Credit analyst says avoid Northrop Grumman as TRW bid turns hostile

By Ronda Fears

Nashville, Tenn., March 5 - The launch of a hostile takeover bid by Northrop Grumman (Baa3/BBB-) for TRW Inc. at the same price as its friendly proposal is flawed and makes a less than compelling case for Northrop, thus increasing the likelihood the company will need to do more in order to prevail, said Carol Levenson, director of research at Gimme Credit. Beyond that, the merger could boost Northrop's debt twofold and constrain its credit rating. Thus, she suggested avoiding Northrop, as well as TRW.

"Northrop is in a quandary at this point," Levenson said in a report Tuesday.

"The bid as currently structured is EPS neutral to Northrop shareholders, implying unless it finds some dramatic cost savings that don't have to passed on to the government, any higher bid would be dilutive, although a cash sweetener might not be. We're puzzled by reports that TRW bonds have rallied on visions of a higher-rated white knight, given the rampant uncertainty about the outcome. We would continue to avoid both names.

While the "bear hug" proposal seemed to promise TRW shareholders would receive stock worth $47/share, the analyst said Northrop's exchange offer is not a straightforward bid but a bid with a floor and a collar related to the trading levels of Northrop's stock. And Northrop's shares traded below the floor price on Monday, she noted.

More important, Levenson said, there's the vague but vital issue of what happens to TRW's automotive business, which may either be sold, spun off to shareholders or a combination of both - all of which could seriously impact the credit quality outcome.

"Moreover, Northrop says it doesn't have sufficient information about the automotive business to reflect the financial impact of its disposition in the pro forma financials, and also says it hasn't decided yet how much debt might be allocated to the business in a sale or spinoff, although it would be a substantial portion of existing TRW debt," Levenson said in the report.

"This is a pretty big question mark from a bondholder's (or a stockholder's) standpoint. The risk factors section of the documents notes how much debt the combined companies will be carrying ($10.3 billion as of March 1 - double Northrop's existing debt) and how this might impair Northrop's financial flexibility and place the company at a competitive disadvantage."

The Northrop proposal outlines in some detail the integration risk of this merger, the analyst said, adding that she believes it would be compounded by Northrop's recent string of major acquisitions and the hostile nature of this one. Although potential cost savings were mentioned, she said, they were not quantified.

"Pro forma fixed charge coverage, according to this document, would have fallen from 2.3x to 1.6x for the first nine months of last year, scarcely reflective of investment grade credit quality," Levenson said.

"However, we note the pro forma figures have not been adjusted to reflect unusual items, and the adjusted coverage ratio does not diminish by nearly this much. On the rewards side of the ledger, apart from an 18% premium, the rest of the justification presented for the merger is of the intangible, touchy-feely variety."

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