Northrop Grumman (NYSE: NOC) – market cap as of 23/09/2017: $49.02bn
Orbital ATK (NYSE: OA) – market cap as of 23/09/2017: $7.64bn
Introduction
On September 18, 2017, aerospace giant Northrop Grumman announced the acquisition of Orbital ATK for approximately $9.2bn, of which $1.4bn financed through debt. The deal, to be completed around mid-2018 subject to approvals, is the biggest in the defense sector in the past two years and comes as North Korea’s missile and nuclear weapons threats grow, heightening tensions with the US and its allies.
Following the acquisition, Orbital ATK will operate initially as a fourth business sector within Northrop Grumman. The deal will bring about considerable synergies thanks to increased capabilities for innovation and growth potential in multiple markets. Annual cost saving could reach $150m by 2020.
About Northrop Grumman Corporation
Northrop Grumman Corporation was founded in 1939 under the name Northrop Aircraft, Inc. and was eventually renamed Northrop Corporation in 1958. Following the acquisition of Grumman Corporation in 1994 the company, based in Los Angeles, changed its name to the current one. Falling behind The Boeing Company and Lockheed Martin Corporation, Northrop Grumman Corporation is the number three defense company in the United States. As of today, the company is made up of three business sectors. Aerospace Systems, which produces aircraft, spacecraft and laser systems, Mission Systems, which creates military radars and sensors for air defense, and Technology Services, which provides a variety of services to civil and defense platforms, as for example training for the military.
The company has been experiencing increasing revenues in the last years: it reported $24.5bn in revenues in FY2016 vs. $23.5bn in FY2015. In 2017, the revenue trend continues to be positive, with Q2 revenues reporting a $375m increase compared to the same quarter the previous year. EPS has also been subject to a substantial rise, surging to $12.19 in FY2016 from $7.81 in 2012.
About Orbital ATK
Founded in 1982, Orbital began as the project of 3 friends (David Thompson, Scott Webster, and Bruce Ferguson) that created the Transfer Orbit Stage, an upper stage (i.e. a part of a multi-stage rocket); soon enough, the company became a provider of space-related systems. On the other hand, ATK was founded in 1990 as an independent company and entered into the aerospace market through acquisitions (e.g. Hercules Aerospace Company, 1995). Orbital ATK was formed in February 2015 as a merger between the two aforementioned companies.
Employing c. 13,000 people, of which 4,200 engineers and scientists, the company is split into three business segments. Flight Systems, which accounts for 35% of total revenues, is specialized in space launch vehicles, propulsion systems and aerospace structures. Defense Systems, that produces missile products, ammunition and armament systems and accounts for 40% of sales. Space Systems, which covers mostly satellite systems and accounts for the remaining 25% of revenues.
Revenues for FY2017 are expected to be c. $4.6bn. Moreover, over the same period, the company expects to achieve an operating margin of 11.5-12% and a FCF of $250m to $300m.
Industry Overview
Following multiple years of weak growth, in 2017 the revenues of the Aerospace and Defense sector are expected to rise by c. 2%.
The commercial aerospace sub-sector is likely to benefit from stable global GDP growth, lower commodity prices (including crude oil) and strong passenger travel demand, especially in the Middle East and APAC. However, due to pricing pressure the sector’s total revenues are going to rise only marginally in 2017, by 0.3%. (for a more in depth analysis of this sub-sector click here)
The defense sub-sector will instead grow in 2017 at a much faster rate, c. 3.2%. Escalating geo-political tensions, terrorist threats and intra-national conflicts have created many opportunities for defense contractors and, in turn, this has given a boost to the A&D industry outlook. The US, which comprises by far the largest market for defense systems and equipment, will lead the way. First of all, thanks to its positive macro outlook, highlighted in particular by the unemployment rate, which fell to a 16-year low in May: a better economy can of course better support defense funding. Moreover, the planned upgrades of the ballistic system of the US armed forces has already lifted the equity of many companies in the sector. Finally, the Pentagon’s FY2018 budget proposal reflected a $54bn increase over the FY2017 figure and the House has already passed a $696.5bn defense policy bill for 2018, which exceed the nation’s statutory budged cap, and, if approved by the Senate, will result in a big sales boost for defense companies. Indeed, contracts with the Pentagon and the US Government are essential to the industry. The Northrop Grumman – Orbital ATK transaction involves two companies that in 2016 realized from Pentagon contracts c. $14.6bn in revenues, or about 50% their combined sales.
