Northrop Grumman Earnings Preview: Impact of Budget Cuts

If you're a defense contractor like Northrop Grumman (NOC) that depends on the U.S. government for more than 90% of your revenue, talk about cutting the budget deficit gets a little prickly because it inevitably turns the spotlight on defense spending.

A huge chunk of the federal budget goes to mandatory spending -- about two-thirds of the total -- which includes entitlements such as Social Security, which the government must pay once certain criteria are met. The rest is
so-called discretionary spending (which must be decided in appropriations bills), and the largest chunk of that goes to defense.

The costs of defending this nation certainly add up -- annual U.S. military expenditures exceed those of the next 16-biggest-spending nations combined, or 46.5% of total world military spending -- especially with two wars in progress. And that doesn't even include spending on Homeland Security, Veterans Affairs and maintenance of nuclear weapons. (Not a place to cut corners.)

Adjusting the Strategy

However, with a record U.S. deficit of $1.47 trillion forecast for 2010, the administration is looking everywhere it can to cut spending, and the defense budget isn't escaping scrutiny. As a result, the companies that the U.S. hires for technological and defense expertise, such as Northrop Grumman, are adjusting their game plans.

Recently, Northrop -- whose main products are its aerospace, electronics, shipbuilding and information systems -- announced that it's going to close down its Avondale, La., shipyard in 2013 in an effort to consolidate its Gulf Coast shipbuilding business. In addition, the company is looking to sell or spin off the entire shipbuilding part of its empire.

This effort will undoubtedly hurt the company's bottom line in the near term. Northrop's shipbuilding business has generated a steady revenue stream -- accounting for $1.524 billion, or 17%, of a total $8.957 billion in total sales and service revenue in the second quarter of 2009 -- and the final cost of the plan will be significant. Still, shipbuilding is a crowded field, and management notes that it produces limited synergy opportunities with the rest of the company, and the competition for government contracts minimizes the potential profit margin.

A Sustainable Business Plan

The move will allow Northrop Grumman to concentrate on the more secure parts of the U.S. defense budget. These include manned and unmanned aircraft programs, both of which are critical to the military. In the long run, a renewed focus on the services that are unlikely to be pared in government budget cuts is a more sustainable business plan.

In time the success or failure of this plan will become apparent, but Northrop's July 29 second-quarter earnings report will probably reflect only the short-term results of the shipbuilding consolidation. Analysts expect profit between $2.13 and $2.27 per share, compared to $1.21 a year earlier. Included will be an estimated pre-tax charge of $113 million for the consolidation plan.

While it's a certainty that citizens will have to pay taxes, who will end up getting to spend them is a more complicated question.