Analysis of Northrop Grumman's Takeover of TRW

Another interesting feature which was quite surprising was redundancy. While a typical merger often implicates cost savings and thus inevitably reducing the workforce, the Northrop-TRW merger actually increased the overall workforce. Indeed Northrop’s CEO Kent Kresa wanted to reassure on this point: “Northrop said it had no plans to lay off TRW workers in Southern California, because there is little overlap. Kresa said that with the country focused on beefing up homeland security and military, employment at TRW facilities in the area could grow.” A final remark that should be made regarding the interesting traits of the takeover is that the whole deal was much a surprise. Prior to the TRW deal, Northrop was actively engaged in acquiring other companies. In 2001 it had acquired Newport News Shipbuilding and Litton Industries Inc, public belief was that it would take a while for Northrop to digest these mergers, but surprisingly, on February 22, 2002 Northrop stroke again. It should also be noted that 2002 was a particularly quiet year for merger activity, hence this deal further surprised the public.

2.1 Timeline of Events

2.2 Company Description 

The following section briefly describes the two companies involved in the deal and the activities in which they endeavour.

2.21 Thompson-Ramo-Wooldridge (TRW Inc.)

The company’s main activity were to provide advanced technology products and services. The group was also into research and performance of system engineering. It used to operate in four segments, namely: Automotive, Systems, Space &Electronics and Aeronautical systems. The operating facilities of the Group were located in 25 different countries. The customers of TRW Inc included U.S Government, Department of Defence, NASA and major car manufacturers. 

2.22 Northrop Grumman Corp.

The Group's principal activity is to assemble and sell innovative products, services and solutions in defence and commercial electronics. The Group operates in the Electronic Systems, Ships, Information Technology, Integrated Systems, Mission Systems and Space Technology sectors. The Electronic systems segment manufactures defence electronics and systems and airspace management systems. The IT segment provides advanced information technologies, systems and services. The Integrated systems segment produces airborne early warning, electronic warfare and battlefield management systems. Ship systems products include sealift transport ships and double-hulled oil tankers. Mission Systems integrates complex, mission-enabling systems for government, military and business clients. Space Technology develops a range of systems at the leading edge of space, defence and electronics technology. 

3.0 U.S Aerospace & Defence – The sector explored

The defence industry is strikingly atypical for a variety of reasons. Unravelling  the sector is going to be crucial in order to understand the merger and to assess it later on. The defence business is far from a perfectly competitive one. In fact, it lacks almost all of the traits of perfect competition. Indeed, “defence is driven by non economic forces.” Rather, it is influenced by socio-political events such as wars and terrorist attacks. Interestingly, it is one of the few industries that behaves adversely to the market. This is due to the fact that the population perceives the events that boost this industry (and we should say, not unjustly) as negative incidents (e.g. September 11th ), likely to influence negatively on the overall economy. Additional explanations relating to the inconsistency of defence to the overall performance of the economy are to be searched in the assumptions underlying perfect competition.

First of all, an obvious, but paramount feature: “it is about the only large sector that sells almost exclusively to governments.” The number of sellers too, is highly limited and the few firms that operate are extremely large and powerful. This leads to firm collusion and arbitrary control of price, making it hard for new competitors to enter the market. “Defence is a bit like cottage industry, says   Sir Richard, in that the number of customers is small, everybody knows everyone else and everything is connected. “If Vance (Coffman of Lockheed) is in London, I’d be upset if he doesn’t call round for a cup of tea”, he says.” Further, “in defence contracts are few but huge, and customers are few but powerful, so market forces do not work. “Defence is not normal.” This point is particularly relevant as it depicts a fundamental requirement for a company to succeed in obtaining contracts from the Government. That is: It must be large in order to provide an entire range of products. This should be understood in the light of transaction costs. Imagine how many companies the Government would have to appoint in order to supply them with the entire range of weapons they require, if the degree of product specialisation would be high (as it would with very small firms). The search, negotiation and bargaining costs would be very high. A better option would be to have a smaller selection of suppliers that could provide them with all their needs. Clearly, these are not the best conditions for freshly started small businesses or firms seeking organic growth. On the contrary, weak firms are likely to be taken over by larger further whom are seeking growth or catching up upon their major peers. This is eloquently summed up in the figure below taken from a special report in the economist.

