NOC - Northrop Grumman Has Much To Gain From Nuclear Modernization

2023-06-07 07:57:19 ET

Summary

• Northrop Grumman is expected to benefit from the generational boom in defense spending due to the receding globalization and increasing great power competition.
• A more tense global environment and Chinese efforts at nuclear parity make the firm's centrality to the US nuclear triad more important than ever.
• The primary risks for Northrop Grumman are supply chain and labor needs, as labor shortages in specialized areas can hold up the entire supply chain.

There is an old Chinese proverb: Rich country, strong army. And while it may have the ringing truth of an aphorism, it is not necessarily true, for instance, in China's case. It is indeed rich. China may have a strong army on paper, but so did Russia! Strongmen leaders Vladimir Putin or Xi Jinping might be willing to test the US in a lot of different areas, but I suspect they don't want to test the US strategic nuclear deterrent.

This is for good reason. US nuclear capabilities are breathtaking and comprehensive, but it is also aging. Modernization is a key defense priority. And while both China and Russia have tried to create parity and are still attempting to, Northrop Grumman ( NOC ) is busy making sure they will never achieve it.

There have been many examples of prosperous nations that cannot contrive enduring military power. Russia, for example, is a rich country, fat off commodities, and was thought to be militarily strong.

However, endemic corruption and perverse incentives in an authority system led to equipment as simple as radios and as complex as hypersonic missiles being paper tigers. State funds were pilfered instead of put to good use. The lack of encrypted radios resulted in the death of many Russian officers early in the conflict.

Unfortunately, recent events appear to be very supportive of the thesis that I advanced in my January piece on Raytheon ( RTX ): the War in Ukraine, and the global threat environment in general, are likely to drive defense spending back toward proportions of GDP last seen during the Reagan Administration.

While this is a positive for the US Defense & Aerospace in general, there's a new long I'd like to add because it will be a company that will continue to benefit from the rise in great power competition. That firm is Northrop Grumman. It's the most vital US defense contractor with regards to the US nuclear deterrent and its modernization. It operates at all three levels of the triad, since it builds Trident II missiles for nuclear subs in addition to more recent high-profile contract wins.

The generational boom in defensive spending is well underway, and Northrop Grumman will be one of the primary beneficiaries of this transformational change in our world. Recent events have unfortunately blended great credence to the thesis that globalization is receding more permanently and dramatically than recency bias would indicate. Recency bias is a massive part of why many are missing the significance of what's happening. The recent episode with the Chinese spy balloon highlights the increasingly shrill tenor of nationalism and resentment on both sides of the Pacific.

• There is bipartisan support for the Ukrainian state in the face of Russian military aggression.
• The Chinese posture toward Taiwan is increasingly aggressive, and the nation is rapidly expanding its strategic nuclear arsenal.
• Vladimir Putin's recent speech indicated that his belligerence is only increasing. His actions with regard to nuclear treaties similarly show the increasingly dire state of international cooperation.

The changing nuclear environment likely means any changes are going in one direction. The firm just recently received a modification for the very important missile defense program it is working on.

Secular Conditions for US Defense Spending Are The Most Favorable in Decades

Most investors have come of age in a world marked by unprecedented global cooperation and connection. Still, and quite unfortunately, in my opinion, the tide of globalization is rolling out as the world reverts to a more historically familiar period of great power competition for importance on the world stage. What this means for the United States is that the Defense budget will probably return to proportional levels of GDP not seen in decades.

What it means for Northrop Grumman is that current projections for earnings and revenue growth could very well be light. Even if there wasn't an ongoing generational boom in defense spending, Northrop has a lot of the sacred cow projects, including the next-generation Land-Based ICBM and the illustrious B-21 Bomber, which together comprise two vital legs of Uncle Sam's future nuclear triad.

While I indeed lament this course of events as a citizen of the world and as a person who has grown up in a world trending toward connection and cooperation as a shareholder, I'd like to insulate myself from the litany of risks our unstable new world thrusts upon the winners of yesterday's more friendly world order. Northrop is a good counter-cyclical name to add to a portfolio.

