Credit analyst sees little upside in Northrop Grumman on TRW buy

By Ronda Fears

Nashville, Tenn., July 2 - Defense juggernaut Northrop Grumman Corp.'s so-called success at offering a winning bid for TRW Inc. leaves much to be desired and Carol Levenson, director of research at Gimme Credit, sees little upside in Northrop as a result.

Northrop (Baa3/BBB-) announced it had finally reached an agreement to buy TRW (Baa2/BBB) for $7.8 billion in stock and an unspecified amount of assumed debt.

"We've been following this takeover battle from Northrop's first hostile overture, and while the takeover game appears to have been well played by TRW, Northrop and its bondholders probably got lucky when nobody else with a stronger balance sheet was eager to buy all of TRW," Levenson said in a report Tuesday.

"So yes, the fact the final offer remains an all-stock one is good news on the credit front, meaning our worst fears, that Northrop would be forced to sweeten its bid with cash, thus practically ensuring the loss of its investment grade status, did not come true."

The bid that prevailed is some $1.7 billion, or 28%, higher than Northrop's initial bid, she pointed out.

"Management tried to make the case that the higher bid actually results in a better credit quality outcome since more equity will be added to the combined balance sheet, but we're not buying this argument," Levenson said.

"In fact, the higher price means a great deal more goodwill will be added to Northrop's already sizeable stash, rendering book leverage, the ratio management would like us all to consider, a less meaningful number."

The other pro forma aspects of the merger agreement remain about the same as with Northrop's prior bid, with cash flow to debt before the automotive spin-off only in the high teens, the analyst said.

Neither cash flow nor free cash flow will change by much from the previous bid, aside from the additional dividends paid on the incremental shares.

The only real financial change is the $50 million to $100 million in potential cost savings Northrop discovered when it was allowed to study TRW's books, she said.

The same information vacuum since Northrop's first bid remains, she said, and that is, what exactly are the plans for TRW's automotive business and its asbestos liabilities.

"Here's where Northrop management was vague to the point of being evasive. Northrop gave out pro forma earnings estimates for the combined companies and promised double-digit growth in EPS," Levenson said.

"But management refused to elaborate on the assumptions underlying these numbers, especially with regard to the assumed disposition of TRW's automotive business."

TRW had $5.7 billion in debt on its balance sheet at the end of the first quarter, she said, but the pro forma leverage number does not include anywhere near this amount of debt.

Northrop plans to sell or spin off TRW's automotive business at closing, allocating an "appropriate" amount of debt to the unit and, if it's spun off rather than sold, presumably some equity.

"Management declined to say just how much debt is appropriate, hinting the $2.8 billion in TRW's own spin-off plan sounds like a good number, or which bonds might go with the weaker automotive operations," Levenson said.

"It is this crucial and far from certain transaction that will bring Northrop's book leverage down to the promised level of 30% or lower."

This means there is more than the usual amount of integration and execution risk involved in this merger, the analyst said.

"In the best case for Northrop bondholders, the company will remain marginally investment grade, but TRW bondholders appear to lose whether they remain with the combined companies or go with the automotive business," Levenson said.

"We see little upside here."

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