3.1 Big Players

Retaining a knowledge of the main competitive forces and their weighting within the U.S defence industry  is a crucial requirement for appreciating the rationale for the merger. It will also provides us with a benchmark to measure success. That is, comparing gains in market share will give us a powerful tool to evaluate the takeover.

The table below provides data regarding the division of market share (prior to the takeover) between the major companies in the sector.  Data is given for both the defence sector in particular and the overall aerospace and defence industry. This market share is calculated as a percentage of the total sales of the selected companies for the sector/industry.  The charts that follow visually illustrate the information.

   

4.0 Northrop’s Motives

As can be seen from the chart above, before the merger Northrop ranks an unsatisfactory 6th and 9th position in the defence sector and the overall aerospace & defence industry respectively. Northrop falls significantly behind major competitors such as Lockheed Martin, Boeing and Raytheon. This gloomy situation was brought about by two major events. Firstly, Northrop “was excluded from the contest to build America’s Joint Strike Fighter – at over $200 billion the biggest-ever defence contract (it was eventually won by Lockheed). Then it was told that the air force did not want many of its B-2 bombers. That left it trailing a weak fifth behind the four leaders.” At this stage, being aware of the characteristics and trends of the sector, one might expect Northrop should have been acquired by one of the leaders. Indeed this was attempted by Lockheed Martin in 1998, although the merger was blocked because of competition concerns. This gave Northrop a clear message. Either it would adapt to the sector  or eventually it would go bust. The first option was chosen, Northrop acquired four companies in three years. It follows that the principal motivation for acquiring TRW Inc. was to enable them to compete more efficiently with the other leaders of the sector. More specifically, recent fighting’s in Afghanistan confirmed the effectiveness of modern technological weapons and warfare techniques. Areas in which TRW was particularly brilliant. “A TRW buy would fill major gaps major gaps in Northrop’s business since the company lacks exposure to missile defence and military space.” 

4.1 Good fit or Fake Jewels?

Northrop surely undertook a careful cost/benefit analysis before going forth with the acquisition. Considering it raised it’s offer three times it is presumable they believed those benefits were much greater than the costs. Although certain other factors might indicate those benefits were not that great. A detailed analysis will be provided later on while assessing the takeover. For the meantime, a few factors should be noted. TRW was particularly strong in areas where Northrop was not active but needed strongly. Northrop simply lacked the knowledge in the area they wanted  to develop, therefore they had no other option than acquiring a company to fill their gaps. Further, TRW had not been performing very well lately, meaning it was destined to be taken over eventually. If Northrop didn’t acquire it, a competitor would have, leaving Northrop further behind. Finally, Northrop’s initial offer came in a period when TRW’s stock price was remarkably low as they had just lost their CEO. If their initial offer was accepted, Northrop would have done an exceptional deal.

Negative factors regarding the takeover emerge on several grounds.  The most blatant is probably the price paid for TRW. Price is consistently an issue in merger activity. Acquiring companies always pay a premium for buying a company, this is obvious as the target must have an incentive to sell their company. However, this premium is given in the expectation that the synergy obtained from the merger will be greater than the price paid. This is not always the case. Northrop paid $7.8Bn for TRW, perhaps it was too much. The real bid premium (calculated later) will assess this. Other difficulties regarded the assumption of more debt (about $5Bn) and diluting current Northrop shares. A final problem regarded the fact that Northrop was interested only in some of TRW’s activities. Spinning off un-wanted business complicated the transaction. As a matter of fact, other companies competing with Northrop for TRW’s attractive businesses found this a key deterrent.

4.2 Buying TRW: How and How much?

Valuating TRW was by no means an easy task. However, the fact that Northrop raised its offer for three times symbolizes that Northrop greatly valued the expected synergies. Of course, even their final offer, 40% higher than their initial one still represents a bargain according to Northrop. The valuation process was greatly aided by reviewing TRW’s books. This allowed Northrop to establish whether there were any major hurdles within the target.

