2023-04-06 14:29:31 ET
Summary
- Northrop is one of the leading aerospace and defense companies in the world, driven by its focus on innovative high-tech solutions.
- The outlook for both the Space and Defense industry is looking very good, which poses well for industry giant Northrop.
- It is the Space Systems segment in particular that will drive growth for Northrop as it has been doing over the last decade as well.
- With the shares down from a high of $550 back in December and relatively flat since the start of the war in Ukraine, the risk-reward offering right now is attractive enough.
- Based on my FY24 EPS projections, I calculate a target price of $503 per share.
Introduction
Morgan Stanley r ecently released its list of the 30 best long-term picks until 2025, and among those 30 companies was defense and aerospace giant Northrop Grumman ( NOC ). Morgan Stanley gave the following reasoning for its choice of this company:
NOC plans to return >100% of FCF to shareholders in 2023 and we expect the management team - which we view as best-in-class - to continue to run its shareholder-friendly capital deployment playbook at least through mid-decade.
And there is not much to argue against this as Northrop has shown in the past that it is a best-in-class company, has an excellent management team that is shareholder focused, and has a lot of technical expertise in-house, which allows it to produce the highest-end defense and aerospace products like the famous James Webb telescope. This combination of factors has resulted in a solid performance over the last 10 years, with the share price up 545%, outperforming the SP500 ( SPY ) performance of 155% by a far margin. So, whereas the company might be viewed as a defensive stock option, it definitely is capable of outperforming the markets without even taking into consideration its excellent dividend payout and growth.
That defense companies were on the Morgan Stanley list (Raytheon ( RTX ) was also on there) is not a real surprise either. The defense and aerospace sector is proven to be one of the best low-volatility investments over the last several decades, driving a solid outperformance versus the overall market. This is partly driven by the ever-increasing defense budget, inflation, and a high innovation rate in the industry. And the defense outlook has not gotten any worse since last year either as the Russia/Ukraine war has shown European countries in particular that the defense budget is not something to save on as they have been doing for the last decades. As a result, many countries have already announced massive increases in defense budgets.
Yet, even though this tailwind will be strong for defense technology leader Northrop, I am even more enthusiastic about the growth potential Northrop has in its space systems segment. Demand for commercial space travel is increasing and Northrop is one of the primary companies to benefit due to a robust long-lasting partnership with NASA. Moreover, the space systems segment has shown impressive growth over the last several years already and I see no reason we should not expect this to remain a strong growth driver over the next decade.
But due to these tailwinds, its shareholder-friendly approach, and strong historical performance, Northrop tends to trade at a premium. So now, to find out whether it is a buy today, I will be diving into the company fundamentals, financials, and growth drivers, and see what we can expect from Northrop over the next several years.
Let's dive in!
Northrop Grumman Corporation
Northrop Grumman Corporation is a global aerospace and defense technology company that designs, manufactures, and delivers advanced systems, products, and solutions for government and commercial customers. To be exact, the company delivers its advanced space and defense products and systems to 25 countries, with the US being its largest customer, accounting for 86% of revenues . In addition, European countries account for about 6% of revenue, the Asia Pacific region (Australia, South Korea, Japan) accounts for 5.5%, and others, including the Middle East, account for 2.6% of total revenue. This shows that the company is quite dependent on revenues from the US. While this is not ideal, the US government's defense spending growth is expected to remain strong with the need to replenish inventories after sending a lot of military equipment to Ukraine functioning as an additional tailwind. Also, with the boost in defense spending in Europe, I believe this region should start accounting for a larger part of revenue over the next decade. Therefore, I do not believe that the current exposure to the US is anything to worry about.
The company was founded in 1939 and has since grown to become one of the largest defense contractors in the world, generating $36.6 billion in revenues in 2022. This means the company has grown revenues at an annual growth rate of 4%, driven by its long history of developing advanced technologies and products for the defense and aerospace industries. Northrop has always been one of the most innovative companies in the industry, driven by high R&D investments and a focus on new technologies. I believe this strategic focus positions them exceptionally well in a time when warfare is increasingly digital and high-tech.
