Northrop Grumman: Value Stock Or Value Trap?
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The shares of defense contractor Northrop Grumman (NYSE: NOC) have the classic appearance of a value stock: attractive dividend yield of 3.3 percent, a price to earnings ratio of less than 10 compared to the S&P 500 P/E ratio of 15 and the share price is coming off a recent multi-year low. The problem with the stock is the distinct possibility of significantly lower defense spending by the federal government in future years. The majority of Northrop Grumman's revenues come from defense contract work.
The company divides its business into five divisions: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The first three bring the bulk of revenues and operating profits, with recent results fairly evenly split between Aerospace, Electronic and Information Systems. Government and defense contract work is often awarded after a competitive bid process. Similar companies in competition with Northrop Grumman include General Dynamics (GD), Lockheed Martin (LMT), Raytheon Company (RTN) and Rockwell Collins (COL). For certain contracts, two or more of these companies will team up to complete a large defense contract. For example, Northrop Grumman will provide the active sensor arrays for the new F-35 Lightning fighter, of which Lockheed Martin is the prime contractor.
When Northrop Grumman released the company's second quarter financial results in July 2011, management guidance for the remainder of the year pushed the market toward a negative outlook on the stock. The guidance included increases on the projected earnings per share for the year and a higher operating margin. However, the guidance also reduced the projected revenue for $2011 to $27 billion from $27.5 billion. The result of this news was a share price decline from about $65 to just under $50 over the next three weeks – the share price had not been at this level since mid 2009. The value drop is very noticeable on the one-year price chart.
So is Northrop Grumman a value stock that can provide an attractive return to investors? These are the positive factors for the company:
- The company is currently throwing off a large amount of free cash flow, the bulk of which management and the board of directors is using to repurchase shares. For 2011, the free cash flow could end up being as high as $2 billion. At the end of the 2011 third quarter, the company had bought in 18 million shares over the previous year. The 279 million shares outstanding was over 20 percent lower than at the end of 2007. The lower share count gives a positive boost to earnings per share growth even if actual earnings growth is slow or flat.
- Dividends have been increasing steadily since 2004, compounding at a 13 percent rate. For that year the quarterly rate was 23 cents per share. Currently Northrop Grumman is paying 50 cents quarterly for more than a 3 percent yield. A dividend increase is usually announced with the first quarter earnings report in April.
- The U.S. military needs the high technology equipment and products produced by Northrop Grumman. For example, the company is a major supplier of unmanned aerial vehicles – UAV's – which are widely used in the war on terror. Also government military business tends to be in the form of multi-year contracts.
The big negative factor is that military spending levels are threatened by real budget concerns in Washington, D.C. Military spending is a very large part of an annual budget which currently spends about 40 percent more each year than it takes in from tax revenues. For a company like Northrop Grumman, defense spending cutbacks could result in fewer projects to bid on for new business and a slowing and extension of existing contracts, lowering the revenue the company receives each year.
For investors, flat to slow growth in revenue would be enough with the share buy backs to keep net income per share and the dividend increasing. At the current share price valuation and low P/E multiple, it seems the market has already priced in a slowdown in defense spending. With 2012 being an election year in the U.S., little will change in the fortunes of the company this year. For future years, the election outcome plus whether or not the economy can pick up its rate of growth will determine if there will be possibilities for stronger growth in the Northrop Grumman future.
The Motley Fool owns shares of Northrop Grumman. Vatalyst has no positions in the stocks mentioned above. 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.