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Northrop Grumman (NYSE:NOC) is trading higher by more than 3% on Wednesday morning following news that the company will consider spinning-off its shipbuilding business. On Tuesday, the defense contractor announced that it will be shuttering one of its seven shipyards, the Avondale facility in Louisiana, in an effort to reduce costs and consolidate its Gulf Coast shipbuilding operations in Mississippi. At the same time, Northrop has hired Credit Suisse (NYSE:CS) to advise them on potentially selling the entire unit which was responsible for sales of $6.2 billion last year. Northrop had seen supplying the US Navy with ships and aircraft carriers as core to their business, but they are reviewing that strategy as the Pentagon has said it will focus priorities on smaller, more nimble weaponry.

As Northrop attempts to conform to new guidelines from the Pentagon, CEO Wes Bush sees little remaining synergies between shipbuilding and the rest of their business. Profit margins for the Navy’s largest supplier of ships had slipped to just 4.8%, or less than half of competitor General Dynamics (NYSE:GD). Already one of the lowest profit margin segments of its business, the reduction of costs and potentially $4.6 billion that could be garnered from a sale of the shipbuilding unit has to be at least intriguing to Northrop’s management and shareholders.NOC

The decision to wind down the Avondale facility by 2013 is a difficult one for the already struggling Gulf Coast economy as it will affect about 5000 people currently working at the facility. The company said that the consolidation of operations in Pascagoula, MS may create some jobs, but that provides no solace to those affected. As saddening as it may be, the move makes financial sense and it is in the best interest of shareholders. The most profitable part of the Northrop’s naval vessel building operations is its nuclear submarine business which are made in Virginia. Northrop cannot ignore the directives being issued by the Pentagon, and consolidating its two Gulf Coast shipyards is essential to reducing costs. The LPD-17 San Antonio-class ship (the one made at Avondale) has no work left in the pipeline after the ones already in construction. The company will take a $113 million charge in the second quarter, which along with a $296 million tax adjustment will net the company an additional 73 cents in earnings per share.

Northrop is slimming down on some of its least profitable operations, and could possibly spin out the entire unit which brought in just under one-fifth of revenues last year. We think this move makes sense if NOC can get somewhere near the $4.6 billion estimates that have been thrown out. From a historical valuation perspective, we believe Northrop is priced rather attractively, in fact we upgraded NOC to Undervalued as of this week’s report. For example, the company has historically fetched between 11.7x and 15.5x times cash earnings per share, but it currently trades will below that level at a multiple of around 9.8x. Similarly, the current price-to-sales ratio of .49x is equal to the low end of its range established over the last ten years (.49x to .72x).

The stock has been hit hard in the recent correction falling roughly twice as badly on a percentage basis than the S&P 500 since the April highs, and we view this situation as a buying opportunity. Detractors will point to the possibility that government spending on defense is likely to be flat or even slightly down with current budgetary pressures. However, Northrop is taking the necessary and often unpopular steps to lower costs and come into line with the new Pentagon guidelines. We think at the current valuation much of the risk of its business shrinking has been effectively priced-in. In closing, Northrop is a great stock and should continue to see long term growth as the world will remain a dangerous place.

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Source: Northrop Grumman: A Bullish Case for Defense