The company operates in four business segments that are Aeronautics Systems, Mission Systems, Defense Systems, and Space Systems. Aeronautics Systems accounts for 29% of revenue and is the second-largest individual segment for Northrop. This segment is responsible for designing, developing, and producing advanced aircraft, spacecraft, high-energy laser systems, and unmanned aerial vehicles (UAVs). Some of the key products for this segment include the center fuselage, radar system, and other key components that Northrop develops as a major subcontractor for the F-35 Lightning. This segment also includes the latest version of the B-21 Raider recently announced by Northrop. This stealth bomber is the highest-end bomber currently available and should bring in decent cash flows for Northrop over the next decade. This segment is very important for Northrop as it is an important driver of revenue and I believe it will continue to do so over the next decade as well, in part due to its new bomber but also increased defense spending will function as a tailwind for this segment. As a result, this segment should be able to grow at a 2-3% CAGR until 2026.
The defense systems segment accounts for 15% of 2022 revenue as the segment has seen a drop in performance over the last 2 years. Yet, due to the nature of this segment, increased defense spending should be a solid tailwind. The defense segment is responsible for developing and producing advanced technologies and systems for defense applications. These include missile defense, tactical missiles, and cybersecurity services. Also, the company is the world's top producer of medium caliber live and training ammunition and gun systems, with more than five million units built in the last five years. Now, with the US sending a lot of its ammunition to Ukraine, they will need to replenish ammunition inventories over the next several years and Northrop could benefit from this. Therefore, I expect a 1-3% CAGR until 2026 for this segment.
The mission systems segment accounted for 28.4% of FY22 revenue, growing steadily over the last 4 years. This segment is responsible for developing and producing advanced solutions for intelligence, surveillance, and reconnaissance (ISR), cybersecurity, and other mission-critical applications. Northrop provides advanced ISR solutions for a range of customers, including the U.S. military and intelligence agencies. Overall, the segment is committed to delivering advanced capabilities to help its customers achieve their mission objectives, making it a crucial product offering for military missions. As a result, growth for this segment should continue to be decent and around 3% until 2026.
Finally, there is the space systems segment which accounted for 33.5% of FY22 revenue, overtaking the Aeronautics Systems segment from the year before as the segment has seen rapid growth over the last several years. This segment is responsible for developing and producing advanced technologies and systems for space applications. This includes advanced space systems for national security applications (including satellites, payloads, and ground systems), space systems for commercial customers, and advanced systems for space exploration. Also, Northrop supports NASA's Artemis program by providing important parts like rocket boosters, the abort motor, and the attitude control motor. This strong relationship with NASA and its involvement in the latest space programs means Northrop is well-positioned to benefit from additional future space missions from the US. Moreover, Northrop played a crucial role in developing and constructing the James Webb Space Telescope , the most complex and ambitious space observatory ever built, illustrating Northrop's technical and innovative expertise. With the increased demand for commercial space services and increasing space activity from governments and NASA, the space segment should continue as one of the primary growth drivers for Northrop, driving double-digit growth over the next several years.
Solid FY22 results and plenty of tailwinds for Northrop
Despite a lot of headwinds during 2022, Northrop delivered outstanding results , outperforming its previous outlook in many aspects. Revenue for the full year grew to $36.6 billion, representing 3% organic growth YoY. This growth was driven by the space systems segment which saw the strongest performance by a far margin as this grew by 16% YoY to $12.28 billion. This was driven by strong industry demand and an improved ability to scale this business segment. Northrop completed 40 successful launch and space missions during the year, exemplifying its end-to-end capabilities in the space market and showing successful growth in the space industry. With increased worldwide interest in consumer space systems and a renewed focus from the US government on space activities, this is expected to bode well for the entire industry as well as for Northrop in particular.
