Government Contracting: Review of Morton Thiokol Separation

Published by the Government Accountability Office on 1990-08-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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                                             Rcpcjr-t,1~)the Honorable
                                             Roy I)yson,   House of’Representatives

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                                             Review of Morton
                                             Thiokol Separation

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                 United States
GAO              General Accounting Office
                 Washington, DE. 20648

                 National Security and
                 International Affairs Division


                 August 28,199O

                 The Honorable Roy Dyson
                 House of Representatives

                 Dear Mr. Dyson:

                 As you requested, we have reviewed the impact of the Morton Thiokol,
                 Inc., separation on the defense production base. This separation, effec-
                 tive July 1, 1989, created two independent companies-Morton Interna-
                 tional, Inc., a commercial company, and Thiokol Corporation, which
                 does 98 percent government business.

                 The objectives of our review were to determine the separation’s impact
                 on (1) Thiokol’s viability in terms of future sales, (2) Thiokol’s ability to
                 service the debt allocated, and (3) the existing Defense and National
                 Aeronautics and Space Administration (NASA) contracts. We also
                 examined the fairness of the debt distribution and the impact of the loss
                 of the automotive airbag operations on Thiokol.

                 Thiokol Corporation, mainly an aerospace company with some specialty
Background       chemical business, was acquired in 1982 by Morton Norwich Products,
                 Inc., a salt and chemical company. The merged companies became
                 Morton Thiokol, Inc. In 1988, Morton Thiokol had total net sales of
                 $2,316.4 million, with $1,248.3 million of that attributed to the compo-
                 nents of the new Morton International and $1,068.1 million to the new

                 Morton Thiokol, Inc., management decided to separate the corporation
                 into two independent companies effective July 1, 1989, because:

             . Morton and Thiokol management represented two groups with different
               and distinct financial, investment, and operating characteristics. There
               were two different management viewpoints and sets of objectives and
               two different markets-government/defense       and commercial.
             l The separation would benefit the stockholders. The aerospace group
               was perceived as holding down the price of Morton Thiokol stock.

                 In the separation agreement, the commercial business of Morton
                 Thiokol, Inc., was spun off as a new company named Morton Interna-
                 tional, Inc., and then the remaining Morton Thiokol, Inc., company was
                 renamed the Thiokol Corporation, Shareholders of Morton Thiokol

                 Page 1                                          GAO/NSIAD-90-220 Morton Thiokol
                   received shares in both new companies. At the time the separation
                   occurred, there were common shareholders, but otherwise, the two com-
                   panies were considered independent. Before the separation, all of
                   Morton Thiokol’s current debt was consolidated into long-term debt.
                   Morton International, Inc., the commercial segment, was allocated about
                   $44 million of this long-term debt, while Thiokol Corporation, the seg-
                   ment with all the government contracts, was allocated the remaining
                   $220 million in long-term debt.

                   If current sales projections for the Thiokol Corporation materialize as
Results in Brief   expected over the next 5 to 7 years, we believe that the separation will
                   not be detrimental to the Nation’s defense production base. Thiokol
                   should remain viable. Thiokol is the sole source for certain components,
                   such as the current family of solid rocket motors and the nozzles for the
                   advanced solid rocket motors, and is therefore, practically guaranteed
                   that business. In addition, Thiokol’s cash flow has increased consider-
                   ably since the separation. With the projected sales and increased cash
                   flow, Thiokol should be able to service its long-term debt.

                   The Morton Thiokol separation caused some existing government con-
                   tracts to have a reduction in cost. This was due to the lowering of the
                   general and administrative (G&A) rate because costs associated with cer-
                   tain Chicago corporate offices are no longer included. The prices of
                   existing firm fixed-price contracts are not affected because those prices
                   are not renegotiable. However, future fixed-price contracts should also
                   reflect less G&A costs, and therefore, lower prices.

                   Since the separation, Thiokol Corporation has become an independent
                   company, and no longer has access to the former corporation’s assets if
                   it should encounter financial difficulties. This is a factor the government
                   will likely have to consider when evaluating whether to continue with
                   any of Thiokol’s contracts or programs. The government may have to
                   subsidize Thiokol if the company does have financial problems, or risk
                   delays or nonperformance on other vital government contracts.