These developments come as some defense companies are already seeking vertical integration, in order to optimize their supply chain and bring repair revenues in-house. As a result, we are witnessing consolidation in the sector, which has already seen four mega deals in 2017.
Deal Structure
According to the terms of the transaction, Northrop will pay c. $7.8bn in cash, on top of the assumption of the target firm’s net debt of $1.4bn. Orbital’s shareholders will receive an all-cash sum of $134.5 per share, which represents a bid premium of c. 22%. JP Morgan will provide Northrop a senior, unsecured bridge facility of up to $8.5bn, and the expected pro-forma Net Debt/EBITDA is 3.1x.
Northrop expects the transaction to be accretive to both EPS and FCF per share in the first full year after closing, with expected pro forma sales of $29.5-30bn. The company also expects pre-tax cost savings of $150m by 2020, thanks to corporate and back-office integration, facility optimization and organisational alignment. The transaction implies a 14.58x EBITDA multiple, vis-à-vis a 24.12x multiple for the United Technologies-led acquisition of Rockwell Collins earlier this month, and a 14.57x multiple for the Rockwell Collins acquisition of B/E Aerospace announced in the past October. The deal is expected to close in the first half of 2018 and is dependent on regulatory clearing and approval from Orbital shareholders.
Deal Rationale
North Korea’s missile tests and threats have been populating articles’ headlined of the most popular newspapers and magazines over the recent weeks. The fear and concern toward the world’s troublemakers are growing, exacerbated by the advancements in missile technologies, and this seems to affect the defense industry. Indeed, the deal was agreed ahead of planned upgrades of US ballistic systems which are expected to drive up the demand for missiles, potentially benefiting defense companies like Northrop. As an evidence, share prices of some of the major incumbents in the industry already started rising (e.g. share price of Aerojet Rocketdyne up 16.1% to $33.89 in the last five days).
The two companies show complementary core capabilities. Northrop has indeed a strong presence in Aircraft, Cyber Systems and Radars & Sensors, among others. However, it lacks a launcher capability, for both missile defense and space operations, which Orbital will be able to hand over. Moreover, thanks to Orbital’s presence in Missiles & Munitions, Northrop will be able to expand its presence in the market at a time when many countries are increasing their military budgets. Finally, the deal would allow Northrop to cover Small Space Systems, in addition to the already served market of Large Space Systems.
Overall, the transaction is expected to deliver significant value creation opportunities thanks to revenues synergies, arising from new business opportunities (e.g. in missile defense and space), cost savings (expected $150m run rate by 2020) and operating synergies (e.g. customer coordination and manufacturing and supply chain).
Following the deal, Northrop Grumman will enjoy a solid investment grade credit rating. Moreover, the strong cash flow generation will support the company’s investments for profitable growth, near term focus on debt reduction and ambitious pay-out schedule. Indeed, Northrop is committed to a pay-out ratio of 30-40% of economic net earnings and share repurchases are also expected to remain an important component of capital deployment. The deal will also benefit Orbital ATK which will enjoy greater access to and coordination of investment resources, increased competitiveness in certain areas and, in general, an enhanced ability to meet customers’ needs.
Market Reaction
After the announcement of the transaction, Orbital shares soared up by more than 19% to $131.79 before the opening bell. In contrast, Northrop’s share price was unchanged in premarket trading.
Advisors
Perella Weinberg Partners acted as the financial advisor of Northrop Grumman, while Orbital ATK was advised by Citigroup.
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