NOC - Northrop Grumman: A Promising Investment Opportunity In The Defense Industry

Summary

• Northrop is a leading global defense contractor with a strong portfolio of products and services in the aerospace and defense industry.
• The company is well-positioned to benefit from secular trends and has significant growth opportunities, such as the Ground Based Strategic Deterrent, the militarization of space, and the B-21 bomber program.
• Despite risks, such as reduced defense spending, geopolitical tensions, and cost overruns, Northrop is a high-quality company with growth potential and a reasonable valuation.

Northrop Grumman ( NOC ) is a leading global defense contractor with a strong portfolio of products and services in the aerospace and defense industry. The company is well-positioned to benefit from secular trends in the defense industry and has several significant growth opportunities, such as the Ground Based Strategic Deterrent, the militarization of space, and the development and manufacture of the B-21 bomber.

Business

Northrop is focused on producing hardware for classified programs and enjoys exposure to several significant military development programs that are still in their early stages. The defense budget is a political process, which makes it challenging to predict, so Northrop Grumman's focus on a steady stream of contract wins provides a tangible growth profile. Defense contractors like Northrop Grumman benefit from regulated margins, mature markets, customer-paid research and development, and long-term revenue visibility, which allows the company to generate substantial cash for shareholders.

Northrop Grumman has three significant growth opportunities in the aerospace and defense industry: the Ground Based Strategic Deterrent, the militarization of space, and the development and manufacture of the B-21 bomber. These programs are expected to provide substantial growth for the company and solidify its position as a leader in the industry.

Northrop Grumman has a strong presence in the space segment, which is its fastest-growing segment. The company is a leader in rocket motors, a market that is expected to see significant growth as new entrants require rockets to launch small satellites into low orbit. Northrop's expertise in the defense sector is highlighted by its involvement in the Ground Based Strategic Deterrent program.

Northrop Grumman's involvement in the United States Air Force's Ground Based Strategic Deterrent program is a significant contributor to the company's success. This next generation of land-based nuclear missiles is currently in the engineering and development phase and was awarded in September 2020. The program is valued at approximately $13 billion through 2029 and highlights Northrop Grumman's expertise in the defense sector.

Great Power Competition, Budget, and Northrop

The rise of great power competition refers to the growing geopolitical competition between major world powers, particularly the United States, China, and Russia. This competition is driven by a range of factors, including economic, military, and technological power, geopolitical influence, and cultural differences.

In recent years, the United States has faced a growing threat environment , characterized by the increasing capabilities of competitors and adversaries, the proliferation of advanced technologies, and a range of new security challenges, such as cyber attacks and irregular warfare. As a result, the US has had to adapt its military strategy and posture to meet these emerging threats, which has led to calls for increased defense spending.

The US defense budget has historically been one of the largest in the world, with an estimated spending of $738 billion in 2021. It is likely to continue to grow in response to the rising threat environment, with some experts projecting an increase to exceed $1 trillion by 2027. Increased defense spending will be aimed at modernizing the US military, enhancing its capabilities, and improving its readiness to respond to emerging threats. This may involve investments in new technologies, such as artificial intelligence, hypersonic weapons, and cybersecurity, as well as in personnel, training, and infrastructure.

In addition to these investments, the US may also seek to strengthen its alliances and partnerships, both in Europe and Asia, as a way of deterring potential adversaries and ensuring that it remains a dominant military power. For example , the US has recently increased its military presence in Europe and the Indo-Pacific region in response to growing concerns about Russian and Chinese aggression. The US has also pushed more weapon sales to allies, which would benefit US defense companies.

From the perspective of Northrop Grumman, a leading defense contractor, the rise of great power competition and the growing threat environment is likely to present significant business opportunities. Northrop's portfolio is highly aligned with the Department of Defense's (DoD) top areas of spending, including space, hypersonic, and new bombers. As the US increases its defense spending, Northrop Grumman is likely to benefit from a growing demand for its products and services in these key areas. This increased demand could lead to higher revenue and profits for the company, and potentially result in new contracts and partnerships with the US government and other defense customers.

Financial & Valuation

All forecasted numbers, unless stated otherwise, are consensus numbers from FactSet.

At a forward price-to-earnings ratio of 21x, Northrop Grumman is currently trading at a premium compared to Lockheed Martin ( LMT ) at 18x. We believe that this premium is justified by NOC's stronger growth prospects. The company is expected to grow 4.7% in 2023 and accelerate to 7.2% in 2024, driven by the increasing mix of the faster-growing space segment and the growing support for military spending.

In our opinion, LMT's revenue growth is less impressive, with a flat outlook for 2023 and modest growth of 3-4% per year thereafter. Despite this, the growth prospects for both companies highlight the potential for growth in the aerospace and defense industry and the strong position of Northrop Grumman within the sector. We believe that NOC's premium valuation is a reflection of its growth potential and leadership position in the industry.

Northrop Grumman is expected to experience improving margins over the medium term as the company shifts into more profitable production contracts from development-stage programs and leverages increased sales from overseas defense spending growth. The margins in the space systems segment are expected to improve as the Ground Based Strategic Deterrent matures and approaches the double-digit operating margins of Northrop's other segments. These modest forecasts are expected to result in significant growth in free cash flow for the company and its shareholders over the next five years and beyond.

Northrop Grumman is expected to maintain its relatively high capital expenditure as a percentage of sales over the next two years to accommodate capacity for the Ground Based Strategic Deterrent. However, it is not expected that the company will need to add capacity indefinitely, and the ratio is expected to normalize at 3% of sales.

Risk

Northrop Grumman is a relatively stable stock with consistent earnings and long-cycle contracts, but investing in the stock still comes with several risks. Some of these risks include:

Valuation risk: If the company fails to meet growth expectations, its premium valuation compared to other defense companies could diminish, leaving it vulnerable to significant downside potential as multiples adjust to align with peers.

Defense budget risk: The defense budget may not live up to expectations, which would have a negative impact on Northrop Grumman given its large size and extensive portfolio in growth areas. The US budget could be pressured by an economic downturn or internal division, or the country could choose to turn inward if the population refuses to support the cost of maintaining a global empire. In either case, both export opportunities for Northrop Grumman and the US defense budget are likely to decline.

Geopolitical risk: Temporary de-escalation in geopolitical tensions between Russia, Ukraine, the United States, and China could lead to reduced defense spending and negatively impact Northrop Grumman's stock price.

Cost overrun risk: The risk of cost overruns could result in higher capital expenditures, higher operating expenses, lower free cash flow, and lower margins. This could occur if the company takes on projects that are more complex or expensive than anticipated, or if it experiences delays or disruptions in its operations.

Conclusion

In my view, Northrop Grumman is a high-quality company with growth potential due to its portfolio and secular trends in the aerospace and defense industry. The company is trading at a reasonable valuation, with a forward price-to-earnings ratio of 21x, compared to its peers. While investing in Northrop Grumman stock comes with some management risks to the downside, such as potential reductions in the defense budget, geopolitical tensions, and cost overruns, the company's position as a leader in the industry and its focus on steady contract wins provides a tangible growth profile.

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