You saw Northrop Grumman's (NYSE:NOC) earnings report, you heard the cheering when it was revealed that Northrop "beat earnings." But did you listen to Northrop's conference call with analysts after earnings came out?
We did -- and here are five things you might want to know about it.
King of the drones
As I think about the future in unmanned, and we've gotten to the point where we'd like to use the word autonomous because most of the real capability is increasingly autonomous capability where there really isn't somebody sitting on the ground flying the vehicle with a joystick. ... We continue to see this as a great growth area for our company. -- CEO Wesley Bush
Historically (if you can call the last decade or so "historic"), Northrop Grumman has gained fame as one of the premier providers of drones for the U.S. military: Global Hawk fixed-wing drones, Fire Scout helicopter drones, the X-47B carrier-capable combat drone, etc. Why, Northrop's even building a mid-size drone capable of carrying weapons and operating off of a frigate's flight deck.
Generally speaking, these drones are designed to be flown remotely by qualified pilots operating out of remote bases far from where the actual drones are operating. But as Northrop's CEO makes clear, the ultimate goal is to shift from remote operation toward true autonomy -- drones that can think for themselves, and operate independently -- and make drones immune to jamming by hostile forces.
As drones continue to evolve, figuring out who's in the lead in making drones operate autonomously is one area where investors should focus their attention. Northrop Grumman certainly is.
The drone Northrop will not build
We have notified the Navy that Northrop Grumman will not be submitting a bid on the MQ-25 program. Our assessment of the final RFP, which required a fixed price incentive bid for this development work, was that we could not put forward an attractive offering to the Navy that would represent a reasonable business proposition for our company. -- Bush
Speaking of drones, a word on what was at one time Northrop's most famous drone -- the X-47B, the first full-size drone ever to launch from and land back on a naval aircraft carrier. Initially, Northrop Grumman had high hopes that X-47B would evolve to become the Navy's new MQ-25A Stingray, the first full-size, mass-produced combat drone designed to operate off of aircraft carriers.
Over time, however, the Navy has steadily ratcheted back its plans for the MQ-25A. First, the Navy took away the Stingray's mission to serve as a combat jet. Then it put its reconnaissance role in the backseat, and told contractors they intended to relegate the Stingray to the role of "flying gas station." Now, it appears MQ-25A won't even need to be "stealthy" -- one of X-47B's strengths.
That last bit appears to be the straw that broke the Stingray's back -- and now, Northrop has decided it won't compete to build MQ-25A at all, a multi-billion-dollar missed opportunity for Northrop.
JSTARS in their eyes
Regarding the Joint STARS Recapitalization ... we have submitted a bid for the Joint STARS Recap program as prime, and our Mission Systems sector has submitted proposals for its radar to all the primes competing on this program. With respect to our bid as a prime, we feel that we, together with our partners, General Dynamics and L3, have put forward a compelling offer. We understand that the U.S. Air Force is conducting an assessment of whether to proceed with this program. -- Bush
One contract Northrop does still plan to bid on is JSTARS, the Air Force's project to "recapitalize" (i.e. replace) its 16 E-8C Joint Surveillance Target Attack Radar System aircraft. Northrop has several irons in the fire on this one.
First and foremost, it's bidding to serve as prime contractor on a project that would install its radar onto G550 aircraft built by General Dynamics (NYSE:GD). However, Northrop is also offering to build the radar systems alone, and help integrate them into aircraft built by the other bidders. For example, Boeing (NYSE:BA) has offered to build a JSTARS fleet based on its 737 airliner, replacing the existing aircraft that are based on its 707 airliner (Lockheed Martin (NYSE:LMT) is the third bidder here).
Why buy Orbital ATK?
If you look at the Northrop Grumman portfolio space capabilities, we tend to focus on the really big things. Think about us as observatories or in the national security domain, we tend to focus on the very large assets. If you look at the portfolio at Orbital ATK, it's more the smaller, in many case, more agile response capabilities that are going to be core to this future. -- Bush
Of course, the biggest news out of Northrop this past quarter was its announcement that it intends (regulators and shareholders permitting) to spend $7.8 billion, and assume $1.4 billion in debt, to acquire space and missile specialist Orbital ATK (NYSE:OA) in a $9.2 billion deal. Why is Northrop doing this, and why is it doing this now, after spending most of the past three years spending itself into a hole buying back its own stock (and burdening its balance sheet with $5.7 billion in net debt)?
Doing a deal that threatens to nearly triple its net debt seems like a crazy move for Northrop, but management thinks it's being crazy like a fox. As the Pentagon's focus shifts toward viewing space as a battleground (there are rumors afoot of a plan to create a new sixth branch of the military, dubbed the Space Corps), Northrop may have looked around and noticed that, out of the three big defense companies focused on aerospace, it's the only one that currently lacks a dedicated space launch business.
Boeing's got one. Lockheed does, too. In fact, Boeing and Lockheed Martin are currently two of the U.S. government's top three contractors putting satellites in orbit. Given the choice between building a dedicated space launch business and buying an existing one, Northrop has opted for the latter -- and bid to buy Orbital ATK and its families of Pegasus, Minotaur, Antares, and (eventually) Next Generation Launch System launchers.
Of course, this still leaves Northrop Grumman with the nagging issue of what to do with all this debt it has accumulated -- and all the new debt it will pile on to acquire Orbital ATK. But Northrop has a plan for that, too.
Working off the debt
We do expect that together we will be ... a strong generator together of cash flow. And after we invest in the business and do that delevering as planned, we will certainly have sufficient cash leftover to continue our strategy of paying a competitive dividend and looking at some share repurchases. -- Northrop Grumman CFO Kenneth Bedingfield
With $1.4 billion in cash on its balance sheet and a $9.2 billion deal in its future, Northrop has decided to bridge the divide between its reach and its grasp by issuing $8.25 billion worth of new debt "to finance the acquisition and pay related fees and expenses." That's step 1, getting ahold of the cash it needs to do the deal. Step 2 will be paying down that debt, and Northrop Grumman will depend heavily on its ability to generate positive free cash flow to make that happen.
Management says it expects to generate positive free cash flow of between $1.8 billion and $2 billion this year, then grow those numbers gradually over time with help from the Orbital ATK acquisition. Given Northrop's history of strong FCF generation (Northrop has averaged cash profits of about $2 billion annually for five straight years), this seems a reasonable goal.
Granted, even devoting every spare penny to debt repayment, it will still take nearly a decade for Northrop to pay off the nearly $15 billion in total debt it will end up with after acquiring Orbital ATK. I'd expect that going forward, dividend hikes and stock buyback announcements will come relatively few and far between. But that's just the price Northrop Grumman shareholders will have to pay for owning a piece of one of the three new superpowers of space.
Let's just cross our fingers and hope it works out for them.