You Can't Put a Price on Nuclear Deterrence

"The United States is entering one of the most complex and challenging periods for the global nuclear order, potentially more so than during the Cold War.” -ISAB Study on Nuclear Deterrence

There are some complicated arguments and industry jargon in this piece that might be confusing. However, one of the main arguments for owning Northrop is quite simple indeed. The United States is embarking on a dual-front Cold War with two nuclear-armed adversaries that are desperately trying to catch up. Uncle Sam is going to prioritize the deterrent and already has offered a lot of relief in the areas of contracts to help alleviate common pressures and uncertainties for contractors.

China has about 400 nuclear warheads right now, but the Pentagon estimates it will have more than three times that many by 2035. There have been some calls on both sides of the aisle to increase nuclear weapons in order to match the dual Chinese and Russian threat. Of course, Northrop would be a primary beneficiary.

It's not always in fashion to talk about, but we've been spending a lot more money on this stuff than our opponents for a very long time. Nonetheless, when it comes to nuclear deterrence, you have to be absolutely sure. When you're the wealthiest nation on Earth defending a rules-based international order, it's probably best to overdo it too. Uncle Sam will err on the side of caution with its sacred cow projects, likely much to the benefit of Northrop.

Valuation

This stock has tended to enjoy a premium lately after winning extraordinary contracts. However, after recent price weakness the firm is undervalued by several metrics which caught my attention. The trading multiples look pretty good, and given the direction of headlines as Ukraine's offensive begins, I think there's potentially some upside both technically and from the news cycle in coming months. The trading multiple ranges look pretty good.

And while the dividend here is good and management is moving toward returning to 100% of FCF to shareholders, the primary thing attracting to me this stock is its premier contracts and their very dear nature to the free world.

When you pair this up with compelling valuation and a solid dividend with good growth prospects, it makes the stock very appealing in my eyes. As you can see above, the stock has healthy upside when using a discounted cashflow model. However, I wanted to bring another interesting metric that shows and even more advantageous upside potential.

I'm a big fan of Peter Lynch, as all equity researchers should be. He has an interesting method that I've always been a fan of called Peter Lynch Fair Value. This methodology is giving the all-clear as well.

Now, when using the Dividend Discount Model method the stock is roughly at fair value. Same with Northrop's EV/EBITDA range. But, as I stated, the dividend is a "nice-to-have" but it's not the primary reason I'm into the stock. However, I'll always happily take a dividend and add to my margin of safety.

Risks for Northrop

Northrop's primary risks occur in two related areas: the supply chain and labor needs. Labor in the Defense & Aerospace Industry is highly specialized, and a lot of those experienced are at, past, or approaching a normal retirement age. Labor shortages can cripple a single component in a complex product and hold up the entire supply chain.

There are very exacting criteria if you want to be part of Uncle Sam's Defense supply chain in terms of labor and standards. This can add to the difficulty of manufacturing incredibly complex products to some of the highest specifications and standards around. But the three main risks for the defense guys right now are still:

1. Supply Chain

2. Labor

3. Inflation

Luckily, the industry has been seeing some improvement along the key risk areas that have vexed management teams over the past months. The supply chain has normalized a bit but you also have to remember given the sensitive nature of the contracts the firm works on, there will always be some opacity involved.

Conclusion

As the global threat environment continues to rise, one of the most important dimensions of maintaining security is in the realm of the unthinkable, nuclear weapons. As distasteful a job as Northrop has, it must ensure that our ability to unleash a nightmare upon our enemies is credible enough to ensure that they do unleash one on us. This task is controversial, but also more essential than ever.

Northrop hits a sweet spot of intersecting along several attributed that I think will be advantageous to long-term shareholders over the next five to ten years. It will be a major beneficiary of increasing defense spending. Regardless of administration, or even if the Defense Budget somehow went down (very unlikely) Northrop's leading edge "sacred cow" products would be the last on the chopping block. This firm has delivered to shareholders and to the United States over decades, but I think its finest hour is still ahead.

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