Northrop's No-Lose Position In Unsolicited Bid for TRW

Corporate Focus
by Anthony Palazzo

Northrop Grumman Corp.'s (NYSE: NOC) unsolicited $11.4 billion bid for TRW Inc. (NYSE: TRW) is a classic business gambit that could pay off big for the acquisitive El Segundo defense contractor.

If the deal doesn't happen either with TRW remaining independent or being acquired by a Northrop competitor the company may not end up the worse for the effort.

Analysts acknowledge the deal's potential benefits, but they've also expressed caution. While some of TRW's operations would undoubtedly benefit Northrop, the proposal requires a number of steps to be carried out successfully, each fraught with risk.

"TRW has two good defense programs that I think would enhance Northrop's very strong defense portfolio," said BNP Paribas fixed-income analyst Domenick Fumai. "Certainly it's an impressive business. The concern I have is integrating TRW into the existing business."

Fumai and other analysts are worried about the prospect of a competing bid pushing up the cost of the deal. They're also unsure whether Northrop can easily sell or spin off TRW's unwanted auto-parts business, and whether it can digest TRW so soon after picking up Litton Industries and Newport News Shipbuilding.

Moody's has placed both companies' debt on review for a possible downgrade. Northrop's debt is already at the lowest rating it could be without sinking to junk-bond status. Notably, however, Moody's said the transaction "could enhance (Northrop's) business position in core markets, and provide a basis for further improvement in earnings and cash flows."

The strategic appeal is clear-cut. As Northrop Chairman and Chief Executive Kent Kresa said in a Feb. 21 letter to TRW leadership, TRW's aerospace and information systems businesses are "highly complementary" to Northrop's existing lines, which include electronic systems, shipbuilding, intelligence surveillance and reconnaissance.

Especially sought after is TRW's Airborne Laser (ABL) program, which partners TRW with Boeing Co. and Lockheed Martin Corp. The project involves placing laser systems on planes flying at high altitudes. The planes would fly a perimeter of the United States and be capable of shooting down incoming missiles.

The other important program is the Space-Based Infrared System (SBIRS), a Star Wars-like surveillance blanket that would likely be mounted on satellites. "The recent Department of Defense budget recognizes the need for additional missile defense," Fumai said. "It's an area that Northrop would like to expand."

Nevertheless, Fumai downgraded his debt rating on both companies to hold from buy. "I think investors are concerned because there is a potential for miscues, and we've seen it before," he said. "Lockheed Martin experienced this, where they made a string of acquisitions, their leverage increased, and there were operational issues that were compounded by the fact that leverage was increased."

Northrop's all-stock bid avoids debt financing. But in addition to paying out $6 billion in stock, Northrop would assume $5.5 billion of existing TRW debt. If the auto-parts unit can be shed, perhaps $4 billion or more of TRW's debt would be shed with it. TRW, however, hasn't ever said how much debt is attached to the unit.

It's difficult to make an educated guess, said Fumai, because the debt incurred in TRW's 1999 acquisition of LucasVarity of the U.K., which had both auto-parts and aerospace operations, was never broken down by segment.

TRW's auto-parts operation generated $10.1 billion in sales in 2001, or 70 percent of the company's overall $16.4 billion in sales. Analysts are estimating its value at perhaps $5 billion, plus the attached debt.

As of late last week, TRW hadn't formally responded to Northrop's bid. However, its stock was trading at $50.25, higher than the $47-a-share Northrop offer. Northrop's shares, meanwhile, have fallen to $107.04 from $117.80 before the deal was announced. Investors clearly see a higher bid in the making, which would drive up the acquisition price for Northrop.

Assuming Northrop prevailed, the next challenge would be to spin off the auto-parts unit. If that were unsuccessful, Northrop would be stuck running a debt-laden business it doesn't want.

Visteon Corp., the former autoparts division of Ford Motor Co., has said it is studying the situation, and Delphi Automotive Systems (a General Motors Corp. spinoff) and Sweden's Autoliv have also been mentioned as potential buyers. However, the auto-parts industry is slumping, and it would be difficult to get a good price for the unit until a broader economic recovery takes hold.

Finally, there is the question of whether Northrop can easily integrate TRW's other operations. Northrop officials didn't return calls, but they've told investors that the integration of Litton and Newport News are going along smoothly.

The ace in the hole may be Northrop President Ron Sugar, who once headed TRW's defense and space operation and knows the target company well. Still, that's not been enough to convince Wall Street. Given the expectation of a higher offer, Northrop's stock-price decline and the execution risks of selling the automotive-parts business, "we would be concerned that the transaction could end up being dilutive to Northrop's earnings per share," First Union Securities said in a Feb. 22 report.



Financial Editor Anthony Palazzo can be reached at 323-549-5225, ext. 224, or at tpalazzo@labusinessjournal.com.

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