On Aug. 18, 2003, Standard & Poor's Ratings Services raised its ratings on Northrop Grumman (NOC). The company's corporate credit rating was raised to 'BBB' from 'BBB-'. All ratings are removed from CreditWatch, where they were placed on Feb. 21, 2003. The outlook is stable. Outstanding debt is about $6.5 billion.
The upgrade reflects improving prospects for earnings and cash flow generation in the next few years and the company's well-positioned portfolio of programs and capabilities in an environment of increasing defense spending.
The ratings on Los Angeles, Calif.-based Northrop Grumman are supported by its very strong business position in a generally attractive defense sector and satisfactory overall financial profile, but also incorporate expectations that the company will pursue a moderate financial policy and disciplined capital allocation. No major acquisitions are factored into the ratings, since the firm has achieved a critical mass in core competencies through a series of transactions in recent years and the pool of available defense properties has been significantly diminished.
Northrop Grumman is one of the nation's largest and most diversified military contractors, with 2003 revenues estimated at $25 billion-$26 billion. The company provides defense electronics and systems, airborne early warning, surveillance systems, and information technology; builds nuclear carriers, attack submarines, and nonnuclear surface ships for the U.S. Navy; and participates in important aircraft programs.
The firm's competitive position in defense has been materially strengthened by the December 2002 acquisition of TRW Inc., which added advanced technology products and services, with significant capabilities in satellite systems, missile defense, and systems integration. Increasing military outlays, combined with Northrop Grumman's leading positions in a number of priority areas, should lead to a revenue growth rate above that expected for the defense industry in the intermediate term.
The all-equity financed purchase of TRW has improved Northrop Grumman's capital structure, with debt to capital in the 30%-35% range, a strong measure for the rating, aided by about a $3 billion debt reduction following the sale of TRW's automotive business. The TRW acquisition substantially increased goodwill, which accounts for about 50% of total assets and exceeds book equity. Debt to EBITDA, another measure of leverage, is appropriate at about 2.5 times.
When sizable unfunded postretirement obligations (about $6.2 billion at Dec. 31, 2002, split about evenly between pensions and other benefits) are included in debt, key credit protection measures weaken noticeably. However, a material portion of those liabilities is fully recoverable under cost-plus defense contracts, with additional recovery possible under future fixed-price contracts. This mitigating factor reduces significantly the adverse impact of unfunded postretirement obligations on the financial profile.
Northrop Grumman's earnings measures are below average for the rating (operating profit margins and return on permanent capital are in the 10%-11% range and below 10%, respectively), stemming partly from the cost-plus nature of many contracts and profit limitations imposed by the government. Still, funds from operations to debt and EBIT and EBITDA interest coverages--in the high-20% area and about 3x and 5x, respectively, expected in the intermediate term--are acceptable given the company's very strong business profile. Moreover, cash flow generation should be fairly reliable, supported by a greater focus on internal growth and operating efficiency.
Although there is some uncertainty about uses of excess cash in future years ($1 billion tax payment related to the B-2 program absorbed most of cash flow from operations in 2003), Standard & Poor's expects Northrop Grumman to pursue a balanced approach to capital allocation regarding potential share repurchases, dividend increases, acquisitions, and debt levels.
Liquidity: At June 30, 2003, Northrop Grumman had about $270 million of cash and equivalents, following a $1 billion tax payment in March, 2003. The company also has a $2.5 billion revolving credit facility maturing in 2006, under which there are almost no borrowings. There is a comfortable cushion in financial covenants. Debt maturities are manageable. Operating cash flow is expected to be about $1.5 billion in 2004. Liquidity is more than sufficient for operating needs, including moderate working capital and capital expenditures.
Outlook: The outlook is stable. Northrop Grumman's management has demonstrated a strong commitment to maintaining investment-grade ratings. Improving prospects for earnings and cash flow generation and a moderate financial policy should offset the effect of potential actions to enhance shareholder value, thus maintaining current credit quality.