In 2021, space industry spending totaled $469 billion , growing 9% YoY, the fastest growth since 2014. Commercial space initiatives accounted for a very surprising 77% of this spending as the commercial space industry is growing rapidly. But also, government spending increased by 19% YoY, adding $107 billion to the equation. Moreover, the US government and military alone contributed $59.6 billion, accounting for 12% of global space spending. As a result of this growing demand, the Space Foundation expects the space economy will grow beyond $634 billion by 2026, according to a 2022 report. In addition, Citigroup predicts the space industry will reach $1 trillion in revenue by 2040, driven by a 95% lower launch cost, more commercial demand, and growth in the satellite market. This prediction is in line with earlier reports from Bank of America and Morgan Stanley and represents a CAGR of 4.38% from 2020 to 2040. With Northrop being one of the primary partners of the US government and NASA and one of the frontrunners in space technology and manufacturing, it is very well positioned to benefit from any further accelerations in space spending. Therefore, Northrop is my top choice for those who want exposure to this highly interesting industry.
The mission systems grew 3% YoY, while defense systems revenue fell 3% and Aeronautics Systems fell 6%. And while these results were not as stunning, they also see plenty of tailwinds. Global military spending has been increasing steadily over the last 2 decades, which is not expected to change.
According to The Business Research Company , global military spending should continue to increase at a 5.6% CAGR until 2027. With Northrop being one of the 5 largest military equipment manufacturers, this should also drive revenues for them. The Ukraine/Russia war is creating an additional tailwind for these segments as well as NATO and other European countries realizing that defense is not something they can save on. Many NATO countries saw their defense expenditure sit below the targeted 2% of GDP in 2022 which means that many of these countries will have to boost their spending on defense. Research by McKinsey painted a similar picture in the sense that European countries will indeed start increasing their defense spending following the Russian invasion. These factors will drive additional growth in military spending which will bode well for the multinational defense giants, including Northrop. This is what management said regarding this :
As we look forward, defense budgets are on the rise, and we see our global customers continuing to seek proven solutions to address rapidly evolving and increasingly sophisticated threats. In the U.S., we are encouraged by the continued strong support for National Security, including overwhelming bipartisan support for a 10% spending increase in the fiscal year 2023 defense budget that was passed in December.
Back to the FY22 results, Northrop reported an operating margin of 11.6% for the full year, down 20 basis points YoY. This resulted in an operating income of $4.25 billion. EPS came in at $25.52 and free cash flow totaled $1.6 billion, in line with expectations from management. Northrop achieved a book-to-bill ratio of 1.07, resulting in a backlog of $79 billion, reflecting the strong demand for products from Northrop.
Overall, Northrop saw steady growth in 2022, despite a challenging macroeconomy. This also allowed it to increase the dividend by 10%, which was the 19th consecutive increase. Shares offer a forward yield of 1.5% right now and although this is not amazing, it is about on par with both the sector average and Northrop's 5-year average yield. A lot more impressive is the dividend growth with Northrop having grown the dividend at an 11% CAGR over the last 5 years. And still, the current payout ratio stands at only 26.5%, leaving plenty of room for further increases. Therefore, I believe Northrop will most likely continue to grow its dividend at a rate of close to 10% for the next several years.
Management aims to keep increasing the dividend at a rapid rate indeed, as well as continuing to buy back its own shares after buying back $1.5 billion in shares last year. This is what was said regarding shareholder returns during the earnings call:
After investing in our business, we continue to expect to return more than 100% of our free cash flow to shareholders in 2023 in the form of dividends and share repurchases.
Outlook & Valuation
For FY23, Northrop guides for another strong year of growth, supported by an increasing headcount. Northrop now expects to report revenue of $38 billion to $38.4 billion, up from the October guidance of a high $37 billion. This new guidance represents about 4.5% revenue growth at the midpoint, slightly better than what we saw in 2022. The space systems segment is expected to continue to be the fastest growing one with sales projected to be in the mid-$13 billion range, up approximately 10%. Mission systems segment revenue is expected to be up mid-single digits, with flat revenue YoY for both aeronautics and defense systems. Growth for these last two segments is expected to return by FY24, driven by higher defense budgets.
