Peraton’s purchase of Perspecta: The latest move in the quest for scale in federal IT

Scale is king

Peraton’s purchase of Northrop Grumman’s (NYSE: NOC) IT services business and pending acquisition of Perspecta (NYSE: PRSP) are clearly aimed at obtaining the scale necessary to compete for large enterprise and digital transformation deals, which have become common in the public sector IT services market.

Peraton is hardly the first in this space to make such transformative purchases. SAIC (NYSE: SAIC) made two large acquisitions in two years with Engility and Unisys Federal in 2019 and 2020, respectively; General Dynamics IT (NYSE: GD) purchased CSRA in 2018; and Leidos (NYSE: LDOS) perhaps started the trend with its purchase of Lockheed Martin (NYSE: LMT) Information Systems & Global Solutions (IS&GS) in 2016. As federal agencies seek to modernize and transform their operations to take advantage of emerging technologies such as cloud, 5G, AI, machine learning, and AR and VR, large monolithic deals, such as the Next Generation Enterprise Networks Recompete (NGEN-R), Defense Enterprise Office Solution (DEOS), Global Solutions Management – Operations II (GSM-O II) and Joint Enterprise Defense Infrastructure (JEDI), among others, illustrate the importance of being able to deliver these technologies and surrounding services at scale.

Companies such as Leidos, General Dynamics Technologies (GDT) and Booz Allen Hamilton (NYSE: BAH) have come out as the clear winners on the vast majority of multibillion-dollar deals like the ones mentioned above, thanks largely to their ability to deliver digital transformation at scale and proven past performance. TBR believes this trend is only going to become more pervasive in 2021 as the federal government pursues continued IT modernization across defense, intelligence and civilian agencies. Alternatively, if the federal government begins to move toward smaller contracts in terms of total value and/or duration, Peraton’s newly acquired scale would no longer be an asset. However, this is likely only a long-term concern, as the federal government shows no signs of ramping down contract sizes or duration for the foreseeable future.  

Why Perspecta had to die

Perhaps nothing illustrates the importance of scale more than the death of Perspecta. When the company was formed from the merger of DXC Technology’s (NYSE: DXC) public sector business with Vencore and KeyPoint Government Solutions in 2018, the clear intention was to create a federally focused contractor of scale that could compete for the large transformative deals that have become commonplace. Most important among these was the NGEN-R contract, whose predecessor, the NGEN contract, was held by Perspecta and represented nearly 20% of the company’s total revenue.

Despite this, Perspecta was unable to win the $7.7 billion NGEN-R, which was awarded to Leidos and will begin to ramp up in 2H21, leaving Perspecta with a loss of 19% of its total revenue, which cannot be replaced quickly enough to avoid steep losses year-to-year.

Losing the NGEN-R bid put Perspecta in a very difficult place, beyond the obvious financial burden. The company’s leadership has fielded tough questions from Wall Street about where the company is headed without NGEN-R. Perspecta has been unable to win any comparable deals, such as DEOS or GSM-O II, on which it has bid in the last year or two. Additionally, the company does not have as strong of a portfolio in emerging technologies as many of its competitors, and it is highly unlikely Perspecta on its own could have returned to growth quickly enough to appease its stakeholders. In this context, it is clear that Perspecta needed to die. With its pending sale to Peraton, there is opportunity to reemerge as a more formidable competitor in the federal IT services market, free from the burdens associated with its past failures as part of Peraton.

On Jan. 27, Perspecta announced its purchase by Peraton, a Veritas Capital portfolio company, for an all-cash price of $7.1 billion. This acquisition comes on the heels of Peraton’s purchase of Northrop Grumman’s IT services business, which closed Feb. 1 (outlined in TBR’s special report End game for Northrop Grumman’s IT services business). The resulting company, which will retain the Peraton name, will be a $7.6 billion to $7.9 billion business on a pro forma basis with approximately 24,300 employees, in TBR’s estimates.

End game for Northrop Grumman’s IT services business

On Dec. 7, Northrop Grumman announced the sale of its federal IT services operations to an affiliate of Veritas Capital, confirming rumors that began in late October with a report that the company had retained a strategic adviser to review a potential divestiture of its technology services group.

The ‘spin-merge’ will create a $3B-plus federal IT services competitor

The transaction will net Northrop Grumman (NYSE: NOC) nearly $3.4 billion in cash and involve the merger of Northrop’s federal IT and mission support businesses with Peraton, the former IT services group of Harris Corp. Peraton was acquired by Veritas in 2017 for nearly $700 million. After the deal closes during 1H21, the new entity will have an initial revenue base of between $3.2 billion and $3.4 billion, by TBR’s estimates. Northrop indicated in the Securities and Exchange Commission filing accompanying the divestiture notice that the consolidated IT operations included in the transaction would account for roughly $2.3 billion in revenue in 2020, spread across three of its four principal business groups: $1.6 billion from the Defense Systems unit, $500 million from the Mission Systems unit, and $200 million from the Space Systems segment. Peraton generated just over $1 billion in revenue in 2019, according to TBR research. Veritas has not indicated plans for an IPO for the entity, and we expect the new company will initially remain privately held but eventually be taken public.

2018 blockbuster space acquisition, 2019 restructuring, and 2020 strategic defense contract bred speculation Northrop’s IT unit was losing relevance

One might trace the genesis of the announced sale of Northrop’s IT services business back to the company’s $7.7 billion acquisition of Orbital ATK in 2018. Buying Orbital ATK expanded Northrop’s addressable market in the space and missile defense sector with capabilities in small space systems, launch vehicles and propulsion, and missiles and advanced precision munitions. Orbital ATK was rebranded as Northrop Grumman Innovation Systems following the acquisition. At the time, the bulk of Northrop’s IT services operations resided in the former Technology Services (TS) group, which was eventually folded into the larger Defense Systems (DS) unit when the company restructured its business lines in late 2019. Adding Orbital ATK generated cross-selling opportunities for TS in large-scale sustainment, logistics, cybersecurity and operations services, but a similarly expanded opportunity set for the legacy enterprise IT services segment of TS remained unclear. Likewise, it was uncertain if the $13.3 billion phase of the Ground Based Strategic Deterrent (GBSD) program that Northrop won with the U.S. Air Force in September 2020 would avail enterprise IT-related opportunities in systems integration or other offerings to the company’s TS group. GBSD will clearly generate multibillion-dollar revenue streams for the company’s Space Systems unit — evidenced by the segment’s 50%, or nearly $12 billion, sequential increase in backlog in 3Q20 that is attributable almost solely to GBSD. There may be additional pull-through opportunities for mission-enhancing capabilities provided by Northrop’s Mission Systems unit as part of GBSD. GBSD may also offer occasions for Northrop DS to provide integrated air and missile defense solutions, integrated battle command systems, training and simulation, and sustainment services.