NOC - Northrop Grumman Stock: A Realistic Approach

2023-07-19 19:21:09 ET

Summary

• Shares of Northrop Grumman Corporation soared in 2022 in anticipation of further growth following the war between Ukraine and Russia.
• This and inflation are not really showing up in the results, which are lagging a bit, notably 2023 margins.
• Given higher anticipations, modest growth, lower margins this year, and higher net debt, I understand the recent underperformance of Northrop Grumman shares.

Shares of Northrop Grumman Corporation ( NOC ) surfaced on my radar after the defense play hit the list of shares approaching their 52-week lows, despite the ongoing war between Ukraine and Russia, prompting Western nations to increase their defense budgets.

In February 2022, when the conflict was on the verge of breaking out, I called Northrop a defensive play in any portfolio, after it guided for stable results in 2022. Moreover, a 16 times earnings multiple looked non-demanding, with the positioning looking quite good, and the emerging conflict around Ukraine providing a wildcard for better performance over time.

A Quick Recap

Northrop Grumman is a major player in defense and aerospace markets, generating about $35 billion revenues in 2021 with 90,000 employees which are involved in development and production of space, aeronautics, defense and cyberspace products and services. The company is very closely intertwined with the U.S., as the actual mission is to protect the U.S. and its allies.

The business reports its results across four sectors, the largest of which is the aeronautics business, which generated over $11 billion in sales from strike, air, dominance, battle management and related systems. Space systems generate over $10 billion in sales from satellites, ground systems, missile defense systems and related services. The third segment is a $10 billion mission systems business which focuses on cyber, radar and electronic warfare, complemented by a smaller near-$6 billion defense systems business, related to weapon systems and their management systems.

2021 revenues for Northrop fell 3% to $35.7 billion, with organic growth posted at 3%. The business posted operating profits of $4.2 billion, for margins of 11.8% of sales as GAAP results at times were impacted by fluctuations in pension related labilities (and assets).

A mere $60 stock in 2013 rallied to $350 in 2018 amidst consolidation in the sector, higher margins, continued share buybacks, a re-rating across the sector, and better operating performance with military moving into cyberspace and aerospace as well. Following this huge move, shares consolidated and traded around a high of $400 per share in early 2022. With realistic earnings reported at $25 per share, the resulting 16 times earnings multiple looked reasonable.

Moreover, net debt of $9.2 billion was reasonable as I pegged adjusted EBITDA around $6 billion. With the company guiding for $36.4 billion in sales for 2022 and realistic earnings seen at $24.8 billion, the performance was seen largely flat, but still I was upbeat on the cash flow generation and modest valuations.

Moreover, continued shareholder payouts were likely in the cards as further consolidation across the industry was more or less prohibitive, after the FTC sought to block a $4.4 billion deal between Aerojet Rocketdyne and Lockheed Martin ( LMT ) , which was looking to acquire the business. Given all this, Northrop looked like a decent cornerstone stock.

Doing Well, Coming Down

Trading at $400 early in 2022, shares of Northrop saw a big rise in 2022 amidst the political conflict and tensions on the rise, as shares rose to a high of $550 by year end. This was followed by a tough 2023 so far, with shares now trading at $440 per share.

After a rather uneventful year 2022, on the operational front, Northrop posted its results for the full year in January of this year. Full year sales rose by 3% to $36.6 billion, largely in line with the original guidance, although that a $25.54 per share adjusted earnings number was a bit better than anticipated. Promising was that the company took in orders worth $39.3 billion for the year, adding to the backlog which stood at more than $78 billion, although part of this is due to inflationary pressures of course. Net debt ticked up to just over $10 billion, mostly due to some buybacks, not being a major concern.

For 2023, the company guided for sales to advance in a rather modest fashion to $38.0-$38.4 billion, while the mark-to-market adjusted earnings per share are seen down to $21.85-$22.45 per share, the result of fixed price contracts in an inflationary environment in combination with higher pension expenses.

In April, Northrop reported a solid 6% increase in first quarter sales as the earnings guidance was hiked by forty cents to still just $22.25-$22.85 per share, all while first quarter net debt ticked up to $12.4 billion following some accelerate buybacks. On top of these buybacks, the company hiked the quarterly dividend payout by 8% in May to a quarterly payout of $1.87 per share, although it still only works down to a 1.7% dividend yield.

What Now?

Fast forwarding over the past eighteen months, we have seen shares of Northrop gain about 10% while the underlying performance in 2022 and 2023 has not been too impressive given the political environment and inflationary environment. Furthermore, 2023 earnings should take a beating and net debt has ticked up quite a bit in the meantime, which means that the risk-reward has been coming down a bit, even as the stock has fallen a bit recently.

That said, the recent disappointing Northrop Grumman Corporation trading action is likely the result of a near 40% run higher during 2022, which is not showing up in the near-term outlook, in fact the contrary.

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