There's likely to be plenty of business buzz over the next five years as the defense industry, supercharged by soaring defense budgets, goes on a deal-making spree. In the latest move Northrop Grumman is attempting to acquire TRW - and TRW's space business. Northrop Grumman initially made an unsolicited $5.9-billion bid that TRW didn't accept; Northrop Grumman then tried a hostile takeover by offering TRW shareholders $47 per share.

It's part of Northrop Grumman strategy in recent years of branching out of aerospace to become a full-spectrum defense contractor. In a speech last March, Chief Operating Officer Ron Sugar said that a decade ago, "The defense industry was in free-fall, Northrop Grumman was a company that was largely dependent on the B-2 bomber and some fighter plane work, and it wasn't clear at all that the company had a long-term future, and what was decided was that the future world was going to require improvement in sensing, intelligence, surveillance, reconnaissance, the ability to project power at great distances and precision strike, and an increasing dependence on fiber warfare and the whole cyber sphere as an environment of warfare..."

Among the company's latest acquisitions have been Litton and Newport News Shipbuilding, which Sugar said has transformed the company from an "Air Force house" to one whose largest customer is the Navy. Scooping up TRW is a logical move that's good  "if they don't pay too much," said Todd Ernst, an analyst for Prudential Securities in New York. A Prudential research report concluded that "TRW's space, aeronautics, and IT businesses are highly complementary to Northrop's businesses, but are also additive, especially in key of defense space and missile defense capabilities, in our view. There also appears ample opportunity to create synergy savings and improve the margins of TRW's businesses, some of which are at the low end of the defense industry range, we believe."

Defense Industries' 'Sweet Spot'

If the deal goes through, Northrop Grumman will be able to use TRW to enter lucrative areas such as missile defense. The Prudential analysis said, "Approximately $5.3 billionâ??about 38 percentâ??of TRW's 2001 revenue was from aerospace and defense businesses, which include complementary capabilities such as UAV development and production, C4ISR, government/defense information systems, and aeronautical systems. Additive capabilities [for Northrop Grumman] include missile defense, laser, and space communications that are in the 'sweet spot' of where future defense spending will grow most rapidly, in our view."

Naturally, the deal has its risks. Some of TRW's projects are "high-risk development programs, such as airborne laser, space-based laser and SBIRS [Space-Based Infrared Systems] Low, where there is some question as to if and when they will enter production," said Ernst. In addition, Northrop Grumman may already be stretched thin as it digests its acquisition of Newport News Shipbuilding.

Yet the biggest hurdle to Northrop Grumman's offer is that TRW shareholders aren't buying it. On April 17, they rejected an Northop Grumman offer of $53 per share of stock. Providing defensive support for Cleveland-based TRW is Ohio securities law that impedes hostile takeovers.

"Northrop Grumman's offer is clearly an opportunistic attempt to acquire TRW's premier franchise," said a statement by chairman Philip Odeen [see separate article, page 12]. "In particular, the current planned increases in government defense spending are expected to benefit many technologies and arenas where TRW's space, electronics and systems businesses are a leader."

TRW's board of directors advised shareholders to reject's Northrop Grumman's because:

• Northrop Grumman's offer grossly undervalues TRW's businesses and opportunities;
• TRW's independent financial advisors, Goldman, Sachs & Co. and Credit Suisse First Boston, concluded that the offer is inadequate to the company's common shareholders; and
• Northrop Grumman's offer is highly conditional, which results in significant uncertainty that the offer will be consummated.
• In the battle for the hearts and minds of shareholders, TRW's board of directors have responded to Northrop Grumman's bid by touting their own plan to boost the company's financial picture. The plan calls for:
• Accelerating TRW's debt reduction program by aiming for a $1.6 billion to $2 billion reduction in 2002, on top of the nearly $1 billion in 2001; and
• Spinning off the company's automotive operations into an independent, publicly traded company in six to nine months.