                   Hecause capital expenditures by the Thiokol segment since 1983 gener-
                   ated most of the debt for Morton Thiokol, Inc., we believe that the debt
                   distribution was equitable.

                   The transfer of the automotive airbag operations to Morton Interna-
                   tional appears to be part of Morton Thiokol’s overall plan to separate

                   Page 2                                         GAO/TUSlALb90220 Morton Tkiokol
                          the government and commercial business. The technology was the prop-
                          erty of Morton Thiokol, to be assigned at its discretion. The new Thiokol
                          Corporation is licensed to use the airbag technology in future noncom-
                          mercial applications. Thiokol appears able to service its debt without
                          the profits from the airbag operations.

                          Based on our interviews with Air Force and NASA officials, our study
Impact on the Defense     indicates that Thiokol will remain a viable part of the defense industrial
Industrial Base:          base. NASA and the Air Force provide the majority of the contract dollars
Thiokol’s Viability in    for the Thiokol Corporation. Air Force and NASA officials provided us
                          with the procurement forecasts of these agencies and said that the con-
Terms of Sales and        tracts that are in place and that are projected will proceed essentially as
Ability to Service Debt   planned. At the time of our review, neither agency expressed concern
                          that the procurement forecasts for Thiokol would be altered signifi-
                          cantly by anticipated defense budget reductions.

                          Thiokol is the government’s sole source for some items, such as the cur-
                          rent family of solid rocket motors used for space shuttle launches, and is
                          virtually assured of this business. Air Force and NASA officials said that
                          it really is not economically feasible to keep two sources in operation for
                          these items. Purchases of Thiokol’s solid rocket motors are planned
                          through 1995 and beyond. Thiokol also is the sole producer of the noz-
                          zles for the advanced solid rocket motor, and these same officials agreed
                          that Thiokol will have that product in its sales base through the late
                          1990s. Unless Thiokol encounters a major problem with one of its pro-
                          grams, it should be able to service the long-term debt allocated at the

                          Air Force, NASA, and Defense Logistics Agency officials have concluded
                          that Thiokol’s projected business base will be sufficient to ensure the
                          company’s viability. Thiokol is regarded as a viable entity by lenders
                          and stock analysts as well. A major bank’s financial analysis compared
                          Thiokol’s financial structure with other aerospace companies and found
                          that key financial measures for Thiokol were within an “average” range
                          for the companies analyzed. In addition, Thiokol’s projected cash flow as
                          a percentage of total debt was stronger than average. One stock ana-
                          lyst’s report concluded that Thiokol could have remained viable even if
                          considerably more debt had been allocated to it.

                          Page 3                                         GAO/NSIAD-90-220 Morton Thiokol
                     Since the Morton Thiokol separation, the existing Defense and NASA cost-
Impact on Existing   related contracts have had a reduction in cost because the Morton Thi-
Defense and NASA     okol corporate offices’ expenses are no longer included in the G&A rate.
Contracts            Some of these former Morton Thiokol corporate officers have moved to
                     Ogden, Utah, as a part of the new Thiokol’s corporate management, but
                     the majority of the former Morton Thiokol offices with their manage-
                     ment layer are now part of Morton International. We cannot say that
                     there will not be any future cost increases, but initial information from
                     Thiokol indicated that the G&A rate was expected to be reduced by about
                     25 percent. The latest evaluation of the G&A cost reduction by the Air
                     Force corporate administrative contracting officer showed a decrease of
                     about 10 percent, which would result in decreased contract costs.

                     Although the prices of existing firm fixed-price contracts were not
                     affected because those prices are not renegotiable, the prices of future
                     contracts should be affected by the reduced G&A rate. For example,
                     according to a NASA official, a recent pricing proposal submitted to NASA,
                     using the most current cost and pricing data, showed a reduction of
                     about 3 percent from the proposal for the same work, based on the pre-
                     vious organizational structure. The new Thiokol Corporation retains
                     ownership of the facilities and equipment regarded as critical to per-
                     formance on defense and NASA contracts.

