Northrop Grumman (NOC 0.77%) is parting ways with the bulk of its IT and services work in favor of focusing its attention squarely on its array of aerospace and space assets. The deal could crimp near-term earnings per share numbers, but makes sense from a long-term perspective.
On Dec. 7 Northrop announced a $3.4 billion deal to sell its federal IT and missions support services business to Peraton, a company owned by private equity firm Veritas Capital.
The sale carves out a $2.3 billion chunk of Northrop Grumman's $35 billion in annual sales, and the company intends to spend much of the $2.9 billion it expects to take in after taxes on share repurchases to help offset the earnings per share impact of the deal.
Still, it's a good deal for Northrop Grumman. Here's why.
Status quo was not an option
Northrop selling the IT division is following in the footsteps of Lockheed Martin, while moving in the opposite direction of General Dynamics. In 2016, Lockheed merged the bulk of its IT assets into Leidos Holdings, creating the nation's largest governments services company. In 2018, General Dynamics spent $9.6 billion to acquire CSRA to position its business as a solid number two.
Government IT contracts are awarded largely on price, and in that environment scale is of the essence. There has been a lot of consolidation among second-tier players in the size range of the Northrop IT business, and Northrop Grumman likely felt pressure to participate in M&A to bulk up the business if it kept it in-house.
In a statement announcing the move, CEO Kathy Warden said that the decision came down to capital allocation priorities.
"This divesture allows us to drive value and reflects our strategy of focus on growing core businesses where technology and innovation are the key differentiators," Warden said.
Northrop already has more debt than either Lockheed or General Dynamics, in part a legacy of its $9.2 billion acquisition of Orbital ATK in 2018. If the choice came down to levering up further to do deals, or exiting the business and streamlining focus on some key projects, Northrop Grumman likely made the right decision.
Northrop is looking to the skies
The foundation for this sale was likely laid out in the purchase of Orbital, which made Northrop arguably the premier player in space tech. The Orbital deal helped Northrop Grumman win a massive contract earlier this year to develop a new Ground Based Strategic Deterrent (GBSD) intercontinental ballistic missile.
Northrop Grumman is also the lead contractor on an effort to design and build the B-21 bomber, making it the prime contractor on two-thirds of a $500 billion effort by the Pentagon to refresh the nation's Cold War-era nuclear triad.
The company's aerospace business goes well beyond bombers. Northrop Grumman is one of the key subcontractors on Lockheed Martin's F-35 fighter program, which could generate upwards of $1 trillion in revenue for all involved contractors over its lifetime.
Space should provide additional opportunities for Northrop Grumman in the quarters to come. The U.S. is shifting its focus away from fighting insurgents and toward so-called "great power conflict" with China or Russia. That means fewer boots on the ground in hotspots like the Middle East, and more of an emphasis on surveillance, both there and in other countries.
Northrop is shrinking to get stronger
We're coming into what could be a difficult period for defense contractors, with the Pentagon after years of budget growth expecting to see funding flatline in the years to come. Military officials are going to have to prioritize in this environment, and contractors would be wise to focus on what they do best and on areas that should hold up well against budgetary pressures.
Northrop Grumman shares trade at a premium to other defense primes. The company today trades at an enterprise value of 13.8 times earnings before interest, taxes, depreciation, and amortization (EBITDA), compared to Lockheed's 11.2 times multiple and General Dynamics' 10.9 times multiple.
The argument for that premium valuation comes down to the strength of Northrop Grumman's portfolio, and its ability to capture an oversized share of total Pentagon spending thanks to its ability to address Washington's most pressing needs.
Northrop Grumman is getting smaller due to this deal, but the portfolio is getting stronger. Investors should applaud that trade-off.