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The Shipbuilding Shake-up

A spin-off of Northrop Grumman Shipbuilding seems increasingly likely

To say that Northrop Grumman has shaken up the shipbuilding industry this year would be an understatement of the same proportion as saying amputations are an inconvenience. Ever since the company’s mid-July announcement that it would explore its strategic alternatives in the case of its shipbuilding arm Northrop Grumman Shipbuilding (NGSB), this entire sector of the defense industry has been awash in speculation, fueled by Northrop Grumman’s relative silence on the subject.

The company has not made a priority of talking about NGSB’s possible future, but the recent consolidation of its Avondale Industries yard in Louisiana confirmed what everyone had long guessed: the words Northrop Grumman and Shipbuilding wouldn’t stand together much longer.

In all the speculation since that initial announcement, the most logical or repeated options for NGSB have been to sell it to another defense company or spin it off. It’s a case made stronger by the announcement of the company’s decision to file a statement with the Securities and Exchange Commission regarding a spin off and Bloomberg’s report of interest in a buyout by four private equity firms. Then, there is also Cleveland Shipbuilding Company, a relative unknown in the industry that is looking to buy its first shipbuilding yard. They’ve been met with some skepticism, but they’ve also been grandly courting the governors of each of the states that would be affected by NGSB’s sale. Cleveland Shipbuilding Company’s even promising Louisiana Governor Bobby Jindal that they could keep his state’s Avondale shipyard (slated to close in 2013 under the current ownership) open with new business.

All the big gestures and cryptic press releases certainly haven’t laid speculation to rest – but at least there is a better place to aim it. Casting NGSB off on its own may provide the best possible outcome for the DoD, simply because the other options – again, speculation – may be far worse.

“The problem here is that their supplier base for shipbuilders is dwindling, and it can get down to just one supplier,” says Todd Harrison of the Center for Strategic and Budgetary Assessments, a D.C.-based defense think tank. “The lack of competition means that prices could go up, but it also hurts us on capabilities – it means there’s less incentive to innovate, but it also means we don’t have the capacity to surge if we needed to… A shipyard is not something you can reconstitute overnight. We’re talking about building ships with nuclear reactors.”

When Northrop Grumman announced it no longer wanted to build ships, the first question asked was, “Who wants to buy one of the largest concerns of this type anyway?” Guesses ranged from no one, to General Dynamics, to possibly someone overseas.

First, you can safely strike the idea of a foreign company buying our nuclear carrier and submarine construction capabilities. “My guess is that the Department of Commerce would have to get involved and approve the sale,” says Harrison. “But I imagine that it would come with a huge political backlash that part of our defense industry could be foreign-owned.”

Consider the outcry a few years ago when Dubai Ports World wanted to buy the management contracts for several U.S. ports. After a storm of controversy, a division of AIG bought the contracts. And then there’s the “buy American” theme to the ongoing Air Force tanker contest, with EADS vying to build a replacement for the KC-135 Stratotanker with an Airbus airframe.

The “no one” was not without a hint of validity. Yes, Shipbuilding is profitable under Northrop Grumman’s ownership. According to an article in Seapower magazine’s September issue, however, Shipbuilding returns the lowest profit percentage of all the company’s divisions: about 3.5 percent in 2008.

That’s a meager return, considering Northrop Grumman took great efforts to acquire such a large segment of the naval shipbuilding industry over the last decade, the most notable of which are its nuclear carrier and submarine capabilities at Newport News. For DoD, its biggest concern right now should be keeping a diversified list of suppliers.

If Shipbuilding is allowed to stand on its own, DoD might not have to get more actively involved in managing the industrial base so that the nation doesn’t lose critical capabilities.

“We haven’t had a lot of success with that in the past,” says Harrison, speaking about the idea of splitting large builds between companies to keep capabilities alive throughout the industry. “The problem is that when you’re buying very small numbers of things – like one new carrier every five years – you can’t split that very well.”

It’s not the same market as the LCS market – where DoD had two competitors, Lockheed Martin and General Dynamics, each build two ships, and planned to award the winning designer the next 10-ship builds before bringing in other builders. Of course, the Navy has changed the original plan, and has opted to buy 10 ships from each builder instead, so there will be two classes of LCS instead of one. You can see an assessment of the situation at the Information Dissemination blog. Either way, carriers just aren’t produced with the numbers that would support this kind of sharing program.

“It also can get expensive sometimes when you split construction, because you lose the learning curve. When one builder finishes a ship, and does it over and over, they become more efficient.” When you split the buy, builders don’t get that added benefit, and it ends up costing DoD more.

And when the idea of two companies working together on the same carrier comes up, Harrison is quick to point out DoD’s well-intentioned attempt to keep two lines of production open when developing the EELV. The endeavor struck a low note, with industrial espionage charges between Lockheed and Boeing. And the two companies ended up combining their production under a single joint company, United Launch Alliance. So in the end, DoD paid more in the beginning to develop a wider, more competitive industrial base and still ended up with a single provider.

In the case of NGSB, Harrison admits that, “We might just have to mitigate the effect of the dwindling down of competition.” But for now, the prospect of the naval industry loosening itself up from the consolidation it’s seen in recent years may be the best option possible.

Most insiders are betting on a spin-off. If that happens, the whole business may have come full circle. In 1996, Tenneco, one of the last huge industrial conglomerates, wanted to divest itself of its shipbuilding arm, and spun it off on its own. The resulting company? Newport News Shipbuilding, which fought off hostile takeover bids from Litton Ingalls Shipbuilding and General Dynamics before becoming part of Northrop Grumman.