Life After the B-2

By ELIZABETH DOUGLASS

Sept. 20, 1998 12 AM PT

TIMES STAFF WRITER

For decades, Northrop was consumed by its B-2 stealth bomber project. The company nurtured it from its top-secret beginnings through its first military flights, then stood gamely in the political cross-fire as debates raged over the batwing aircraft’s cost and relevance in the post-Cold War era.

The bomber stubbornly hogged center stage at the Los Angeles aerospace firm, supplying both controversy and a cutting-edge image for Northrop while, at its peak, accounting for nearly 60% of the company’s yearly revenue and employing about 13,000 Californians.

Today, as Northrop Grumman prepares for the historic project’s demise, the company must deal with the aftermath of another major loss: the July collapse of its planned merger with Lockheed Martin, a plan that had once again put the company at odds with the government as the two aerospace giants refused to shed key operations to satisfy antitrust demands.

In the wake of the canceled deal, Northrop Grumman has been sued by shareholders over an executive stock package and its share price has plummeted to $63--down from a high of $139 just six months ago--erasing $5.2 billion of the company’s market value. Late last month, Northrop Grumman announced a widespread reorganization that includes facilities consolidations and deep staff cuts that include thousands of aerospace jobs in its Southern California plants.

Northrop Chairman and Chief Executive Kent Kresa is taking pains to reassure shaken backers that the company is strong enough to survive and grow, despite a 14% drop in earnings in the second quarter. The results and cutbacks reflect a temporary downturn in the fighter and commercial jet businesses, the completion of B-2 production and an effort to make the company more competitive, Kresa said.

“There may be some who believe we can’t compete, but I absolutely don’t agree with that at all,” he said. “We are a $9-billion corporation, we are the fourth-largest in our industry, and we have a growing backlog.”

Information Business Growing Rapidly

Already, Northrop is moving ahead on the path it started down seven years ago to reduce its reliance on the B-2. Just weeks after the Lockheed deal was scrapped, Northrop bought Reston, Va.,-based Inter-National Research Institute, an information technology company, for $55 million in cash.

Kresa said that although the aircraft business will remain a staple within Northrop, the company’s future now lies in sophisticated military and commercial electronics and information systems--in radar and surveillance and computer networks, and in air traffic control, target location and infrared countermeasures.

In particular, the company is betting on its information business--which nearly doubled in size in the last year. The business includes hundreds of seemingly obscure “support” and “systems integration” projects that often involve critically important computer systems and computerized communications, training and other functions.

For example, Northrop’s Logicon subsidiary maintains the White House Web site on the Internet, and provides technical support for personal computers and other systems for the Executive Office of the President of the United States. It also is working with the Internal Revenue Service on image-recognition systems that could improve tax form processing.

By 2003, the company plans to book $12 billion in sales, with nearly 75% of the revenue coming from electronics and information technology and services, according to Northrop estimates.

“I think we’ve done an awful lot,” Kresa said. “We’ve moved over the last five to seven years from basically an airplane company into a much broader defense electronics company, with a large focus on the things of the future.”

In fact, those new and growing businesses were a big part of the attraction for suitor Lockheed Martin, which has been aggressively diversifying from its aircraft roots. When Pentagon officials insisted that many of Northrop’s newer businesses be sold off to win approval for the proposed merger, Lockheed resisted, arguing that those were among the most valuable parts of Northrop.

An Active Player in Industry Consolidation

Northrop’s current makeup reflects the company’s efforts to ensure life beyond the B-2.

Over the last five years, Northrop has been an active player in the industry’s consolidation, bidding with gusto to buy companies that would help wean Northrop from its dependence on military aircraft and bolster its overall position in the industry.

The company fell short in attempts to buy the defense businesses of Hughes Electronics and Texas Instruments, but in the rapidly contracting industry, Northrop found other partners.

In 1994, it bought aircraft maker Grumman for $2.1 billion, and later that year bought the half of Vought Aircraft that it didn’t snap up in 1992.

Northrop Grumman then moved to gain a foothold in two growing components of the Pentagon budget: electronics and computer systems. It paid a whopping $2.9 billion in early 1996 for Westinghouse Electric’s defense electronics systems group and about 18 months later completed the $750-million purchase of Logicon.

The acquisitions were made under the directive of executives bent on securing a new future for the company. For the most part, the strategy has succeeded.

“They’ve got more market share of the defense budget now than they did [before the consolidation], and not too many firms have done that,” said Paul Nisbet, an aerospace analyst with JSA Research in Newport, R.I. “Many of them didn’t survive, and Northrop nearly joined the parade.”

But although the new businesses have helped reinvigorate Northrop, the company is still relying on the B-2. The stealth bomber, although now in a diminished role, brought in $1.6 billion of revenue in 1997--18% of the company’s total.

Together, the B-2 and the company’s other bread-and-butter aircraft projects--ranging from major sections of the Boeing 747 and many other jets to the F/A-18 fighter and other military craft--also accounted for much of Northrop’s 1997 operating profit.

On Wall Street, analysts say Northrop will be reduced to a second-tier aerospace company unless it lands another merger partner or goes on a buying spree of its own.

“The move into information technology came about because they saw that they were not going to be able to maintain a leading edge in aircraft manufacturing, but they do not have anything that will replace the B-2,” said Richard Pettibone, an industry and government analyst at Forecast International/DMS, a Newtown, Conn., research firm. “They are in the midst of a major transition, and they have to rethink what their future is going to be.”

Kresa dismisses the notion that his company can’t grow in the shadows of the industry’s “Big Three”--Boeing, Lockheed Martin and Raytheon.

