Great news, Northrop Grumman (NYSE:NOC) fans! Even though Boeing (NYSE:BA) and Lockheed Martin (NYSE:LMT) joined forces to compete for the Air Force's Long-Range Strike Bomber contract (LRS-B), it wasn't enough to beat Northrop Grumman.
Yes, you read that correctly: Northrop Grumman just landed a contract to engineer and manufacture a next generation bomber for the Air Force. Furthermore, this two-part contract is estimated to be worth over $80 billion. Here's what else you need to know.
Show me the money
Northrop Grumman has four business segments, and of these its most profitable is Aerospace Systems -- in its 2015 third quarter report, Aerospace Systems reported over $2.5 billion in sales. The next highest business segment, Electronic Systems, reported over $1.7 billion. However, Northrop Grumman's Aerospace Systems division is lacking one key thing -- a prime combat air force contract. Indeed, this lack led aerospace industry analyst, Richard Aboulafia of the Teal Group, to question Northrop Grumman's long-term viability in the aerospace sector.
In fact, according to Defense News, Aboulafia went so far as to say that if Northrop Grumman were to lose the LRS-B contract, it could result in Northrop Grumman also losing the ability to compete for future jet programs. This is because Aboulafia believes that without an airframe to build, Northrop Grumman could lose its current aerospace infrastructure. This could then lead a competitor -- namely, Boeing -- to try and acquire Northrop Grumman's Aerospace Systems.
Honestly, this idea seems somewhat far-fetched (Northrop Grumman selling it's most profitable business sector doesn't make a whole lot of business sense), but it does draw attention to the fact that one of the biggest prime contracts in Northrop Grumman's Aerospace Systems is the Global Hawk -- arguably the most advanced UAV available, but not something that brings in the cash like Boeing's contract for the KC-46A Tanker or Lockheed Martin's contract for the F-35 fighter jet. Thus, the LRS-B win is not just good news for Northrop Grumman's bottom line, but it also solidifies the health of its most profitable sector. For investors, this is especially important to note.
The LRS-B contract specifics
In addition to increasing Aerospace System's overall health by keeping Northrop Grumman in the combat warplane game, the first part of the LRS-B contract -- the Engineering and Manufacturing Development (EMD) phase -- is estimated to be worth $21.4 billion. Additionally, it has the added benefit of being a cost-reimbursable type contract. This means that unlike Boeing's fixed-price KC-46A EMD contract (which has cost Boeing a pretty penny thanks to cost overruns), Northrop Grumman has a certain amount of flexibility when it comes to spending. That's not to say Northrop Grumman can go crazy (there are incentives to staying within a certain budget), but it does mean Northrop Grumman isn't subject to the same kind of penalties that Boeing is with it's KC-46A. Considering the LRS-B is a new plane, and could end up costing more than anticipated, this is great news for the company.
The second phase of the contract, the production portion, is a fixed price contract with incentives for cost. This means the Average Procurement Unit Cost, or what the Air Force is willing to pay per plane, is set at $550 million in 2010 dollars (this translates to $606 million in FY2016 dollars). As such, Northrop Grumman is responsible for making a plane that doesn't exceed the agreed upon cost -- if it does (through no fault of the Air Force), it could impact profitability.
In brief, this contract is estimated to be worth in excess of $80 billion, but it could far exceed this amount thanks to the nature of the contracts.
A possible kink
Clearly, the above is great news for Northrop Grumman's investors, but it's not time to celebrate just yet. As I mentioned previously, Lockheed Martin and Boeing teamed up to compete for the LRS-B, and there's a strong possibility that they'll protest the Air Force awarding the contract to Northrop Grumman. If, and when this happens, the Government Accountability Office (GAO) will have to decide if their protest has merit -- if it does, the GAO can recommend a recompete, which could start the entire LRS-B competition over again.
However, according to a 2010 study, there's a 55% chance that the GAO will throw out such a claim. If it doesn't and there's a recompete, it's almost assured that Northrop Grumman will compete again. Who will win such a recompete is anyone's guess, but I'd put my money on Northrop Grumman.
What to watch
Northrop Grumman's recent LRS-B win is fantastic news for the company. Not only is it an incredibly lucrative contract, but it also shores up Northrop Grumman's Aerospace Sector. Still, while this news is fantastic, there's a strong possibility that Lockheed Martin and Boeing will protest this award. This could then cause the GAO to recommend a recompete, which could result in Northrop Grumman's shares suffering in the short-term. If this happens, I know I'll be increasing my Northrop Grumman holdings as I think it's a great long-term investment. Consequently, if you're looking for your next defense investment, this is one story I'd keep close tabs on.