This is a classic example of how what you see on Wall Street may not be what’s really going on. To understand, let’s flash back to January. That’s when Northrop agreed to pay Westinghouse $3 billion for its defense and electronics businesses, whose major product is radar for air-traffic-control systems and military planes. Northrop also agreed to take over Westinghouse’s obligation, about $600 million, to pay pensions and after-retirement medical-insurance costs for current employees.
Neither party will talk until the deal closes, scheduled for later this year. But you can see both companies are playing games. Westinghouse would have us believe it got $3.6 billion on the deal. That’s about $1 billion more than people expected the businesses to fetch–and would go a long way toward repairing the damage Westinghouse did to its image earlier this year. That’s when it paid a whopping $5.4 billion for CBS, the tarnished remains of the former Tiffany network.
Then there’s Northrop, which has kept up a Stealth-like all-but-invisible profile. On the surface, Northrop seems to have overpaid on the deal. Why? Because the businesses it’s buying would typically sell for 1 to 1.1 times their annual revenues; at $3 billion, Northrop would be paying 1.2 times revenues. At $3.6 billion, the cost looks too high. But… thanks to money from Uncle Sugar, Northrop’s actual cost is far less. Here’s why:
Contracts first. The $600 million of pension and medical obligations that Northrop is taking over are figured into the price the federal government pays for the radars and other goodies it now -buys from Westinghouse and will soon be buying from Northrop. So even though these obligations are Northrop’s, Uncle Sam will compensate Northrop for them over the life of the contracts. So I don’t consider that $600 million to be real money.
Then there’s something called “good will.” Put bluntly, this deal is structured to yield all sorts of juicy tax savings for Northrop. To be technical–and technicalities are vital here–Northrop is buying assets from Westinghouse, rather than buying the stock of the Westinghouse subsidiaries to be sold. The difference? At least $400 million, courtesy of a special piece of tax law Congress passed in 1993 to let companies buying assets deduct the so-called cost of “good will.” For nonaccounting types, that’s the difference between what you pay for something and the value of the assets you get, such as buildings, inventory and cash.
Normally, you can’t deduct good will from taxable income. But this deal is set up to allow Northrop to do just that. By my estimate, the Westinghouse purchase will create $1.75 billion worth of good will for Northrop-meaning it can deduct about $115 million a year from its federal taxes for the next 15 years, reducing its taxes by some $600 million. That’s the same as saving $400 million today. Subtract that from the $3 billion cash price.. and Northrop’s real cost drops to $2.6 billion. That’s roughly one times the businesses’ $2.5 billion of annual revenues: in other words, exactly the price you’d expect.
The benies don’t stop there, however. Unlike other tax games, Northrop’s is completely straightforward. “Northrop is using the 1993 law in exactly the way that Congress intended,” says Robert Willens of Lehman Brothers. And so is its partner in the deal. Normally, the fat tax breaks for Northrop would mean a whopping tax bill for Westinghouse. But not here. That’s because Westinghouse can shelter its profits on the sale with the billions of dollars of tax losses created by its disastrous foray into financial services during the 1980s. And so, we come to the secret beauty of this transaction. It’s one of those cases where the seller can claim to be selling dear, while the buyer claims to be buying cheap. And both of them are right.
The moral? When you see a savvy company like Northrop forking over what seems to be an excessive price for a defense business, take another look. The money may be coming not from Northrop’s pockets, but from yours.