The means for the acquisition was never questioned. All the offers tendered by Northrop were always in stock. The reason for this was that Northrop was not willing to put even more pressure on its cash flow. This was due to the fact that Northrop was going to assume a substantial debt from TRW, to be added to the already high debt levels of Northrop. Borrowing cash for the acquisition would have increased the debt level even more.

5.0 TRW’s Motives

TRW was quite surprised and unhappy to receive an acquisition offer from Northrop. In fact, it commented as follows: “TRW finds it regrettable that Northrop Grumman has chosen to make this proposal immediately following the unexpected departure of its former chief executive officer, David Cote, and an aberrationally low stock price that resulted.” The main reason for rejecting the first offer was that they believed Northrop was not offering enough compared to the costs they were going to bear. Mr. Odeen, TRW’s CEO replied to Mr. Kresa (Northrop’s boss) stating that “Northrop’s offer grossly undervalues TRW’s business.” TRW’s board surely genuinely believed that their company was worth more. However, after observing the succession of events, it is clear what TRW really wanted, that was: a bidding war. This would ensure they received the highest possible price for their company.  This was in fact what happened. TRW finally agreed on a ‘friendly’ merger at a price of $60 a share.

5.1 Defending The Company

In order to protect their company, and obtain the highest possible price for it, TRW adopted a few classical anti-takeover measures. The major defence technique adopted (which was only partially carried out as its fruits quickly developed) was to split up the companies into many smaller ones. This would ensure greater efficiency, raising stock prices and thus reducing the risk of a takeover. “Odeen unveiled a program of asset sales, debt reduction, and a spin-off of the automotive unit by tear end.” Additionally, TRW heavily relied upon Ohio’s Law’s which are particularly protective of companies targeted for acquisition.

5.2 Defence Tactics, Successful?

Considering that TRW finally conceded to Northrop, one might believe TRW’s tactics were unsuccessful. Nevertheless, the main reason for planning to split TRW, was not to rescue it. If the board of directors was really seeking to protect the company, it would have spun-off the attractive business, the technology operations. Why? A spin-off (of the attractive business) “has the potential to become a tax-based poison pill.” This is due to U.S federal rules. “If the spin-off is engineered deftly in the face of a hostile bid, it could trigger a huge and unpalatable tax bill for a buyer.” The reason for TRW’s plans were to be justified (as mentioned previously) in the hope of launching a bidding war. Only Northrop was willing to buy TRW entirely in order to obtain the technology operations; yet many were interested in TRW’s “jewels”. By selling the unattractive businesses  TRW would have been able to “clear the way for an auction designed to generate the highest possible price for its remaining technological assets.” This tactic was so successful that as soon as TRW announced this plan it received four other offers. When it divested its aeronautical unit (one of the unwanted businesses) it received a third offer from Northrop, fearing it was going to lose the deal.

6.0 Share Price Performance

Analysing trends in share price performance is one of the main tools required to assess and explain the various steps in the merger. It will become clear that the share price performance of both companies is very closely related to the events regarding the merger. A requirement that is fundamental in interpreting share price performance is the Beta coefficient. That is, how responsive are the company’s shares to changes in the overall market (in our case measured by the S&P 500). The Beta for Northrop is 0.05. The Beta for TRW will be assumed to be 0.3 as it is no longer available in financial databases. These are very low Beta values, meaning they are not very sensitive to market changes. This is not surprising as we have established that the defence industry is not driven by market forces. TRW’s beta is considered slightly higher as the company also operated in activities other than defence.

6.1 Comparing Share Price Performance Of The Target & Acquirer

The first graph compares the fluctuations in the prices of TRW’s and Northrop’s stocks over a period of  7 months (From 1 Dec. 2001 to 15 Jul. 2002). This should aid us in describing some typical “merger-related” trends in share price movements during a takeover contest. These are particularly important as they represent investors views on the merger.

The main reasons for movement in prices are provided in the diagram. One addition that should be made is the rationale for the typical inverse relationship between the acquirers and target’s company stock price. That is, investors of the acquiring firm usually believe their company is going to overpay the target causing losses (an investment with negative NPV) hence their willingness to sell their shares. On the other hand, the target company is going to receive a high premium offer meaning their shares will be worth substantially more.