TRW Acknowledges Other Suitors

Even if Northrop Grumman's offer falters, other companies could try to scoop up TRW. A TRW statement acknowledged interest from other parties: "TRW and its independent financial advisors have received unsolicited indications of interest from third parties with respect to a transaction with the company as a whole which would involve a separation of the Automotive business. In addition, the company has received unsolicited indications of interest from third parties with respect to each of its operating businesses as well as a private equity investment in the entire company." In addition, TRW said it has begun "preliminary negotiations for a potential sale of its Aeronautical Systems Group."

Some prospective suitors that have been mentioned include Lockheed Martin, Boeing and U.K-based BAE Systems. High stock prices give companies leverage for acquisitions, and Northrop Grumman shares dipped below $80 last August before roaring back to a post-9/11 high of $118.89 on Feb. 21. As of April 15, shares were fractionally above $113.

However, Ernst said, there's a question whether any of these others suitors are really suitable. Northrop Grumman. Lockheed Martin would find it difficult to face more debt, he said, while both Lockheed Martin and Boeing would face more regulatory hurdles than Northrop Grumman. As for BAE, "we have encountered serious doubts among our most trusted sources that the UK-based company might be allowed to seriously bid on part of America's space-related family jewels."

More Deals on the Way

Meanwhile, other deals in the defense industry are in the offing. Ernst sees a possibility of a major deal among The Big Five contractors, which include Lockheed Martin, Raytheon, Boeing, Northrop Grumman and General Dynamics.

Yet the real hot spot will be the numerous medium- and small-size aerospace companies. Since Sept. 11, stock prices for smaller public companies have soared. Take FLIR Systems, a Portland, OR-based maker of imaging equipment, whose share price surged from just over $7 in March 2001 to a high of $59.50 on March 6 this year.

This has spurred a herd of privately held companies to ride to Wall Street. Since Sept. 11, there has been a spate of Initial Public Offerings (IPOs). In February, Integrated Defense Technologies, a Huntsville, AL-based maker of electronic systems for platforms such as the F-16 and C-17, went public. Anteon International, a Fairfax, VA-company with fingers in the intelligence and missile defense pies, went public in March. In the opening hours of its debut, Anteon jumped 17 percent.

Soaring prices give these companies the cash to buyâ??or an inducement to sell. Wall Street has seen a spate of privately held companies that have decided to go public, as Mantech, Anteon and United Defense Industries. Philip Finnegan, an analyst for the Teal Group in Fairfax, VA, expects to see other defense contractors divest operations as they focus their operations on selected areas. TRW already plans to spin off its auto parts operations, while Raytheon has divested its aircraft integration systems unit.

L3 Communications, a medium-sized maker of communications and surveillance gear acquired the unit for $1.13 billion in cash. The cash infusing the defense industry is certain to encourage a wave of acquisitions as buyers and sellers capitalize on high share prices. This is likely to consolidate the defense industry into the Big Five plus a narrower base of smaller firms.

"Instead of the pyramid we have now, you will see a rectangle," said Jon Kutler, chairman of Quarterdeck Investment Partners in Los Angeles.

L3 Aggressively Seeking Buys

Several analysts cite L3 as a prime example of a company that is aggressively hunting acquisitions. L3 has scooped up more than 24 companies in the past five years. In January it acquired SY Technology, a small company whose business includes missile defense. "SY Technology is an excellent acquisition for L-3 because it broadens our base of capabilities within the missile defense market," said L3 CEO Frank Lanza at the time (see sidebar).

A major incentive for this is that the highest profit margins lie in delivering complete systems rather than components. "Smaller players will find it more difficult to compete against the larger companies," said Finnegan, who expects to see smaller companies coming together to offer integrated systems.

Financial analysts tend to be wary of naming specific stocks that might be acquired. But Finnegan did note that intelligence is a likely sector for consolidation because of the number of small firms making surveillance gear.