Should Investors Be Happy About An Additional $4 Billion Share Buyback?

Nick is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Northrop Grumman (NYSE: NOC), a leading global security company, is buying back an additional $4 billion of the company's common stock, totaling the authorized share repurchase amount to about $5 billion, which is near 27% of the current market cap of $18.58 billion as of May 16, 2013. Northrop plans to retire about 25% of its shares outstanding by the end of 2015. The company will use its cash balance or free cash flow to fund the repurchase and issue debt if necessary. Earlier, Northrop had also increased its dividend by 11% to $0.61 per share. Northrop is working aggressively to create value for its shareholders.

By digging further and take a look at Northrop’s balance sheet and free cash flow, investors may want to pause before jumping in. First, as of March 31, 2013, Northrop had $3.18 billion total cash and $3.94 billion in total debt. Second, despite the earnings beat in the last quarter, the free cash flow was not pretty for Q1, as seen from the chart below. Lastly, by increasing its dividend, the company will likely need to borrow to fund the accelerated share repurchase. Northrop’s current debt/equity ratio of 0.4 is better than Lockheed Martin's (NYSE: LMT) debt/equity ratio of 20.2 and the industry average of 0.7, but slightly higher than its close rival, General Dynamics' (NYSE: GD) debt/equity ratio of 0.3.

Source: YCharts.com

Lockheed Martin is the No. 1 defense contractor in the US, whereas General Dynamics offers a broad portfolio range from tanks, to IT, to weapons. While both companies and Northrop won’t be significantly  impacted significantly for their profit due to sequestration, their sales already be negatively impacted by the budget cuts. Cost cutting is essential for these three companies to maintain profits, while the revenues are expected to be pressured further in the second half of the year, and even more so in 2014.

General Dynamics is also facing the same situation as Northrop. General Dynamics had increased its dividend by 10% to $0.56 per share in March and informed investors to expect more “shareholder-friendly” share buybacks in 2013. Taking a look at the chart below, General Dynamics' free cash flow does not look promising either with increasing dividend. That might be one of the reasons why Berkshire Hathaway sold its stakes in General Dynamics.

Source: YCharts.com

Although Lockheed Martin has a higher leveraged balance sheet, its free cash flow paints a better picture than the other two to support its increasing dividend. Lockheed Martin’s share repurchase activities had only picked up slightly since early 2012, as seen from the chart below.

Source: YCharts.com

Bottom line

While the share price had climbed double digits for all three companies YTD, investors need to be more careful with these so called “defense” providers now. With expected sales decline, increasing share repurchase and dividend further pressured the weak free cash flow for Northrop and General Dynamics. Investors need to stay alert, as share buyback may not always be a good thing for the long-term.

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Nick Chiu has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, Lockheed Martin, and Northrop Grumman. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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