Reasons to Buy This Defense Contractor
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Northrop Grumman Corporation (NYSE: NOC) is a leading defense contractor, with 2011 net sales of ~ $26 billion. Northrop reports through four segments: Aerospace Systems (37% of 2011 sales); Information Systems (28%); Electronic Systems (26%); and Technical Services (9%). The company has been consistently posting better than expected results and as a result, the stock price has seen an impressive ~29% year to date run up. The company’s EPS has been ahead of the street estimates for every quarter since early 2007, and 2Q12 was no different. Q2 upside was largely driven by stronger than expected margin performance that more than offset the weaker top-line (which declined for a 7th consecutive period in Q2). New awards in the quarter totaled $8.1billion, up 50% sequentially with a book-to-bill of 140%. Following awards contributed largely to the Northrop’s performance:
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Last quarter, on May 21, Northrop announced the long anticipated $1.7 billion AGS system contract with NATO.
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On June 21, Northrop received an upgrade award for its Battlefield Airborne Communications Node (BACN) for $156 million raising the total program value to $1.6 billion.
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Northrop also won $1.4 billion in awards in the quarter, with NASA's Goddard Space Flight Centre for the James Webb Space Telescope.
Similarly, key potential awards for Northrop are lined up over the next 18 months including the Next Generation Enterprise Network (NGEN) and Next Generation Jammer (NGJ) programs. I believe these potential awards will provide huge upside at the top line. Apart from this, the company is likely to benefit from its strong position in defense space.
Strong Position in Defense Space
Northrop is well positioned in defense space given strong demand of fighter jets via Boeing Company's (NYSE: BA) F/A-18 (40% content) and Lockheed Martin Corporation’s (NYSE: LMT) JSF (20% content). I believe LMT’s F-35 program will continue to make good progress for the foreseeable future which eventually will benefit Northrop as it makes major sub-assemblies of the F-35 Joint Strike Fighter. Further, Northrop's leadership in UAVs allows it to be a part of impressively growing industry. Therefore, I view this segment as a long-term structural growth driver.
Acquisition of M5 Network Security
Northrop Grumman depends heavily on Department of Defense (DoD) spending by the U.S Government as about 90% of the company’s revenue comes from products and services sold to the U.S. Government. In recent budget submissions, US Department of Defense (DoD) has set aside ~$11 billion to be focused on C4 related systems. Therefore, in my opinion, Northrop’s announced acquisition of M5 Network Security Pty Ltd. (Australian Cybersecurity Company) is a huge positive for the company.
Strong Balance Sheet and Cash Flow
The company’s impressive 2Q diluted EPS of $1.88 attributes to strong margins and share repurchases (bought back 4.9 million shares in Q2). Northrop returned 134% of operating cash to shareholders in 2011 and has averaged 77% since 2007. I expect this to continue through 2014 driven by the dividend and consistent share repurchases (including a ~10% YoY reduction in share count in 2012), and thus, provide a support to stock price. The company offers dividend yield of 3.3% which puts it in line with competitors General Dynamics (NYSE: GD) and Raytheon (NYSE: RTN).
The following table summarizes the forward PE and dividend yield of Northrop, Raytheon, General Dynamics, Boeing and Lockheed martin:
|
Company |
Dividend Yield |
Forward PE |
|
Northrop |
3.3% |
9.54 |
|
Raytheon |
3.4% |
10.26 |
|
General Dynamics |
3% |
8.91 |
|
Boeing |
2.4% |
12.63 |
|
Lockheed martin |
4.3% |
11 |
Clearly, Northrop and General Dynamics both are trading with a lower forward PE on a relative basis. I believe the lower valuation of General Dynamics is justified as the company has recently lost the Joint Light Tactical Vehicle (JLTV) Engineering Manufacturing and development (EMD) Contract and therefore the company will lose its market share in tracked and wheeled vehicles . But Northrop seems undervalued given the high dividend, potential to further increase the dividend, and strong long term growth prospects.
Despite stiffening macro headwinds, I believe management will continue to create a value through suitable measures like portfolio shaping. Although the company stock prices have seen an upside after the announcement of its 2Q results, the stock reaction was less positive than I would have anticipated given the EPS, cash, and bookings. Aerospace might be the sector to watch in Northrop for growth given the recent backlog performance. I believe the company’s use of cash flow to repurchase shares and potential acquisition of cyber security related companies will continue to deliver better than expected results. The stock has pulled back ~4% over the last 2 weeks and I think that presents a window for investors to put this stock on their portfolio.
ankitagrawal has no positions in the stocks mentioned above. The Motley Fool owns shares of General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