6.2 Comparing Against The Market and The Sector

The analysis described above is certainly valid and realistic. However it fails in one big respect. That is, that the interactions are assumed in a “ceteris paribus” environment. Clearly, the firms are not operating in some sort of vacuum, they are affected by market conditions (actually, the beta will tell us this). The purpose of the graph below is to determine whether the events we claim are causing the shifts described in section 6.1 are actually caused by these events; or if they are caused by changes in the sector or the market. Furthermore assessing against the market will be one of the key tools for determining the success of the takeover. Unfortunately TRW data is not in databases anymore and hence it is not included in the graph.

Comparing Northrop With The Market And The Sector

The graph compares Northrop to the market (measured by the S&P 500, the index of which it is member) and the specific aerospace and defence index. Obviously, as confirmed by the graph Northrop is more closely related to the sector than the overall market. The low Beta value explains why Northrop is behaving adversely to the market index, illustrating how the sector and the companies within it are not affected by market forces. Instead, events such as September 11th and the war in Afghanistan are dragging the industry up. The fact that the A&D index is increasing in late Feb. 2002 (and Northrop is related to this index) proves that the decrease in Northrop’s share price registered is entirely dependent on the announcement of the takeover. Also, the volume of shares traded is astronomical. Contrastingly, and here is where we were deceived from the previous graph, the decrease in July 2002 was not only caused by takeover events -the whole industry was down.

7. Corporate Governance Issues

Throughout the investigation so far we have touched upon many corporate governance issues although not specifically describing them. When discussing corporate governance issues we are essentially addressing one question: have the companies acted in the shareholders best interests? A clear picture emerges. TRW, through their cunning defence measures managed to receive an offer 40% higher than  the initial one. The result is remarkable. TRW’s comments as follows: “this is a real win for TRW shareholders. For the past several months, TRW’s board has undertaken a comprehensive strategic review with the sole objective of enhancing shareholder value. This transaction achieves that objective.”It does not automatically follow that Northrop has destroyed shareholder value by overpaying for TRW. This can be ascertained only after analysing financial figures discussed later.

8. Assessing The Takeover – Increases In Market Share

The issue to consider when determining the extent of success of the acquisition is to evaluate whether the objectives were met. Given that Northrop’s goal was to become more competitive, new figures on market share will be an initial tool to establish this.  The article mentioned previously from The Economist shows this very well.

The takeover has shifted Northrop from 6th to 5th in the defence sector and from 9th to 2nd in the overall sector. This graphs speaks for itself.

8.1 Assessing The Takeover – The Real Bid Premium

Calculating the real bid premium is another very important instrument to establish if TRW was a bargain. The real bid premium calculates how much more the company is paying for the target than the market valuates it, before speculation occurs. This premium is calculated with reference to changes in the market index.

Calculating The Real Bid Premium

The figure might look alarming. Yet, it lies well within typical merger premiums, particularly hostile ones. These premium rates tend to fall between 20-100% of the pre-bid price. Further, the figure is calculated against an index to which TRW is not very correlated; meaning that the expected TRW share prices should have been expected higher, lowering the premium rate.

2. Assessing The Takeover – Financial Ratios

Financial ratios are another key requirement to illustrate the extent of success of the merger. We shall look at a series of key ratios in order to continue our analysis of the success/failure of the merger. NB. All data shown in this section is obtained from Thomson Financial Database.

8.21 P/E Ratio

Observing the price/earning ratios is always a first step in judging the financial performance of a company. It is a crucial ratio as it is a market assessment of the firm. Essentially, it tells whether investors like the company or not. The P/E ratio is widely used as it provides insight into valuation using an easily understood measure: earnings. P/E ratios are not that meaningful on there own, they work better if compared to other companies within the same sector.  This is shown in the table below.

The table shows that Northrop is not viewed as positively as the other companies in the sector. Meaning that Northrop still has work to do if it wants to join the lead with the other top companies.

8.22 EPS

Earnings per share is another largely used profitability ratio. It calculates how much of a company’s profit each share receives. High, or increasing EPS are a good sign as it indicates a company is healthy and generating profits. The table below and the graph that follows shows EPS past and future figures.

Forecasted EPS for Northrop Grumman

The figures show rising EPS since the merger took place, indicating Northrop’s profits are likely to rise. This tool judges the acquisition positively.  

