Why Leidos' $1.0bn Levered Acquisition Of L3Harris' Security Detection & Automation Looks Defective
Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled "Detecting A Major Cover-Up Threatening Earnings and Global Public Safety” that outlines why shares of Leidos Holdings, Inc (NYSE: LDOS ) ("Leidos" or the "Company"), an S&P 500 company, faces up to 60% downside risk. The report focuses on the $1.0bn acquisition made by Leidos from L3Harris (NYSE: LHX) of its Security, Detection, and Automation (SD&A) business. We also explore the CEO Roger Krone's history at Boeing (NYSE: BA) under Dennis Muilenburg, who fostered a "culture of concealment" during the MAX scandal. Mr Krone is giving a glowing assessment of the SD&A business while we have evidence it suffers from defective products and market share loss. In addition we explore the growing risk to Leidos' Information Technology and cloud modernization services business from the likes of Amazon (Nasdaq: AMZN) and Microsoft (Nasdaq: MSFT). Please download or view the report by visiting www.sprucepointcap.com . Follow us on Twitter @sprucepointcap for additional information and exclusive updates and read our investment disclaimer.
Ben Axler, Spruce Point’s Founder and Chief Investment Officer, commented:
“One of the fundamental flaws on Wall Street is its research model. Research from investment banks is effectively paid for by public companies through other service fees. As a result, there are too many institutional biases that produce too many unwarranted ‘Buy’ recommendations. We believe this is one of the reasons why there is not a single ‘Sell’ recommendation on Leidos despite extensive evidence to suggest management is covering up failure of a material acquisition, as well as product defects that put all of our safety at risk.
Spruce Point continues to believe short sellers play a valuable role in the marketplace, and that this role is not purely profit motivated. We want to ensure that our country remains safe and that it avoids allocating taxpayer dollars to potentially flawed business contractors. We also realize these are challenging times as we are all making sacrifices while battling the COVID-19 pandemic. The divide between the haves and have nots has grown even wider as the Federal Reserve and central banks have endorsed ultra-accommodative monetary policies to ensure ample liquidity in the system. Accommodative monetary policies alone cannot quickly resolve the pandemic or the growing divides plaguing world economies. Those of us who are able should play an active role in giving back to society and supporting charitable endeavors. This is why Spruce Point plans to donate a portion of profits made from this report, which was self-funded and made available to the public for free, to three worthy causes: UNICEF, The American Red Cross and United Way. ”
Spruce Point Report Overview
We urge investors to review key findings in Spruce Point’s report and hold management accountable for answers to the following issues:
- We believe Leidos wasted $1 billion on the acquisition of L3Harris’ (NYSE: LHX) Security Detection & Automation (“SD&A”) business – and has potentially misled investors on its financial benefits. In early 2020, Leidos leveraged its balance sheet to acquire this business. While management claims the SD&A deal will help Leidos achieve double digit growth, 15% margins, $500 million in revenues and boost international sales from 10% to 13% of total revenues in 2020, Spruce Point believes none of these claims are possible. After conducting expert interviews, evaluating foreign financial filings and dissecting management’s claims, we are still unable to reconcile at least $100 million of total, and $355 million to $367 million of claimed, international sales. We find evidence that one foreign entity in the UAE tied to the automation business recently restated sales and net income lower by 68% and 98%, respectively. We also find unusual transactions with a Thailand distributor – M.I.T Solutions – that has been linked to a graft scandal that led to the imprisonment of a Thailand Transportation Minister. We believe Leidos should impair the value of the business, and that the Board of Directors (the “Board”) should immediately terminate Chief Executive Officer (“CEO”) Roger Krone, Chief Financial Officer (“CFO”) James Reagan and Chief Accounting Officer (“CAO”) Christopher Cage for abysmal due diligence failures.