Margins are expected to remain stable at between 11.3% and 11.5%, resulting in EPS ranging between $21.85 and $22.45, down about 13% at the midpoint as a result of pension liabilities. Free cash flow growth is also expected to remain strong with a free cash flow projection of between $1.85 billion and $2.15 billion. With management targeting to return more than 100% of free cash flow to shareholders, this should result in about $1 billion to $1.2 billion in share repurchases in addition to $1.1 billion in dividends.
Following my deep dive into the company and all the aspects laid out above, I arrive at the following financial expectations for the years until FY26.
(1Q23 expectation: revenue of $9.22 billion and EPS of $5.20 vs consensus of $9.19 billion and $5.14)
Shortly explaining these estimates, I expect both revenue and EPS for FY23 to come in slightly higher than management projected, driven by a stronger realization of backlog and a falling inflation number. For the following years, I expect Northrop to see a normalization of the supply chain and drive solid revenue growth driven by continued growth in the space industry and renewed growth in its defense segments from 2024 onwards. EPS will grow faster, driven by management's focus on cost efficiency and shareholder returns in the form of buybacks. Overall, its technological advantage will allow it to show above-industry growth rates and deliver excellent returns to investors.
Yet, these solid long-term expectations result in quite a steep valuation for this defense and aerospace giant. Northrop rarely trades cheaply due to its defensive and consistent nature. The company is an excellent hedge against market volatility while delivering strong long-term returns. Still, its forward P/E of 21x is 26.5% above its 5-year average. Indeed, it is not cheap right now. And when comparing its current valuation to those of its peers, we can see Northrop is the most expensive by far. Yet, this is in part due to its EPS falling off a cliff next year due to pension liabilities as mentioned earlier. Taking these liabilities out of the equation, Northrop would trade at a forward P/E of approximately 18x, much more in line with its peers. Also, the comparison is not completely fair with Northrop either showing faster EPS growth (compared to Lockheed ( LMT )) or being double the size, offering more stability (compared to ( LHX )). Therefore, I believe Northrop is trading near fair value which is not a bad moment to buy a defensive giant like this.
Valuation comparison (Seeking Alpha)
So, considering better growth expectations and a highly volatile and uncertain market right now, a higher valuation compared to the last 5 years and its peers should not come as a surprise.
As a result, I believe a P/E of 20x is justified for this quality compounder and offers a fair entry valuation. Therefore, based on my EPS projections for FY24, I calculate a price target of $503 per share, leaving investors with approximately a 7% upside. For comparison , 20 Wall Street analysts currently maintain an average $510 price target, combined with a buy rating.
Conclusion
Northrop is an excellent company and one of the best-performing companies in the defense and aerospace segment over the last decade, driven by a focus on innovative high-tech solutions and rapid growth in its space systems segment. The company is an excellent hedge against market volatility while also being very well able to deliver stunning returns. Add to this the potential for impressive dividend growth over the long term and it's hard to argue against investing in this company. Therefore, I think Northrop can be an excellent choice for any portfolio.
The one big issue I have is the limited upside that remains for investors from its current share price of around $470 per share. Based on my FY24 EPS estimates and a share price target of $503, the upside is limited to just 7% or 10% including dividends. Still, an investment in Northrop appears to be relatively risk-free due to the defensive nature of the company and the industry it operates in. Also, considering the time we live in right now with continuing tensions between the US and China, and an ongoing war in Ukraine, an investment in one of the leading defense companies might not be such a bad choice. The tailwinds are strong for Northrop Grumman and its peers.
With the shares down from a high of $550 back in December and relatively flat since the start of the war in Ukraine, the risk-reward offering right now is attractive enough, despite the relatively low calculated upside. Therefore, I rate Northrop a buy.
For further details see:
Northrop Grumman: Expensive, But For Good Reasons