You get a Pentagon contract! And you get a Pentagon contract! Every ... body ... gets ... a Pentagon contract!

It was a real Oprah moment at the Department of Defense last week. Once upon a time, all defense investors could hope for was that they had "backed the right horse" in the race to win a contract to build 10 new Littoral Combat Ships for the Navy. Lockheed Martin (NYSE: LMT) and General Dynamics (NYSE: GD) were both vying for the honors, but each had gone vastly overbudget on its prototype offerings. Determined to control costs, the Navy presented them with an ultimatum: Give us your best price to build 10 LCSes, and rather than splitting the contract evenly, as we have been doing, the Navy will award all 10 ships to the bidder it likes best.

Now here's the surprising part: The plan turned out even better than hoped.

Christmas comes early
Expecting it would have to pay $5 billion to acquire 10 ships (plus some computer system extras), the Pentagon found its bidders unusually generous in their offers. So generous, in fact, that it says it believes it can secure fixed-price contracts for 20 ships for an amount it previously expected would buy only 15. Translation: The two firms appear to be pricing their boats not at the expected $500 million apiece, but at the low, low price of just $375 million a pop.  

It's basically a reprise of Boeing's (NYSE: BA) offer to build 124 F-18 model aircraft for the Navy at a fixed price 10% below the expected cost back in September. Just like with that deal, the Navy is jumping on it, and investors should be jumping for joy as well.

Why? There are a couple of reasons. First and most obviously, General D and Lockheed Martin both walk away winners. The aggressive pricing poses a risk to their profit margins, but I doubt they would have bid so low if they didn't think they could make a profit on the deal. Second, by giving each bidder a contract, the Pentagon is eliminating the risk that a losing bidder will hold up the production process by challenging the award.

That's good news for the Navy, which will get its ships not just cheaper, but sooner. And it's absolutely fabulous news for investors, who now have more faith in their companies' revenue streams.

Defense from taxes
In other naval news, Northrop Grumman (NYSE: NOC) has decided to spin off its shipbuilding unit to shareholders, rather than try to find a buyer. I'm not enthused about Northrop's decision. According to a Bloomberg report on the spinoff, Northrop was fielding bids for the unit in the neighborhood of $2.5 billion to $3 billion, and didn't like the prices on offer (or the fact that it would have to pay taxes on the sales price). Yet analysts say Northrop's spun-off shipbuilding business would probably carry a market cap of only $2 billion. To me, that number seems too low.

Remember, across the length and breadth of the defense market, we've been seeing buyers regularly paying one times sales and up when bits and pieces of defense companies change hands. If Northrop's shipbuilding unit does about $6 billion in business annually (and it does), this suggests a market cap of closer to $6 billion on the spinoff would be more appropriate.

Then again, if Northrop's castoff really does price at just $2 billion when it goes independent, this suggests there's huge upside to be reaped by fishing this bit of flotsam out of the drink. We're talking a discount so big as to make the 67% and 92% discounts relative to one-times sales on Textron (NYSE: TXT) and L-3 Communications (NYSE: LLL) pale by comparison. The stock of a Northrop spinoff could potentially be a huge winner.

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General Dynamics is a Motley Fool Inside Value pick, but Fool contributor Rich Smith does not own shares of any company named above. The Fool has a disclosure policy.

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