If you're a defense investor, you're probably aware that the Department of Defense awards thousands of defense contracts every year. However, the majority of these contracts never breach the billion-dollar mark. As such, when a company receives a contract that's worth more than $1 billion, that's considered fairly significant news.
Well, great news, defense investors: Northrop Grumman (NYSE:NOC) just scored a massive $3.2 billion contract for its Global Hawks. While this contract is great news for Northrop, however, it could be bad news for Lockheed Martin (NYSE:LMT) and its U-2. Here's why.
U-2 vs. Global Hawk
The Air Force currently has a number of platforms that can perform high-altitude intelligence, surveillance, and reconnaissance (ISR) missions, but two of the main ones are the Global Hawk and the U-2. But because of budget constraints a couple of years ago, the Air Force tried to retire the Global Hawk, citing higher operating costs and a desire to use the funds for upgrades to the U-2. Congress, however, rejected the Air Force's request.
Then, in its fiscal 2015 request, the Air Force changed its tune, and instead sought to retire the U-2, as the Global Hawks' per-flying-hour costs had decreased. But retiring the U-2 would have necessitated a fair amount of upgrades to the Global Hawk -- thus negating a significant portion of what the Air Force would have saved -- so the Air Force's request was again rejected.
This year, the Air Force yet again said it plans to retire the U-2, only this time, it said it wants to retire it in 2019, and in the meantime, upgrade the Global Hawks. Furthermore, on Sept. 30, the DoD issued a $3.2 billion indefinite-delivery/indefinite-quantity contract (IDIQ) for "Global Hawk development, modernization, retrofit, and sustainment activities for all Air Force variants."
The winner and the loser
Northrop Grumman's contract win is great news for its investors. Of its four business segments, aerospace systems -- which includes the Global Hawk -- is by far the most profitable. In its most recent quarterly report, it brought in $2.5 billion in sales, while the next highest business segment, Electronic Systems, brought in $1.6 billion. As such, a contract worth up to $3.2 billion is quite significant.
However, because the contract is an IDIQ, the Air Force has until Sept. 30, 2020, to place orders for needed parts and services for the Global Hawk. After that, all work must be completed by Sept. 30, 2025. Simply put, Northrop Grumman won't immediately receive $3.2 billion, but it will likely receive steady work -- and payment -- when it comes to modernization and development for all Air Force Global Hawks.
More important, because the National Defense Authorization Act for Fiscal Year 2012 restricts the retirement of the U-2 until "equal or greater [ISR] capability [is] available to commanders of the combatant commands," this contract award could be a way to modernize the Global Hawks, and pave the way for the U-2's retirement.
What to watch
In the National Defense Authorization Act for Fiscal Year 2016 -- the current defense authorization act that's passed the House and the Senate -- Congress notes that it has concerns about the Air Force's efforts to retire the U-2. Specifically, it states:
[T]he committee supports the Department of the Air Force efforts to upgrade the Global Hawk Block 30 aircraft to meet the requirements of the combatant commanders, but notes that this will take several years. In light of the known gaps, the committee has concerns with any plan that will leave the combatant commanders with less overall capacity and capability than they have today.
Put another way, Congress is open to letting the Air Force retire the U-2 in 2019, but if, and only if, the Global Hawk is able to meet combat commanders' requirements. Consequently, if the Air Force is successful in upgrading the Global Hawk fleet to a capacity that meets, or exceeds, the current ISR demand, the Global Hawk could become the Air Force's primary ISR platform. If that happens, Northrop Grumman will be in a continued position to benefit from future Global Hawk modernization and upgrades.
Conversely, this would be unwelcome news for Lockheed Martin, as its Skunk Works team has been working on replacement of its U-2, called the TR-X. If the Global Hawk is able to complete the needed ISR missions, it seems unlikely that the Air Force would pay for a new platform like the TR-X given the current budget environment. Accordingly, while Northrop Grumman's recent $3.2 billion Global Hawk win is great news for its investors, it might be unwelcome news for Lockheed Martin.