Northrop's OCI-induced sale of TASC, and what the resulting share repurchase plan says about the business

Earlier this week, Northrop Grumman announced the expected sale of its government consulting business, a company that back in the 1990s was known as TASC (The Analytical Sciences Company, for those who remember). Rebranded again as TASC, the division and a few other businesses are being sold for $1.65 billion to private equity firms General Atlantic and KKR. The reason for the deal centers on what industry and government these days call organizational conflicts of interest (OCI). As Chairman and CEO Ron Sugar put it in a press release, the sale “reflects Northrop Grumman’s desire to align quickly with the government’s new organizational conflict of interest standards, while preserving TASC’s unique organizational culture and its status as the advisory services employer of choice.” One couldn’t make the motivations more apparent.

Time was, the idea of the US federal government asking a large company to advise it on whether it should buy that company’s products seemed crazy. Such work was reserved for standalone consultancies; frequently, it was reserved for nonprofit businesses designated Federally-Funded Research & Development Centers (FFRDCs)—places like RAND, IDA, and MITRE. At some point in the early part of this decade, the government decided the conflicts would be manageable, and declined to object to the acquisition of many of the consultancies, such as TASC, by hardware-makers like Northrop. The Obama Administration’s reversal of this position isn’t the first time that the US federal government has gotten religion about OCI. RAND, which also undertakes space advisory business for the DoD, started out in the 1940s as a unit of Douglas Aircraft; spinning it off was strongly favored by the USAF at the time. Another crosstown competitor, The Aerospace Corporation, was formed in the late 1950s as a spinout from the merger that formed TRW from Thompson Products and Ramo-Wooldridge. The former was in the hardware business; the latter was largely advising the USAF on space programs, and the combination made the government nervous.

This sea change has probably been coming for some time; indeed, the current administration may have just made a policy of (re)emerging preference. Back in 2007, when I tried to develop some business at the Pentagon on behalf of another (for-profit, publicly traded) consultancy, folks there told me that they loved the idea of the work that we could do, but preferred to hand it to an FFRDC. I couldn’t complain: it was one clear way of avoiding any conflict, real or imagined. In this case, the divestiture of TASC has been expected for many months because it was one of the problematic cases for all concerned. To provide a bit more detail, I refer to recent analysis by Cai von Rumohr, Gautam Khanna and Mark Hokanson of the Cowen Group. They argue for the deal for perhaps four specific reasons (that I’ve rephrased slightly):

1. TASC's primary customer, the National Reconnaissance Office (NRO), has taken perhaps the toughest line of any federal agency OCI issues, and both Northrop and TASC have lots of business with the NRO.
2. Some of TASC’s business with the NRO is up for recompetition, and Northrop has been worried that it might lose this business for just this reason.
3. In the sale, Northrop transferred to TASC other operations with potential OCI issues to avoid further problems on its side.
4. KKR and General Atlantic face no such OCI issues as owners of TASC.

Von Rumohr et alia separately mentioned the possibility that TASC’s business with the NRO might slow if, as some of their sources in the industry expect, the Defense Department’s spending on NRO satellites slows. That, however, only affects the price at which Northrop would sell the property, not its reasons for selling in the first place.

It’s important to note that handing work to even an FFRDC won’t eliminate all charges of conflicts of interest. When the USAF proposed a few years ago to ask RAND to evaluate some aspects of its handling to the KC-X aerial tanker program, US senator John McCain complained that RAND shouldn’t be trusted to deliver an honest answer. So much of RAND’s business was with the USAF, he said, that RAND had effectively gone native. Knowing RAND’s work, I thought that this charge was a little too strong, but there are other examples of FFRDCs thought too close to their sponsors.

All that said, even if the reasons for Northrop’s sale of TASC are obvious, what’s perhaps more notable is what Northrop plans to do with the proceeds. After taxes and fees, the sale will net about $1.1 billion, and all of that will be offered to repurchase shares of NOC. Indeed, Northrop’s management could be said to be on a bender of share repurchases. It’s a very strong signal that Northrop's management is sending its shareholders: we're offering you all the cash because we are unconvinced that we'll outperform, on the margin, any given mutual fund, if we keep that cash for our own uses.

This tells us that management is rather sanguine—or just realistic—about the prospects for the company. I am sympathetic to that view, as I expect military spending in the US to drop sharply, and more sharply than spending elsewhere in the world. As Dick Bitzinger put it in the Straits Times a few months ago, the market in the US looks particularly grim for many of the charismatic macrofauna in Northrop Grumman’s portfolio. Many of these big systems aren’t likely to be prioritized within the US government’s declining military investment spending. Here, there are both an income effect and a substitution effect: with less money to spend, the new Pentagon leadership will trade towards investment in more numerous and less expensive alternatives to the Cold War’s “exquisite” solutions. Since Northrop does only about six percent of its business outside the US, quickly expanding its sales overseas could be quite difficult. All this adds up to a vulnerable position—unless management is willing to recognize it as such, and earn its returns another way.

So, rather than finding this relative industrial disinvestment alarming, I find it deeply refreshing. Frankly, I'd call the relative infrequency of share repurchases a mystery, if corporate double-taxation, agency problems, and general managerial hubris didn't conspire to help the Man hold the shareholders down. :) Northrop’s management deserves credit for thinking better of all those widows and orphans whose retirement portfolios back their operations.