By Calvin Biesecker and Geoff Fein
Northrop Grumman‘s [NOC] early morning surprise yesterday that it would take $320 million to $360 million charge on the LHD-8 amphibious assault ship it is building for the Navy left some analysts discouraged about the company’s ability to overcome a series of execution issues on several large programs.
“Program performance has been an issue for Northrop Grumman, particularly in Shipbuilding, and we believe this news indicates the company still has problems to iron out at its Gulf Coast yards,” JP Morgan analyst Joe Nadol said in a note to clients.
Stifel Nicolaus analyst Troy Lahr said “contract execution continues to be somewhat of an overhang” for the company.
Some analysts also questioned the judgment of the company’s management in negotiating a fixed price contract with the Navy in 2002 despite the fact that the new ship has several major new subsystems compared to the LHD-7.
“The acceptance of fixed-price terms for a ship where 75 percent of the systems were new was a major corporate misjudgment in our opinion,” Wachovia aerospace and defense analyst Gary Liebowitz said in a research note yesterday.
Northrop Grumman has taken charges on a number of programs the past few years, including a $55 million hit last year on the LHD-8, an electronic warfare upgrade program to F-16 fighters for the United Arab Emirates, the Multi-role Electronically Scanned Array radar system, and Wedgetail, an Airborne Early Warning & Control program it is helping Boeing [BA] with for Australia.
While most of these are major development programs, where fixed price contracts are rare and risky, LHD-8 is a production effort, which is typified by fixed price contracts once initial lessons are learned early in construction. However, Northrop Grumman said the new vessel has characteristics common to a first in class production design.
Wes Bush, Northrop Grumman’s president and Chief Operating Officer, told analysts on a conference call that the new vessel is being converted to an all-electric ship. He said the various upgrades meant that “two-thirds of the design drawings and about 75 percent of test procedures were new or modified by the LHD-8.”
The difficulties on the LHD-8 program show the company’s Gulf Coast shipyards are still haunted by the impact Hurricane Katrina left in the summer of 2005, which dislocated a hefty percentage of its workforce. The company estimates that up to one-third of its Gulf Coast workforce never returned.
For example, the fiber optic cable network that supports a new centralized machinery control system was found to be buried under other cables, which resulted in them being crushed and unable to function as planned, Jim Palmer, Northrop Grumman’s chief financial officer, said. This is the type of mistake that happens with a “green” workforce, company officials said.
About 60 percent of the workforce in the Gulf Coast yards has less than five years experience, the officials said. However, Bush didn’t blame the workforce as much as he did the company’s approach to training and overseeing its workers.
A variety of new management, quality control and training initiatives are underway, Bush said.
The LHD-8, which was slated to be delivered late this year following workforce related difficulties last year, is now expected to be delivered before July 2009. The ship was in the late stages of testing where program engineers were doing the final connections of the various electrical systems when problems began to arise.
“We were noticing a slowdown in the testing and things being connected were not working,” Palmer said. “We did an audit to see what tests weren’t being completed.”
Bush said the company had expected integration issues with the ship that it didn’t face with production of the LHD-7. However, company officials said the magnitude of the issues was “unexpected” and left them “disappointed.”
Because the problems were discovered late in testing and construction is the major reason for the huge charge, Bush said.
The Navy said yesterday it has been aware of cost and schedule issues with LHD-8 for more than eight months and has been working closely with shipyard leadership to address these concerns, the service said in a statement.
“The Navy appreciates Northrop Grumman’s initiative in this matter, and their commitment to take corrective action,” the service said. “We understand that the costs of this delay will be assumed by the Northrop Grumman Corporation,” the service said.
Navy Secretary Donald Winter, who last year raised concerns about Northrop Grumman’s efforts with LPD-17, has asked for a full status review of the shipyard work force, as well as the significant quality problems identified by Northrop Grumman.
Most of the charge, about 80 percent, is related to additional labor and engineering rework for the ship. The remainder of the cost is due to the impact on other Navy ship programs the company is working on that will have to do without certain workers until the LHD-8 program is righted, and on write downs of purchased intangibles due to the loss of expected profits on the program.
All charges except those on the intangibles are eligible to be written off against taxes, Palmer said. Northrop Grumman said the new charge has sufficient margin built in and is not expected to recur.
The design contract for the LHD-7 was originally awarded to Litton Corp. in 2000, which was acquired by Northrop Grumman in 2001.
The charge will hurt earnings between 61 cents earnings per share (EPS) and 69 cents EPS in the first quarter. Northrop Grumman will update its financial guidance during its earnings call later this month. Currently, the company expects earnings from continuing operations this year to be between $5.50 and $5.75 EPS with free cash flow between $1.9 billion and $2.3 billion.
Despite the expected gouge in earnings, the company isn’t backing off its long-term financial targets it presented to analysts in February, Ron Sugar, Northrop Grumman’s chairman and CEO, said at the outset of the call. Those targets include sales of $42 billion, $8 EPS, 10 percent operating margins and free cash flow equal to net income.
Earlier this year Northrop Grumman moved to consolidate the management of its shipbuilding divisions in Virginia, known as Newport News, and along the Gulf Coast, into a single sector.
While the Navy yesterday said it is encouraged by the fresh look and new management oversight applied by Northrop Grumman on this issue, it noted that at the same time, “that it remains concerned about the schedule issues and the associated impacts to the fleet, and is exploring options to mitigate that operational impact.”
Following the company’s own recent audits of its ship programs, Bush said the problems uncovered in the LHD-8 are not “representative of the other ships in the yard.”
The Gulf Coast yards have about 18,000 workers, with about 1,500 assigned to the LHD-8. Bush said the size of the workforce in Pascagoula, Miss., should permit most deliveries for the Navy to occur within their contractual period, Bush said. Still, Northrop Grumman is meeting with Navy officials to make sure the company has the right priorities for other programs in its yard, he added.
The issue on LHD-8 is not reflective of the work on other ships on the Gulf Coast, Jerri Dickseski, Northrop Grumman spokeswoman, told Defense Daily.
“Our path ahead will focus on programmatic, systemic and leadership improvements for the Gulf Coast operations,” she said. “Some of the things we are doing include a heavy focus on workforce development, recruiting, skill training and developing a culture of accountability and ownership. We’re also driving accountability into our first-time quality metrics.”
Additionally, Northrop Grumman will improve its financial predictability, focusing on processes for developing accurate and timely estimates and the progress of its work – and this includes aggressively leading teams to respond early to negative trends.
Dickseski added that the issue with LHD-8 is a unique situation and not systemic to other ships on the Gulf Coast. ” Other ships are only being impacted as a result of the work flow efforts being focused on the LHD-8.”
Northrop Grumman stock yesterday fell 5.27 points from 76.84 to 71.57.