8.23 Return On Net Assets

R.O.A is another key profitability measure. It calculates the amount of profits earned (before interest ant taxes), expressed as a percentage of total assets. Clearly, the higher the number the better. Below is the data for Northrop.

The figures, despite increasing after a slump should still be adjusted. Since Northrop acquired a substantial amount of assets from TRW, clearly, new profits are being compared against a larger number (the value for total assets has increased), inevitably reducing the R.O.A percentage. Nevertheless the figures should be higher. The merger has definitely not helped this measure.

8.24 Gearing

Viewing the changes in the gearing level of the company will provide very useful in assessing the merger. Indeed, many of the concerns regarding the acquisition emerged on the grounds that Northrop would become to debt entrenched. The debt/equity ratio, which measures the proportion of a company's long term liabilities to its equity will illustrates this.

The figures are much a surprise. However, the explanation for this (which Northrop had planned) is that the spin-off of the unwanted businesses (like TRW’s automotive section) raised a substantial amount of money which greatly aided the debt reduction.  

8.25 Current Ratio

The final ratio we will discuss is a again, a widely used one. The current ratio “gives you a sense of a company's ability to meet all short-term liabilities with liquid assets, should it need to. A ratio of 1 implies adequate current assets to cover current liabilities, and the higher above 1, the better.” 

The ratios do not show a great deal of variance throughout the years. Although there is a decrease between 2002-2003 suggesting a negative impact of the merger.

3. Assessing The Takeover – Long Term Market Comparison

We have previously compared Northrop to the market index and its sector. However, this was done for a focused time frame and for the purpose of relating the events throughout the takeover battle and the price shifts. In order to assess the  success of the merger, under investors view point, a long-run comparison should be performed against the sector (not the S&P 500 as it is not a good benchmark).

Long Term Market Comparison

The graph clearly shows that Northrop has caught up all of the gap against the sector index owing to its acquisition strategy carried out throughout the years. Even though from 2003 it starts to slightly fall behind, perhaps due to merger integration lapse.

8.4 So, Good Fit or Fake Jewels?

An apprehensive analysis of various factors seem to give evidence that the merger was beneficial. The financial analysis is fairly neutral, shareholder value has not been greatly damaged. The market share gains and market performance are definitely encouraging, likely to favour capital gains for shareholders in the future.

9. Academic Theory

Throughout the investigation we have described where a typical “merger-related” trend  was occurring. It is therefore unnecessary to carry out an extensive analysis to establish how well and why this case reflects empirical evidence on mergers & acquisitions. Although it is worthwhile recapping on a few typical trends. First of all, a principle motive for acquiring new companies is to gain market share. Secondly, when a bid is announced the acquirer’s share price typically decreases and the target company’s price increases. Thirdly, the acquirer always has to pay a substantial bid premium to convince the target company to sell its shares. Finally, when the merger is completed, the new company will suffer a depressed stock price for a while owing to integration costs.  

10.  Bibliography

 Books

• Arnold G, Corporate Financial Management,  2nd Edition, Prentice Hall 2002

 Journals & Databases

• Business Week Online, “From retirement to a takeover battle” (March 25, 2002)
• Carson I, The Economist, “Odd industry out” (July 18, 2002)
• Crock S, Palmeri C, Business Week online, “Northrop’s Risky Flight Path”,  (July 29, 2002)
• Financial Times Online, url: www.ft.com
• Pae P, LA Times, “TRW Board agrees to takeover by Northrop”, (July 2, 2002)
• Sikora M, Business Week Online, “ TRW Fights a Hostile Offer With a Nuanced Breakup” (May 1, 2002)
• The Economist, “An Industry Reinvents Itself” (July 20, 2002)
• The Economist, “On Manoeuvres” (July 4, 2002)
• The Wall Street Journal
• Thomson ONE Banker, Financial Database
• Yahoo finance database (available at url: http://yahoo.finance.com)

 Websites

• www.cndyorks.gn.apc.org
• www.cnn.com
• www.forbes.com/tools/glossary/

• www.google.com
• www.hoover.com
• www.northropgrumman.com
• www.thedeal.com
• www.trw.com
• www.usatoday.com

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