Northrop's high-tech strategy facing major test with coming budget cuts.

Northrop Grumman Corp. weathered some $1 billion in damage to its Gulf Coast shipyards from Hurricane Katrina as it posted a 5.4 percent rise in third-quarter net income last week.

It's now expected to weather a storm of another kind.

Pentagon cuts in major weapons programs and ships are likely, but the Los Angeles-based aerospace giant should be insulated because of its emphasis on space, information technology and electronics--all areas expected to escape major pruning.

"Northrop was one of the earliest companies to recognize those trends, well before 9/11, even before the end of the Cold War," said aerospace analyst Jonathan Kutler at Jeffries Quarterdeck, a subsidiary of Jefferies & Co, "While it's perhaps best known for big ticket programs, they receive substantial revenues from very well positioned smaller programs which will survive and prosper in any reasonable assessment of budget spending."

The company's quarterly performance was strongest at divisions that focus on technology for intelligence, reconnaissance and surveillance. These are growth areas supported by Defense Secretary Donald Rumsfeld, a leading proponent of transforming the military to confront non-conventional threats, such as the urban terrorism and insurgency seen in Iraq.

Years ago, Northrop began aggressively acquiring companies that produce the kind of technology needed for battling terrorists. "We think our customers will want things required for the military transformations--unmanned systems like space (satellites) and unmanned aerial vehicles, and intel and recon," said Northrop spokesman Dan McClain.

Sales at its integrated systems segment were up 23 percent in the third quarter over last year. The division builds systems for aircraft surveillance and battle management.

It also builds the sensor and communications systems into aircraft for "network-centric warfare," the Pentagon's plan to interconnect soldiers, planes, ships and command centers through satellites and the Internet in real time. Much of those programs are in Southern California.

The Redondo Beach-based space technologies business, which builds spy and communications satellites, also saw quarterly sales rise to $842 million, up 2 percent from a year ago. Classified spy satellite programs were also up 6 percent.

The electronic systems division, the company's largest, had third-quarter sales of $1.59 billion, a 2 percent gain over the year-ago period. Sales within the division's government systems area, which builds package sorting and delivery systems for the U.S. Postal Service and other government customers--including built-in biohazard and explosives detection--were up 32 percent over last year.

Still, Northrop is a huge and complicated company and won't fully escape one of the toughest Pentagon budget cycles in years, as the government must decide how to deal with a deficit-ridden federal budget.

That's been reflected in the stock price, which hit nearly $58 in early September but closed at $52.75 on Oct. 26, sliding more than a dollar after the earnings announcement.

The Bush administration is looking to cut between $10 billion and $15 billion a year from defense spending between 2007 and 2012, and Northrop will inevitably see some declines in its major weapons systems.

Sales at the company's shipbuilding divisions on the Gulf Coast were $1.22 billion, down 20.5 percent from last year. Hurricane Katrina caused about $1 billion in damage, but at least half of that is expected to be covered by insurance. (The company also reported in a recent Securities and Exchange Commission filing that its insurer may dispute coverage of losses higher than $500 million.)

The ship business was also hurt by the Defense Department's budget problems. Northrop's sales of its next-generation DD(X) destroyer were down after the program was restructured.

The Navy wants eight to 12 of the ships and initially projected that the first units would cost $3.3 billion. But this summer the Congressional Budget Office projected that each ship was coining in at $4.7 billion. Now, the House Armed Services Committee wants to cap costs at $1.7 billion per ship, and the Navy has restructured the program. "A lot of sales we would have received from the subcontracting business are going directly to the Navy," McClain said.

Also considered a prime target for budget cuts is the Air Force's F/A-22 stealth fighter jet and F-35 Joint Strike Fighter, whose fuselages are built by Northrop and which also have incurred major cost overruns.

"There will be tremendous pressure on the defense budget for the next couple of years," Kutler said "In this environment, everybody looks for the largest dollar impact, and that tends to be in the highly visible top-10 programs."

Even so, Northrop is well positioned--and even these high-ticket programs may go relatively unscathed. Defense cuts have always been fought by members of Congress looking to protect high-paying aerospace and defense jobs in their districts.

"Congress really wants to protect its jobs. and the defense contractors are very smart about spreading the jobs around the country," said Beth Daley, spokeswoman for the Project on Government Oversight, a Washington watchdog group, who noted the F/A-22 is built in more than 40 states.

Most of all, the company is benefiting from a string of acquisitions that began with Grumman Corp. in 1994 and ended with TRW Inc. in 2002, leaving it with expertise in unmanned vehicles, defense electronics and other now advantageous niches.

Northrop has more than a dozen different unmanned aerial vehicles in various stages of development. At a fraction of the cost of traditional fighter jets, they can gather battlefield intelligence, and even deliver weapons, and are popular politically because they are seen as a way of saving military lives.

Its Global Hawk unmanned jet has already been widely used in Iraq and Afghanistan to patrol forward of advancing forces and warn of ambushes through high-altitude surveillance. Its unmanned Fire Scout helicopter is being developed to take off from Navy ships and patrol wide perimeters around them.

"If you go back to the company's strategy over the last decade," McClain said, "there was a conscious effort to understand where war fighting was going in the future."

Northrop Grumman Corp.

Stock Prices

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Quarterly Net Income (millions)

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YEAR (Dec. 31)                   2004    2003 *

Revenue (billions)             $29.85     $26.4
Total Expenses (billions)       27.85     24.93
Operating Income (billions)      2.01     $1.47
Net Income (billions)             1.1      $0.9
Earnings Per Share              $2.97     $2.32

SUMMARY

Business: Defense contractor
Headquarters: Century City
CEO: Ronald D. Sugar
Market Cap: $18.8 billion    Dividend Yield: 2%
Total Liabilities: $16.6 billion    P/E Ratio: 14.6
Long-Term Debt: $4.57 billion

* Restated Dec. 31, 2004