By Calvin Biesecker
Despite its surprising announcement on Tuesday that it plans to exit the shipbuilding business, Northrop Grumman [NOC] yesterday said its shipbuilding operations can increase revenues and have significant room to improve profit margins in the years ahead.
The Shipbuilding division is expected to have sales this year of $6.2 billion, and eventually growing to about $6.5 billion annually, Wes Bush, Northrop Grumman’s president and CEO, said on an analyst call yesterday. In addition, the business has backlog worth three years of revenue and “substantial opportunities for margin rate expansion that will lead to strong cash flows in the future,” he said.
But that positive outlook for the Shipbuilding division isn’t enough to hang onto the business.
Bush described a “unique environment” for Shipbuilding in terms of the market outlook and missing “synergies” with the remainder of the company’s business.
As to the outlook, Bush said an assessment of the Navy’s most recent 30-year shipbuilding plan showed that Northrop Grumman’s Gulf Coast operations are facing excess capacity. That lack of sufficient demand by the Navy for vessels is behind the company’s decision to consolidate its shipbuilding operations in the Gulf Coast to its facilities in Pascagoula, Miss., while shutting down work in Louisiana by 2013.
“The decision to consolidate is driven by the need for a smaller, leaner and healthier industrial base,” Bush told investment analysts on a conference call. “The consolidation of these facilities will reduce future costs, increase efficiency and address shipbuilding overcapacity. These actions are consistent with the affordability initiatives recently announced by the Defense Department.”
Bush said the primary focus for divesting the Shipbuilding division for Northrop Grumman will be a spin-off to the company’s shareholders, although it will simultaneously pursue a sale of the division. A spin-off is preferable because the company has complete control of the process while a sale will require validating potential buyers, said James Palmer, Northrop Grumman’s chief financial officer.
“We do believe there will be a number of interested parties,” Palmer said.
Bush said that the company is not looking to break the Shipbuilding sector into smaller parts for a sale. In addition to the Gulf Coast operations, Northrop Grumman has nuclear shipbuilding facilities in Newport News, Va., where it makes and overhauls aircraft carriers and submarines. Two years ago the company put the Virginia and Gulf Coast operations under a single management structure to improve their efficiencies and organizational direction.
At the time, the Gulf Coast operations were struggling with performance issues that led to a number of charges to shipbuilding programs, in part stemming from the direct effects of Hurricane Katrina in 2005 but also from poor quality management.
The company believes it is making good progress related to performance.
“We’ve been intensely focused on driving operational improvement in the Gulf Coast and we’re making very good progress,” Bush said. “These operations are now benefiting from an experienced leadership team, new operating systems, and better program execution, risk management, engineering and quality disciplines.”
Palmer said that the shipbuilding business could achieve high single-digit margins and possibly double-digit. The outlook this year prior to the consolidation announcement was for margins between 5 and 6 percent, Palmer said. Factoring in charges related to the consolidation, which will result in a 2.1 percent hit to Shipbuilding margins, Palmer said that margins are still expected to be about 4 to 4.5 percent this year, which demonstrates that performance improvements are taking hold.
Northrop Grumman said on Tuesday that it is exploring strategic alternatives for the shipbuilding operations because it sees little in the way of synergies between that business and the core businesses at the rest of the company. The portfolio of core work that is spread across the rest of the company’s divisions includes C4ISR systems and electronics, manned and unmanned air and space platforms, cyber security and related applications, and logistics and sustainment, Bush said.
“Consequently, separating the businesses may afford each the opportunity to better serve its customers and optimize value creation for shareholders,” he said.
Analysts generally like Northrop Grumman’s decisions, both to consolidate operations and to shed the ship business. Morgan Stanley defense analyst Heidi Wood congratulated Bush on making a “bold” and “intriguing” move.
Howard Rubel of Jefferies & Co. believes the “move has the potential to unlock some value for…shareholders,” adding that without Shipbuilding the rest of the company could grow faster. J.P. Morgan analyst Joseph Nadol also believes a divestiture “makes sense,” although shareholders may not benefit for a while.
Bush said the potential divestment of Shipbuilding coupled with Northrop Grumman’s sale last year of its former advisory services business TASC Inc., was due to unique market factors facing each business rather than a wholesale effort to sell off more parts of the company.
As for potential suitors, the United States-based division of Britain’s BAE Systems was rumored to be interested in Northrop Grumman’s Shipbuilding operations two years ago, excluding the Louisiana facilities. Rubel said in a research note yesterday that a combination with the other major U.S. shipbuilder, General Dynamics [GD], is unlikely due to anti-trust concerns.
With the pending consolidation of its Gulf Coast shipbuilding operations, Northrop Grumman expects its costs to complete production of the LPD-23 and LPD-25 troop carrying ships to increase about $210 million. The company will take a $113 million charge in the second quarter of this year and additional charges out to 2013 to account for reduced profits on the ship programs.
These charges are solely due to the consolidation and not to new performance problems, Palmer said.
The second quarter charge will be more than offset by a $296 million tax benefit. The tax benefit, combined with the charge, will result in a 73 cents benefit to earnings per share from continuing operations in the second quarter.