“There’s no question that with the growth of the Boeing and the Raytheon mega-mergers, the dimensions and the dynamics of the business have changed slightly. But I don’t see that we will not be as competitive and as viable as we were prior to” the Lockheed deal, Kresa said.

“In the areas that we compete in, we have very, very major positions, either No. 1 or No. 2. And in the areas where we’re not there yet, we’re certainly growing and trying to be in that position,” he said.

But Northrop, which employs 16,800 workers in Southern California, remains tiny compared with its rivals. Ranked by annual sales, Boeing is five times the size of Northrop; Lockheed Martin is three times as big; and Raytheon--the smallest of the three--is 50% larger. And although size isn’t everything, the bigger companies are often the firms that can afford to share the risk and costs on major government projects.

“The Street believes that they are not capable of going up against the Big Three in the U.S.,” said Jack Modzelewski, an aerospace analyst at PaineWebber.

“They’re a $9-billion company with some great programs, so it’s going to survive,” Modzelewski said. “The thriving part may be a little bit of a wish, but I think the company’s going to do well.”

For shareholders, the Lockheed merger would have produced a princely profit--a per-share payout equal to about $125 a share when it was announced in July 1997. But when the deal failed, the stock price plunged, causing a sell-off.

Part of the hit may have come from Wall Street’s realization that the disintegration of the Lockheed deal was a clear sign that big merger deals in the U.S. defense market have ended.

“Another deal is probably unlikely in the U.S. And because of the nature of [Northrop’s] business, a foreign buyer is very, very unlikely, and I think that is probably why the stock has sold off so much,” said Gregg Watkins, vice president and a portfolio manager in the Detroit office of Loomis Sayles Funds, which manages institutional accounts and owns more than 1 million shares of Northrop stock. The company has about 68.8 million shares outstanding.

Possibilities for Growth Are Many

There is still room for speculation, though, and analysts say there are lots of possibilities: Northrop could continue to buy information systems companies; could join up with Litton, TRW or GTE’s defense electronics business; or could buy B.F. Goodrich for its aerospace concern and spin off the chemicals business and other operations that don’t fit.

“If Northrop wants to merge or be acquired by anyone other than a Raytheon or a Boeing, or a Lockheed Martin, of course, the government will probably approve it and bend over backward to help them,” said JSA Research’s Nisbet. “They don’t want to be accused of killing Northrop.”

Kresa’s response: “We’re not for sale.” Of course, Kresa said that before the Lockheed Martin deal too.

As for further acquisitions, Kresa hinted that Northrop may well be active, but cautious.

“We have to ensure that we can be successful not only in the business we have, but also to acquire additional businesses that will help that top-line growth,” he said. “Bulking up is not an issue in my mind--it’s to have focused energy in areas that you really believe you can become a leader.”

In fact, Northrop’s fairly heavy debt load could make it difficult to finance a major transaction. But the company produces a healthy flow of cash, and that may come in handy for smaller purchases as well as for paying off its B-2-related $1-billion deferred tax payment, which is due in 2000.

“The important thing is to decide what really makes sense for the corporation,” Kresa said. “What’s that new vision? How can you grow?”

That’s precisely what shareholders want to know. So Kresa and company have been making the rounds, meeting with major investors to try to regain their confidence.

“They’re in the show-me stage right now, where they’re going to have to prove that they can survive on their own,” said Charles Mayer, director of investments at Invesco, which owns about 700,000 shares of Northrop stock.

“The way this [Lockheed] deal fell apart was very difficult for all parties involved, and it was disappointing and surprising,” said Mayer, who recently met with Northrop officials. “But it looks as though the stock has been hit unduly hard. I think they can grow double-digit earnings for years to come without doing anything.”

Meanwhile, Northrop’s low share price limits the company’s ability to make stock-related acquisitions--especially if there are more bidding wars--and leaves it vulnerable to a takeover.

In addition, the stock price remains an irritant for shareholders, who continue to stew over the collapsed deal.

Some shareholders felt company officials misled them about the extent of the government’s opposition to the Lockheed merger. In the lawsuit, they contend that company reassurances led them to approve the accelerated payout of stock awards and options for key Northrop executives, along with the merger itself. The suit seeks unspecified damages and the return of profits from merger-related stock sales or payouts.

The stock and options--which were paid even though the deal failed--were worth an estimated $61.6 million in January.

Retaining Top Executives

Kresa acknowledged that the payout created “a very odd situation.” But he said Northrop executives voluntarily placed about 75% of the newly awarded stock in escrow for two years, making it subject to forfeiture if an executive leaves for another job before then.

And Kresa emphasized that the awards helped the company retain top executives during a very uncertain year. “I think it served the company very, very well to have it,” he said.

But now Northrop managers have already received the stock that was meant as a performance incentive, said Doug Scott, a vice president at Institutional Capital, a Chicago firm that owns about 2 million shares of Northrop stock. “The stock value has gone down a lot, though, and maybe that’s enough of an incentive.”

Still, Northrop’s been well-run in a very rough environment, said Nisbet of JSA Research. “With Kent Kresa’s ability to keep things going, a year from now I think you’ll see a lot different company than you have today.”

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The New Northrop

Faced with shrinking defense budgets and waning support for its signature B-2 stealth bomber (left). Northrop has gradually re-created itself, adding high-growth electronics and information systems businesses to reduce its dependence on big-ticket plane projects.

1993

Military aircraft and modifications: 71%

Commercial aircraft assemblies: 11%

Electronics: 11%

Information technology and services: 7%

$5.4 billion in sales

2003 (Northrop projections)

Military aircraft and modifications: 17%

Commercial aircraft assemblies: 9%

Electronics: 54%

Information technology and services: 20%

$12 billion in sales