Northrop's Risky Flight Path

Buying TRW is a coup, but will it pay off for shareholders?

If Kent Kresa were a fighter pilot, he would certainly qualify as an ace after his performance over the past year and a half. The low-key chairman and CEO of Northrop Grumman Corp. completed two big mergers in 2001, adding Litton Industries Inc. and Newport News Shipbuilding (NNS ) to Northrop's lineup. In the past nine months, Northrop has also shared in such big new contract awards as the $225 billion Joint Strike Fighter, a new jet fighter that will replace older planes in the Air Force, Marines, and Navy, and a $17 billion modernization of the U.S. Coast Guard fleet.

Then, on July 1, Kresa scored again, announcing that Northrop had won a bruising five-month battle to acquire TRW Inc. (TRW ). When Kresa and TRW Chairman Philip A. Odeen finally shook hands on the deal, Northrop was poised to become the second-largest defense contractor in the U.S.--after Lockheed Martin Corp.(LMT )--with sales estimated at $26 billion next year.

In theory, TRW, with its information- and space-based technology businesses, should give Kresa's outfit a big boost. Northrop is projecting a 23% rise in profits in 2003, from 2002's estimated $750 million. Kresa believes the acquisition, scheduled to close before yearend, will make Northrop even more of a player in space and missile-defense systems. TRW brings long-term expertise in developing spy and military communications satellites. It supplies critical parts for the Milstar satellites, for instance, the military's main method for relaying critical data from remote regions such as Afghanistan. Northrop is already strong in radar systems, intelligence-gathering aircraft, and battlefield management computer systems. Pentagon spending on missile defense systems alone is projected to climb to $11 billion by 2007, from $7.8 billion today.

At the same time, Northrop is still working to supply the Navy and Coast Guard with a new generation of smaller, faster, and more technologically sophisticated ships. Next year, its shipbuilding expertise will be on display when the Navy accepts its latest aircraft carrier, the USS Ronald W. Reagan, from Newport News. "While Kresa keeps a reasonably low profile, he's been one of the industry's bigger forward thinkers," says Jon B. Kutler, a defense industry investment banker at Quarterdeck Investment Partners LLC.

If Kresa's grand strategy works, Northrop will emerge as a well-rounded defense contractor, capable of supplying high-tech armaments or components to most of the military. That's a key reason Northrop fought so hard to obtain Newport News and TRW. But Kresa will need all the skill he can muster to make this merger pay off. It's full of potential pitfalls: the TRW debt Northrop is likely to inherit, the acquisition's potentially dilutive effect on Northrop stock, and the possibility that Congress cuts, delays, or eliminates funding for key contracts.

Worst case: Kresa, who is expected to retire next March, could repeat the experience of former Lockheed Martin Chairman Norman R. Augustine. He steered that company through a series of acquisitions, but earnings tumbled after he retired in 1997. Kresa and all other Northrop executives declined to comment for this article. But Kresa has said that Northrop's well-honed merger integration process will let it continue its record of successful acquisitions.

One reason Northrop shares have fallen since mid-June from $132 to about $108--following a 50% rise over the previous 18 months--is the potential for dilution. Later this year, Northrop will issue 71 million shares to TRW shareholders, more than half the current number of outstanding Northrop shares. Based on estimates from Deutsche Bank Securities Inc. (DB ) analyst Christopher H. Mecray, Kresa is paying about 8.7 times 2003 cash flow for the two TRW businesses he plans to keep, space electronics and information technology. Northrop as a whole trades for 7.8 times cash flow. Some analysts had cut their earnings estimates to reflect that. But the company's report of strong second-quarter earnings may push up the 2003 consensus, which stood at $7.49 per share, according to earnings tracker

Although the TRW merger is a stock deal, Northrop's debt has steadily risen as a result of its earlier buys (chart) to $5.4 billion. TRW has a similar amount. Prior to the merger deal, TRW said it would sell its aeronautical systems unit for $1.5 billion. The proceeds would be used to pay down debt, leaving a combined debt of about $9 billion. Kresa also hopes to sell TRW's auto-parts business. Analysts say that could raise $5 billion to retire debt.

If only it were that easy. TRW's auto-parts business, which has $10 billion in annual sales, has been in play since Northrop made its first hostile offer in February--with no takers. That's because parts companies are being squeezed unmercifully by carmakers trying to cut costs. If Kresa can't find a buyer at close to $5 billion, he may have to spin off the unit to shareholders in a manner that could leave Northrop holding $1 billion or more in additional TRW debt. That possibility led Moody's Investors Service to put Northrop (NOC ) on credit watch for a possible rating downgrade when the deal was first proposed.

Kresa gets lots of credit for spotting a potential boom in space spending by the Pentagon, and TRW's satellite business was one of the prime targets in the deal. But the space unit has faltered recently. Last year it earned $117 million before special charges, on sales of $2 billion. That's less than half of what it earned in 1999. Sources familiar with Northrop's plans say TRW had been investing in unprofitable commercial communications programs that Kresa will cut. Still, TRW's space and info-tech units together earned about 6.3% on sales last year. That is below Northrop's 7.4% overall margin, suggesting that if Kresa can't boost profits at the acquired units, Northrop's margins could tumble.

Even though regulators are expected to clear the TRW merger, the Pentagon still figures to have a say in how it comes together. Unless the military brass feels comfortable that certain sectors of the industry remain competitive, it has the ability to quash the deal. Some military contractors are already fretting that a more integrated Northrop will be able to squeeze out smaller contractors in critical new programs such as the Space-Based Infra-Red System (SBIRS) Low, which uses low-orbiting satellites to track incoming enemy missiles and relay the information to a defensive missile or even a laser weapon. Northrop is discussing remedies that would ensure competitor access to future missile contracts, say sources close to the company.

Moreover, even though funding for space and missile programs is expected to climb, Northrop runs the risk that financial pressures could force Congress to cut some of its bread-and-butter aircraft programs. "There will have to be trade-offs in the Pentagon budget," says William Hartung, a defense industry analyst at the World Policy Institute, a foreign policy think tank in New York City. "[Northrop] could easily find that this isn't all gravy." The U.S. Navy is already weighing cuts in the Joint Strike Fighter, which Northrop is building with Lockheed Martin. Northrop also faces trouble with its high-profile Global Hawk reconnaissance plane, the unmanned jet that will replace the U-2 spy plane. Higher costs have prompted the Air Force to request a 50% cut in the plane's $48 million per-unit price tag.

Kresa so far has done an outstanding job of piloting Northrop through the defense industry's troubled skies. Next March, he reaches Northrop's mandatory retirement age of 65. His expected replacement, Northrop President Ronald D. Sugar, is himself a 20-year veteran of TRW, where he once served as chief financial officer. Sugar is by all accounts a credible leader whose time at TRW should prove helpful. But if things don't go according to plan, Kresa could find himself retiring as an ace but leaving his wingman in a tight spot.

By Christopher Palmeri in Los Angeles, with Stan Crock in Washington, D.C.

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