                     If Morton Thiokol, Inc., had spun off the Thiokol segment as a new com-
                     pany, then the remaining Morton Thiokol, Inc., would have been
                     required to execute a novation agreement, giving the government con-
                     tinued rights with the original contracting party. Novation is a contrac-
                     tual procedure whereby the original party to the contract (Morton
                     Thiokol) would guarantee the performance of the new company (Thi-
                     okol) on the existing government contracts. Since Morton Thiokol man-
                     agement instead chose to spin off the commercial segment, and rename
                     the remaining government business entity the Thiokol Corporation, the
                     only applicable government regulation required execution of a name
                     change agreement, which does not give the government any further
                     rights with the original contracting party. Morton is no longer respon-
                     sible for Thiokol’s performance on government contracts and Thiokol no
                     longer has access to the former corporation’s assets if it encounters
                     financial difficulties. This is a factor the government will likely have to
                     consider when evaluating whether to continue with any of its contracts
                     or programs with Thiokol. The government may be forced to in essence
                     underwrite the company if it does have financial problems, or risk
                     delays or nonperformance on other vital government contracts.

                     Page4                                          GAO/NSLAD-90-220MortonThiokol

                             Based on our review, it appears that the allocation of debt was founded
Debt Allocation              on the debt incurred and use of capital by the Thiokol segment over the
Appears Equitable            past several years, and therefore, was equitable. Most government and
                             Thiokol officials we interviewed agreed that the debt allocation was
                             equitable, and the Air Force provided a list of the Thiokol segment’s
                             capital expenditures since 1983, which supported this agreement. In
                             addition, government and Thiokol officials indicated that contractual
                             problems resulting from the shuttle Challenger disaster contributed sub-
                             stantially to Thiokol’s need for working capital, which increased the
                             Morton Thiokol debt.

Morton Thiokol’s Rationale   Officials of both new companies said that they believed that the debt
for Debt Allocation          allocation was equitable because the Thiokol segment had created most
                             of the Morton Thiokol debt. Further, Morton Thiokol’s position was that
                             the purpose for the debt allocation between the two companies was to
                             provide the most total value to the Morton Thiokol stockholders. Morton
                             Thiokol officials believed that as separate companies, the commercial
                             Morton International would have a much higher price to earnings ratio
                             (P/E) than the defense and space contractor, Thiokol. Therefore, the high
                             debt and its related interest expense were allocated to the low P/E com-
                             pany, Thiokol. Under the separation agreement, the shareholders in
                             both companies would be common at the time of separation. Morton Thi-
                             okol officials concluded that the high debt would have minimal effect on
                             the company with the low P/E ratio, and that the value of the two stocks
                             after the separation would be greater than the value of the Morton Thi-
                             okol stock before the separation, A number of stock analysts made the
                             same conclusion.

                             A Morton Thiokol official said that they consolidated the long- and
                             short-term debt into new long-term debt structured so that Thiokol
                             would be better able to service it. In addition, Morton International was
                             allocated 87 percent of the June 1989 dividend obligation. The dividend
                             obligation represents an additional liability, and if Thiokol was required
                             to pay its proportionate share of the dividend, this would have been an
                             additional debt burden.

                             The transfer of the automotive airbag operations took place in May
Impact of the                1988, over a year before the Morton Thiokol separation occurred. Since
Automotive*Airbag            the airbag’s market consists of commercial automobile manufacturers,
Operations Transfer          while the rest of the Thiokol segment’s business is government, manage-
                             ment officials thought the transfer to the commercial segment seemed

                             Page 6                                         GAO/NSIAD-90-220 Morton Thiokol

              logical. The new Thiokol Corporation has a license to use the airbag
              technology on future noncommercial applications, such as inflatable
              helicopter restraint harnesses and bomb ejection systems. Air Force offi-
              cials told us that some of the airbag development costs were accumu-
              lated as Independent Research and Development costs, which are
              reimbursed in part by the government, while the contractor retains own-
              ership of the developed technology. Other development costs were paid
              through contracts with automobile manufacturers. Consequently, the
              rights to the airbag technology were the property of Morton Thiokol, to
              be assigned at its discretion. Thiokol appears able to service the debt,
              without the profits from the airbag operations.