- Evidence suggests that under CEO Roger Krone’s leadership, Leidos is concealing numerous product defects from investors, including faulty explosive detection systems at airports, ports and borders. Mr. Krone joined Leidos after a long career with Boeing (NYSE: BA), where he worked under Dennis Muilenburg, who eventually rose to CEO and was later ousted following the Boeing 737 MAX scandal. Federal reports detailed a “culture of concealment” at Boeing under Mr. Muilenberg’s leadership and noted that the desire to meet goals and expectations jeopardized the safety of the flying public. We believe this is troubling in context. Backed by import records, a distributor lawsuit alleging fraud and expert interviews, Spruce Point finds evidence that the Company is concealing numerous product defects – C-Mobile TM , ClearScan TM and MV3D TM – and that the SD&A business has underinvested in the latest technology, resulting in market share loss. These challenges could present a “Material Adverse Effect” with tail risk financial liabilities to Leidos shareholders.
- Evidence indicates Leidos is deflecting growing competitive threats from Amazon (Nasdaq: AMZN) and Microsoft (Nasdaq: MSFT). As an outsourced IT service provider to federal agencies, Leidos participates in cloud modernization projects. Amazon has been investing heavily in this area and growing its presence in the Washington D.C. region. There is a growing risk, acknowledged to us by a former senior C-Suite Leidos executive, that the technology leaders could start doing direct deals vs. subcontracting. Booz Allen Hamilton (NYSE: BAH), a key competitor to Leidos, has already acknowledged the increasing competitive environment for hiring technology talent and recently disclosed recruitment challenges. Leidos has failed to acknowledge any risk to its business from these dynamics.
- We believe investors should be extremely concerned by the Company’s current and recently departed CAOs, each of whom have questionable track-records. Prior to joining Leidos, former CAO Ranjit Chadha worked at Computer Sciences Corp (“CSC”) in accounting and financial reporting roles during a period in which the SEC charged its executives with accounting fraud and noted unusual unbilled receivables. Curiously, we find Leidos’ unbilled receivables also rising without clear explanation. Mr. Chadha became Leidos’ SVP Corporate Financial Planning and Analysis in June 2019, and recently departed in March 2020. In his new role, he removed from his biography his CAO role at Leidos. Public filings show that Leidos’ current CAO and long-time SAIC (NYSE: SAIC) employee, Christopher Cage, has a legacy criminal record in California. We find it troublesome that the Company’s financial strains increased post-acquisitions and following the departure of Mr. Chadha.
- Unfavorable Risk/Reward Owning LDOS Shares: The current sell-side consensus price is $116.67 which is ~8% above the current price. Yet, there is no evidence that the sell-side understands the magnitude and gravity of the problems faced by the Security Detection & Automation business. Despite all of our concerns, including concrete evidence of defective products jeopardizing the safety of citizens across the globe, Leidos trades at a premium to peers despite having below average gross, EBITDA and OCF margins. Peers include: Northrop Grumman (NOC), General Dynamics (GD), Cognizant Technology (CTSH), CGI Group (GIB), Jacob's Engineering (J), Booz Allen Hamilton (BAH), Aecom (ACM), SAIC, CACI International (CACI), Perspecta (PRSP), Maximus (MMS), Parsons ( PSN), Mantech (MANT), ICF International (ICFI). Analysts' are enamored with Leidos near-term organic sales growth prospects, despite the fact we have evidence that management has manipulated this figure to its benefit in the past
Please note that the items summarized in this press release are expanded upon and supported with data, public filings and records, and images in Spruce Point’s full report.
Disclaimer
This research presentation expresses our research opinions. You should assume that as of the publication date of any presentation, report or letter, Spruce Point Capital Management LLC ("SPCM") (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our and clients has a short position in (and are long/short combinations of puts and calls on the stock) Leidos Holdings, Inc (“Leidos” and “LDOS”), and therefore stand to realize net significant gains in the event that the price of its stock declines. Spruce Point has a long position in CACI International ("CACI") and stands to benefit if its share price rises.
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To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of LDOS or other insiders of LDOS that has not been publicly disclosed by LDOS. Therefore, such information contained herein is presented “as is,” without warranty of any kind – whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.
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