(Corrects story published March 31 in 16th paragraph to say General Dynamics makes nuclear submarines)
Northrop Grumman Corp. (NOC), the third largest U.S. defense contractor, has potentially set a precedent for other defense giants by spinning off its $6.7 billion ship unit as Huntington Ingalls Industries Inc.
“This is one of the first big divestitures in a long time and it’s pretty dramatic because of that,” David Berteau, director of defense-industrial initiatives at the Center for Strategic and International Studies, a nonpartisan study group.
Other defense contractors may consider spinning off “their armament division or rotorcraft business and still retain a core” as Northrop has, Berteau said. The Pentagon may not stop such divestitures because it hasn’t yet analyzed the effect of spinoffs, Berteau said. He declined to name companies that might be candidates for similar actions.
Los Angeles-based Northrop’s chief executive officer, Wes Bush, last July decided to divest the ship unit because it had “little synergy” with the rest of the corporation, whose products include Global Hawk surveillance drones and electronic radar. The decision marked a reversal for a company whose former CEO, Kent Kresa, made 20 acquisitions between 1990 and 2003, expanding the airplane maker’s business into shipbuilding.
In November, Bush chose to spin off rather than sell the unit that makes nuclear-powered aircraft carriers, submarines and destroyers because offers from private equity bidders weren’t high enough, people familiar with the discussions said.
Northrop rose 49 cents to $62.71 in New York Stock Exchange composite trading. The shares have gained 25 percent since July 13, when Bush announced the company would seek options for divesting the ship unit. Huntington Ingalls began trading today as an independent company under the ticker HII and closed at $41.50.
Spinoff Versus Sale
Company strategies vary on whether to spin off or sell units that no longer fit their strategies, Howard Rubel, a New York-based analyst for Jeffries & Co., said in a phone interview.
In Northrop’s case, a “spinoff was appropriate and in other cases a sale was appropriate,” Rubel said, citing the example of Lockheed Martin Corp. (LMT)
Bethesda, Maryland-based Lockheed, the world’s largest defense supplier, in February sold its Pacific Architects & Engineers unit to private equity firm Lindsay Goldberg & Co. The company also sold its Enterprise Integration Group unit to comply with U.S. regulations.
ITT Corp. (ITT), whose defense unit makes military night-vision goggles and jammers to counter roadside bombs, announced in January it would split the company into three parts -- a defense company, a unit focused on water business and a third dealing in specialized products for oil and gas industries.
Shareholders of Northrop get one share of Huntington Ingalls for every six shares of the parent company, according to Northrop.
The new unit, which had 2010 sales of $6.7 billion, will operate yards at Avondale, Louisiana; Pascagoula, Mississippi; and Newport News, Virginia, according to Northrop. The company will have 39,000 employees and will be based in Newport News. CEO Bush has said the company plans to close Avondale yard by 2013 and move work to Mississippi.
The separation of the ship unit will mark the end of an eight-month process when Northrop worked to overcome Pentagon concerns that the stand-alone unit may lack the financial strength to meet its obligations, including pension liabilities and unforeseen cleanup expenses from the planned closure of the Avondale yard, according to a government official familiar with the negotiations.
The Navy on March 15 said Northrop had resolved all concerns posed by the spinoff, without further explanation.
Huntington Ingalls will start with a net debt of $1.58 billion, Northrop said last week.
Northrop is applying “much of their debt to the spinoff,” as is common in spinoffs, William Mitchell, author of Spinoff & Reorg Profiles, a monthly newsletter published from Costa Mesa, California, said in an interview. Still, investors may be attracted to Huntington, seeing the unit as “too big to fail,” he said. Huntington is the sole supplier of nuclear-powered carriers and shares submarine work for the Navy with Falls Church, Va.,-based General Dynamics Corp. (GD)
Northrop, the parent company, would benefit from lower debt and a higher return on invested capital than the ship unit, Mitchell said.
Huntington’s long-term goal is a profit margin exceeding 9 percent, compared with 5.5 percent in 2010. Success depends on “how good the management team” led by CEO Michael Petters will be at “wringing cost out of the business,” Rubel said. He has a “buy” rating on Northrop shares.
Still, Huntington is “not going to collapse,” Rubel said. “The reality is the operational focus of Huntington Ingalls can be better and more attuned” to the Navy’s needs, “as opposed to being part of a large corporate portfolio.”
Northrop’s earnings have been hurt by $431 million in charges since 2008 for delays, poor-quality work and damage from Hurricane Katrina at Avondale and Pascagoula.
Huntington’s potential for improved profit margins over the next five years will generate investor interest in the company, Michael Broudo, New York-based analyst for Miller Tabak & Co. LLC wrote in a March 25 note to clients. He has a “buy” rating on Huntington.
Spun off entities often yield better returns for investors than the broad market, according to the Bloomberg U.S. Spin-Off Index. The index, which includes Chipotle Mexican Grill Inc. (CMG), Time Warner Cable Inc. (TWC) and cigarette maker Lorillard Inc. (LO), jumped 170 percent from Dec. 31, 2002, through yesterday. The Standard & Poor’s 500 Index has increased 51 percent over the same period.
Not all divestitures succeed at first, Mitchell said, citing the example of Tronox Inc., which was spun off from Kerr- McGee Corp. in 2006. Since the separation, Tronox, the maker of titanium dioxide, went into Chapter 11 bankruptcy in May 2009, after environmental clean-up costs saddled the company with $550 million in liabilities.
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