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Fitch Expects to Rate Northrop Grumman's New Notes 'BBB+'; Outlook Stable

The new notes will be issued at the holding company level and they will be structurally subordinated to the consolidated enterprise's existing debt because there will be no upstream guarantees from the operating subsidiaries. For this reason, Fitch considers the new notes to be in a weaker credit position than NOC's existing debt, but Fitch does not consider the difference to be great enough for the new ratings to be lower than the existing ratings, for several reasons: significant operational and strategic linkages throughout the consolidated enterprise, including among the subsidiaries; the credit strength of the consolidated enterprise; low debt levels at several of the operating subsidiaries; and the holding company's 100% ownership and strong management control of the subsidiaries.

Fitch currently rates NOC, its subsidiary Northrop Grumman Systems Corporation (which includes the former Litton Industries), and its subsidiary Northrop Grumman Space & Mission Systems Corporation (formerly TRW Inc.) as follows:

--Issuer Default Rating (IDR) 'BBB+';

--Senior unsecured debt 'BBB+';

--Bank facility 'BBB+'.

The Rating Outlook is Stable. Approximately $3.9 billion of existing debt is covered by these ratings. All existing senior unsecured debt is located at the operating subsidiary level, primarily the Systems Corporation subsidiary. The bank facility is located at NOC (the holding company), and it benefits from guarantees from two operating subsidiaries.

The ratings reflect the company's competitive position within the defense industry, a balanced defense product portfolio, high levels of U.S. defense spending, financial flexibility, solid cash generation, and good bookings and backlog. Concerns focus on the potential for continued large share repurchases and increased acquisition spending, performance issues on some defense contracts, U.S. government budget deficits and their potential impact on defense spending after fiscal 2010, continued exposure to hurricanes at the company's Gulf shipyards, and large goodwill/intangibles balances.

Negative rating actions could result from large, cash-funded acquisitions; significant program performance issues on large contracts; or material changes in U.S. defense spending trends. Given NOC's strong credit metrics for its existing ratings, more than one of the preceding would probably have to occur for NOC's credit quality to decline. Positive rating actions could result if the company adopts a more conservative financial strategy, coupled with continued strong execution in the company's core businesses. While NOC's credit metrics are strong for the current ratings, Fitch believes that NOC's financial strategy is not currently consistent with attaining and retaining a rating higher than 'BBB+.'

Liquidity at June 30, 2009 was approximately $2.5 billion, consisting of $1.1 billion of cash and full availability under the $2.0 billion credit facility (expiring in August 2012), offset by $520 million of short-term debt and current maturities. NOC's debt-to-operating EBITDA ratio for the latest 12 months (LTM) ending June 30, 2009 was 1.0 times (x) compared with 1.1x in 2008 and 2007. Adjusting debt and EBITDA for operating leases, these ratios were 2.0x for all three periods.

NOC's solid cash generation is a key element supporting the company's ratings. Free cash flow (cash from operations less capital expenditures and dividends) was $1.6 billion in 2007 and $1.9 billion in 2008; both years included $200 million of discretionary pension contributions. Free cash flow in the first half of 2009 was only $55 million, including the impact of $126 million for discretionary pension contributions, but NOC's cash flow is typically weighted toward the second half. Going forward, Fitch expects the company's cash deployment to be skewed toward share repurchases, although acquisitions and discretionary pension contributions could increase. Share repurchases in 2008 were $1.55 billion and they were $423 million in the first half of 2009. Acquisition spending has been modest in the past 18 months, but Fitch expects NOC to be opportunistic in pursuing acquisitions in the areas of C4ISR, tech services, and government information technology (IT).

As a result of financial market declines, NOC's pension situation deteriorated in 2008, but the company is in a good position compared to other major defense contractors. NOC's pension funding status fell to 84% ($3.6 billion deficit) at the end of 2008 from 104% in 2007, and NOC took a pension-related equity adjustment of $2.8 billion. Required pension contributions in 2009 are modest, but the company has made voluntary contributions of $500 million to date this year. Fitch believes the company has the financial capability to manage the pension deficit, and NOC's status as a Department of Defense (DoD) contractor provides additional mitigants to the pension situation. Most of NOC's pension contributions are recoverable through government contracts because they qualify as allowable costs under government cost accounting standards (CAS). In addition, the major DoD contractors have been given the opportunity to delay implementation of the Pension Protection Act of 2006 while Employee Retirement Income Security Act (ERISA) and CAS accounting standards are harmonized.

High spending levels for national security continue to support NOC's credit ratings, with approximately 90% of NOC's revenues coming from the U.S. government. DoD spending levels are high after nearly 10 years of substantial growth, but Fitch believes the spending upcycle has ended and going forward there will be modest core budget growth and gradually declining supplemental spending. The core defense budget is the most important for NOC's outlook given that the company gets only a modest amount from the supplemental budgets that fund Overseas Contingency Operations. DoD spending in fiscal years 2009 and 2010 will continue to rise, so the outlook for NOC's defense operations is still favorable in the near term.

Fitch believes that fiscal year 2010 (FY2010) is probably the peak in core U.S. defense budgets, and there are several risks to monitor in FY2011 and beyond. These include the Obama Administration's first full budget in fiscal year 2011, the Quadrennial Defense Review, and the large projected federal budget deficits in FY2009-FY2011. In addition to spending levels, some other changes proposed by the new administration could have a detrimental impact on NOC and other defense contractors, including acquisition reform and the 'insourcing' of services previously contracted out by the DoD.

Most of NOC's thousands of programs are performing well and are well-funded in the recently submitted FY2010 DOD budget. However, NOC has had a noticeable number of programs that have experienced problems due to execution, technical issues, or cost growth. The main problem programs recently have been in the Gulf Coast Shipbuilding operations, where several hull types have suffered higher costs, delays, and significant amounts of rework, leading to several hundred million dollars of charges in the past year.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Fitch Ratings
Craig Fraser, +1-212-908-0310
Kathleen Connelly, +1-212-908-0290
Cindy Stoller, +1-212-908-0526 (Media Relations)
cindy.stoller@fitchratings.com