Could Bid Make Northrop a Takeover Target? : Defense: Option trading activity reveals its battle to acquire Grumman makes contractor vulnerable to hostile acquisition.

A surge Friday in options trading in Northrop shares has prompted speculation among investors that Northrop itself may be vulnerable to a hostile takeover bid, even as the company pursues a tender offer for Grumman.

Northrop’s battle with Martin Marietta for control of Grumman already was considered to carry high stakes; the Los Angeles manufacturer badly needs to make a major acquisition to assure its future as a viable contractor amid the aerospace industry shakeout.

But those stakes may be rising dramatically if Northrop itself is considered to be potential prey. Analysts say Northrop and Grumman may be the only two aerospace companies trading at prices below their underlying breakup value.

On Thursday, Northrop offered to buy Grumman for $60 per share, topping Martin’s $55-per-share offer of last Monday. Under an agreement with Grumman, if Martin’s bid is not accepted, Grumman must pay Martin $50 million in a so-called lock-up fee.

Investment industry sources say that unnamed Fortune 500 companies have begun examining Northrop itself as a potential takeover candidate. Northrop executives were not available Sunday for comment.

One indication of the interest in Northrop came Friday in trading on the Chicago Board of Options. Investors traded 808 contracts, each allowing investors to buy 100-share blocks of Northrop stock. On the previous Monday, only 30 such contracts traded.

The price of the contracts also surged. An option to buy 100 Northrop shares for $45 before mid-May closed trading Friday at $275, up $144 for the day. Investors purchasing such a contract are betting that by mid-May, the value of Northrop stock roughly will be more than $47.75 per share. Northrop shares closed Friday at $41.38 on the New York Stock Exchange.

There are two ways to explain such an anticipated share run-up.

Investors may be speculating that a successful Northrop acquisition of Grumman will enhance Northrop share value by making a more successful long-term competitor in the aerospace industry.

But at least some options traders more likely are speculating that Northrop might be put into play, whether or not it wins the bidding for Grumman.

For example, Martin could elect to walk away from the battle for Grumman, but agree with a third party to buy portions of Grumman and Northrop if the third party can mount a successful hostile bid. In that way, Martin would get both its $50-million lock-up fee and the Grumman units it has been seeking.

If Northrop acquires Grumman, it would carry a debt load amounting to 63% of its total capital, limiting its flexibility to mount a strong defense against a hostile bid.

Such a scheme would be contrary to the normal conduct of aerospace contractors, but the battle for Grumman has already broken the convivial mold.