              Because the airbag operations facilities are physically located within the
              Thiokol complex, the transfer of ownership to Morton posed some legal
              questions with respect to liability in the event of an accident. For
              example, the government’s liability could have increased because pro-
              tection under Utah Workman’s Compensation statutes would be lost.
              Subsequently, the Air Force, Thiokol, and Morton International signed
              an agreement which will indemnify the U.S. government in event of an

              Our work was performed in Ogden, Utah; Chicago, Illinois; and the
Scopeand      Washington, D.C. metropolitan area, from July 1989 to April 1990. We
Methodology   interviewed contracting officials at Air Force Systems Command Head-
              quarters, the Air Force Contract Management Division, and the Air
              Force Plant Representative Office. We also interviewed the Defense Con-
              tract Administration Services corporate administrative contracting
              officer, the president and chief executive, financial, legal and con-
              tracting officials of Thiokol Corporation, and the chief financial officer
              of Morton International, Inc., NASA Headquarters contracting and pro-
              gram officials, and the NASA Marshall Space Flight Center Contracting
              Officer responsible for Thiokol contracts.

              We obtained and analyzed stock analysts’ reports, the Defense Logistics
              Agency’s financial analyst’s study, briefings by Thiokol officials, and
              financial data provided in Morton and Thiokol quarterly reports. We
              reviewed future business projections provided by the Air Force Plant
              Representative Office based on input from NASA, Air Force, other gov-
              ernment agencies, and Thiokol, and corroborated these projections with
              NASA Headquarters contracting and program officials. Our work was
              performed in accordance with generally accepted government auditing

              Page 6                                        GAO/NSIAIHO-220 Morton Thiokol


    W e p r o v i d e d a draft o f this report to th e D e p a r tm e n t o f D e fe n s e ,N A S A ,
    a n d Thiokol o fficials for their review a n d c o m m e n t. Their c o m m e n ts
    e x p r e s s e dg e n e r a l c o n c u r r a n c e a n d h a v e b e e n incorporated w h e r e
    appropriate in th e report. T h e D e p a r tm e n t o f D e fe n s eletter is i n c l u d e d
    a s a p p e n d i x I.

    W e p l a n to distribute this report to th e S e c r e tary o f D e fe n s e ,th e A d m in-
    istrator o f N A S A , th e Director o f th e O ffice o f M a n a g e m e n ta n d B u d g e t,
    a n d appropriate c o n g r e s s i o n a lc o m m i tte e s . W e will m a k e copies avail-
    a b l e to o thers u p o n r e q u e s t.

    P l e a s ec o n tact m e a t ( 2 0 2 ) 2 7 5 - 8 4 0 0if y o u or your staff h a v e a n y q u e s -
    tio n s c o n c e r n i n gthis report. M a j o r c o n tributors to this report a r e Clark
    G . A d a m s , Assistant Director, a n d Carol S . M a r k s o n , E v a l u a tor-in-

    S incerely yours,

    P a u l F. M a th
    Director, Research,D e v e l o p m e n t,
       Acquisition, a n d P r o c u r e m e n t Issues

    Page 7                                                         G A O / N S I A D 9 9 - 2 2 0 M o r t o n Tkiokol
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Appendix I

Comments From the Department of Defense

                                                       ASSISTANT     SECRETARY        OF DEFENSE
                                                             WASHINOTON.    O.C.   20301-8000

                                                                                                July 30, 1990
             PROOUCTlON          AND


                          Mr. Frank C. Conahan
                          Assistant    Comptroller    General
                          National    Security    and International
                            Affairs    Division
                          United States General Accounting                    Office
                          Washington,     DC 20548
                          Dear Mr.          Conahan:
                                  This is the Department   of Defense (DOD) response to the
                          General Accounting     Office  (GAO) Draft Report GAO/NSIAD-90-220,
                          entitled     "GOVERNMENT CONTRACTING: Review of the Morton Thiokol
                          Separation,"     dated June 26, 1990 (GAO Code 396136/OSD
                          Case     8400).

                                 The Department         takes no exception          to any of the findings           in
                          this draft      report.       In fact,       the GAO findings       closely      parallel
                          those of the cognizant              DOD contract     administration         office     for
                          the Thiokol       Corporation         during    its own review      of this      matter,
                          conducted prior         to the Morton Thiokol           separation.         That DOD
                          office    similarly       concluded       that the allocation         of debt between
                          the two new corporate            entities       was equitable     and that Thiokol's
                          projected     business      base should be sufficient             to ensure the
                          company's continued           viability.

                               Thank you for            providing      the    Department              with   the opportunity
                          to comment on this            draft    report.

                                                                                   David'J.        Berteau
                                                                                   Principal        Deputy

(3MlM)                        Page8                                                                 GAO/NSIAD-90-220Morton     Thiokol
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