Northrop Grumman's Fight for a New Warship

Much of Northrop's future hangs on the fate of a next-generation warship that could be crucial to U.S. defense.
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As the world focused last week on the terror attacks in London, a much more dangerous threat continued to develop thousands of miles away. That would be the buildup of the People's Liberation Army of China, which has garnered scant comment from the Bush administration for fear of losing Beijing's help in neutralizing North Korea.

Combating a Chinese threat five to 15 years from now, potentially over scarcities of energy and food, will make facing Middle Eastern terrorism look like child's play. Yet the U.S. increasingly bulks up on homeland defense and Iraqi operations at the expense of developing weapons systems necessary for fighting a much larger and well-armed adversary.

Ground zero, for those who believe that the government is willfully ignoring a major future threat, is the battle over the U.S. Navy's new DD(X) warship program, which faces a big appropriations cut in Congress in a fiscal 2006 budget set to spend $364 billion on defense. Bean counters have attempted to slash $1 billion in research and development from the program, which is intended to create a new class of stealthy, high-tech destroyers to replace our aging warfare fleet.

A Game of Battleship

Critics of DD(X) go so far as to suggest that the Navy instead drag two 60-year-old battleships out of mothballs, slap on some lipstick and float them out to face a future enemy. In the defense equivalent of the popular MTV show

Pimp My Ride

, veterans nostalgic for the intimidating sound of 16-inch guns propose that the USS Wisconsin and USS Iowa -- originally commissioned in the 1940s and removed from active service in 1992 -- receive a $2 billion, two-year makeover of electronics and paint.

For investors, this battle royal is more than just a curiosity. It is of critical importance to the fortunes of

Northrop Grumman

(NOC) - Get Report

, which has developed the DD(X) program so far, as well as its chief shipbuilding rival,

General Dynamics

(GD) - Get Report

. The two contractors are competing for the final contract, worth up to $50 billion -- winner-take-all if the Navy gets its way, or split between the two if a group of stubborn congressmen prevail.

Northrop and General Dynamic shares are both up 125% since the start of the decade, vs. a decline of 18% for the broad market. They haven't exactly been marking time. But making money in defense contracting requires a fiendish attention to the extraction of new business from the Pentagon and Congress. One big deal can devastate the loser and propel the winner to new heights, as happy shareholders of

Lockheed Martin

(LMT) - Get Report

certainly learned when that company won a $200-billion program to build the joint-strike fighter for the Defense Department in October 2001.

Northrop shares have muddled along this year, up 3%, as the betting has shifted against the likelihood of the DD(X) program's success. Ultimately, one would hope that Congress would come to its senses and get this program passed, as it doesn't just provide the standard air, submarine and ship defenses of past destroyers, but also supports amphibious Marine landings and provides other naval gunfire support with a barrage of next-generation missiles and 155-millimeter guns.

Each ship is expected to cost $1.7 billion, which sounds like a lot. But that total amortizes the development cost of an entirely new type of hull, propulsion system and gun system that would be used on many other ships to come. Substituting a couple of old battleships for a new destroyer is pennywise and pound foolish, as the main cost of running a navy over the long term is manpower. The battleships require 1,500 sailors who would have to be trained on the ancient art of steam-driven propulsion, while the destroyers, stocked with productivity-enhancing automation, require fewer than 150 sailors each.

War-Worries in a Portfolio

The beauty of battleships is that they are floating fortresses, buttressed by steel a foot-and-a-half thick and capable of shooting two-ton projectiles 50-plus miles. But they are noisy in the water and require costly escorts to guard against air and submarine attack. Their powerful weapons are largely incapable of being retrofitted with modern targeting technology. The DD(X)'s 155-mm guns, in contrast, will shoot the same GPS-guided projectiles developed for use by the Army, which can hit a coffee mug 100 miles away. At the end of the day, battleships are the past and DD(X) destroyers are the future.

The problem in Congress is that the U.S. hasn't engaged in serious naval warfare since World War II, as the Navy has primarily been used to provide air support for ground and air missions in the Persian Gulf War, Somalia, Vietnam and in the Bosnian conflict. It seems, indeed, that lawmakers have forgotten the value of a sea-based force.

But a battle against China -- which reportedly has 206 million people fit for active duty -- would be different, to say the least. Short of a full nuclear conflict, battles would be fought along the country's 10,800-mile coastline, with the first conflict likely waged over the sovereignty of the island of Taiwan. That means "littoral," or shoreline, warfare -- seen primarily in history books in recent decades -- could ultimately become as important as desert warfare. China does not yet have the capacity to project its naval power to our own 11,000-mile coastline, but has made the development of a "blue-water," or open-ocean, force a priority.

One's speculations as a citizen jibes with one's views as a value-hunting investor when it comes to Northrop, as the company seems cheap today under the dark cloud of DD(X) uncertainty. The company, which earned $1.3 billion over the past 12 months on $30 billion in sales, ought to be trading with its peer group at a forward price/earnings multiple of 18 or better. Instead, it's stuck at a punishing P/E of 14.

Veteran defense analyst Paul Nisbet says that if the market comes to view Northrop's prospects more positively once the destroyer contract is resolved one way or another, and if Northrop continues to grow earnings at 15% over the next two years, it should trade as high as $92 by the end of 2006, which would be a 70% move from current prices. His view encompasses an expectation of $3.85 in earnings per share this year, $4.35 in fiscal 2006 and $4.85 in fiscal 2007, and a price-to-earnings multiple of 19, which it was accorded in 2001-2003.

Diversified in Sea, Air and Space

That is certainly possible, as most other divisions at Northrop appear on track, and last quarter it enhanced shareholder value by boosting its dividend nearly 15% and announcing a continuation of its $1.7 billion stock buyback program. It is now the third-largest U.S. defense contractor, providing everything from submarines and nuclear aircraft carrier refueling to missile defense, jet fighters, stealth bombers, unmanned surveillance aircraft, satellites and command-and-control systems to all military branches, and to most major U.S. allies. Its return on equity and capital are not as robust as General Dynamics', but they are improving.

Cai von Rumohr, longtime defense analyst at SG Cowen, points out that while the stock may be dead money until DD(X) is resolved, Northrop has strong prospects to win big contracts for a space exploration vehicle (teamed with Lockheed); space-based radar; and a large aircraft infrared countermeasures system aimed at jamming enemy missiles' guidance systems with a high-intensity laser. It is in trouble with the Navy over the escalating cost of a new class of amphibious-force ships called Landing Platform Dock 17, which it inherited with its purchase of Litton Industries. But a favorable resolution appears likely.

At this point, the DD(X) program remains Northrop's biggest overhang. In a June 14 report, the Government Accountability Office, the investigative arm of Congress, added to the lack of clarity by citing cost overruns and questioning the maturity of some of the system's new technology, including "volume search" radar. If you're wary about initiating a position at this time, then at least put these two last hurdles on your radar: A design review due by August that assesses the ship's readiness to proceed to production, and then a so-called Milestone B review -- due by November -- will determine if the Navy should award a detail design and construction contract for the first ships.

If the DD(X) program cracks up and Northrop shares crater, you could use that opportunity to march in on these shares, as the franchise can certainly withstand an attack that is already largely discounted.

As originally published, this column contained an error. Please see

Corrections and Clarifications.

At the time of publication, Markman was long Lockheed Martin, although positions may change at any time.

Jon Markman, writer of Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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