Reagan will serve as CFO there.

Leidos held a market capitalization of $3.87 billion as of the Monday trading day’s end, while Lockheed’s total share value was $64.82 billion.

Reuters, which first reported details of the negotiations Tuesday, said CACI International (NYSE: CACI) also sought to acquire the IS&GS assets up for sale but its offer was beaten out by Leidos’ proposal.

Shares of Leidos have fallen 2.31 percent since the start of 2016 and are up 24.99 percent over 12 months, while Lockheed’s stock has declined 2.35 percent since January began and has risen 6.52 percent in 52 weeks.

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