Thursday, March 11, 2010

The Only Company Left Standing in a $40 Billion Battle

Know when to hold 'em, Kenny Rogers taught us.

Know when to fold 'em. Know when to walk away.

And know when to run.

Northrop Grumman CEO Wes Bush evidently knows the song. Mr. Bush has decided to fold and walk away, if not run, from the U.S. Department of Defense's multibillion-dollar contest to build the Air Force's new tanker.

Northrup Grumman (NYSE: NOC), one of the top defense contractors in the world and the third-largest in the United States, announced Monday it was abandoning its bid for the new plane, clearing the way for rival Boeing (NYSE: BA) to win the $40 billion contract.

Boeing shares rose slightly on the news, though the stock is a clear winner so far this year. Shares are up +25% in 2010, utterly thumping of the Dow Jones Industrial Average's +1.4% year-to-date gain and thoroughly trouncing the broader S&P 500 Index, which Boeing has outpaced by an eye-popping 22.8 percentage points.

The path to this point has not been one of the great stories of American business. In fact, it's been a long-running and wholly disastrous soap opera, a cheap melodrama that has kept the military using refueling aircraft that were built during the Eisenhower administration. (No joke: The first of the 803 KC-135s the Pentagon bought took off on Aug. 31, 1956. That's five years before the current commander-in-chief was even born.)

The troubled tanker contract has encompassed more than just harsh criticism from lawmakers like Sen. John McCain, who objected to the terms of the initial deal, which was for the Pentagon to lease the planes; it has at times degenerated into outright scandal. A Boeing chief financial officer and a senior Pentagon buyer involved in the deal actually went to jail over illegal employment talks. Then, in 2008, Northrop won the deal. Boeing complained and won a do-over. Finally, after years of wrangling, Northrop bowed out.

Wall Street and Washington had been prepared for the possibility of a single-vendor contract. The question is not what this deal means for Boeing, the question is what comes next for the aerospace giant.

One possible answer could be India.

India is shopping for a fleet of 126 fighters to defend it from potential threats in Pakistan or China. The $11 billion deal has drawn serious competition: Lockheed Martin's F-16, Dassault's Rafale, the latest Russian MiG-35 and even Sweden's Saab. Boeing's F/A-18 Super Hornet is also a contender, as is the Eurofighter Typhoon, a joint project of Germany, Spain, Italy and Great Britain. The Eurofighter is considered the frontrunner to win the contract, according to India's ambassador to Italy, though Russia is typically India's main arms supplier.

We'll know which company will have the contract soon enough: Late last month, India said it was fast-tracking its procurement efforts and that the testing phase, during which time the country's military puts each company's plane through the paces, should wrap up by the middle of the year.

A handful of emerging countries have made it a top order of business to bolster their national defenses. India is a particularly dramatic example given sometimes troubled northern neighbors like Afghanistan and Pakistan, but the fact is the world grows smaller and more dangerous every day. This threatens the wealth and improved standards of living that dozens of small countries have toiled for decades to achieve. As more countries seek to protect themselves from aggression, business will continue to boom for Boeing.

And it's not like business is bad here at home. A $40 billion contract is a material chunk of business -- Boeing had $68.3 billion in revenue in 2009 -- but even that's a drop in the bucket. President Obama's overall defense budget for fiscal 2011, which Congress has yet to finalize, calls for $708.3 billion in Pentagon appropriations. Or, to put bring the number a little closer to home, Obama is calling for $7,083 per U.S. household in defense spending.

Only governments can spend money like that.

And companies like Boeing -- the only competitor left standing for the tanker and one of the finalists for the Indian fighter contract -- will profit from increased defense spending, both here and abroad, this year and next, to the benefit of shareholders who understand how government actions can deliver such strong returns.

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