Summary
- Northrop Grumman shares have had a horrible start this year as shares have dropped almost 20% year-to-date.
- The company was hit by policy uncertainty and an ugly full-year EPS guidance number.
- However, the company remains in a good spot thanks to high defense demand, fading supply chains, and accelerating revenue and free cash flow growth.
- The valuation has become attractive. I rate NOC shares a buy.
Introduction
The Northrop Grumman Corporation ( NOC ) , which is one of my largest defense holdings, has crashed. The stock is down roughly 20% year-to-date, which is one of the worst performances of the past two decades. "Funny" enough, I wrote an article titled Northrop Grumman: Buy the Next Correction just hours before it all started.
While losing 20% on a large investment does hurt, I'm far from concerned. On the contrary, I used weakness to buy NOC exposure for some portfolios that I manage/advise, as I like the risk/reward this sell-off provides us with.
Hence, in this article, I will walk you through my thoughts, explaining why NOC sold off and why I'm a buyer. I will also incorporate the recently-released 4Q22 earnings, which were quite good.
So, let's get to it!
Northrop Grumman Sold Off Hard (Let's Get Political)
This might be one of the most underreported stock price declines I've witnessed in a long time. In this case, I mean in general, as we're dealing with a topic that nobody seems to be willing to touch due to high uncertainty.
Everything was going according to plan (as we'll discuss in this article). Supply chain issues are fading rapidly, the defense budget was hiked by 10%, and foreign governments are eagerly boosting their own spending plans.
Now, let me explain what I mean by high uncertainty in the industry.
On January 6, when NOC sold off hard, we got headlines related to the election of Speaker of the House: Kevin McCarthy. As some of you may know, McCarthy lacked the votes to be voted Speaker in the first rounds of the election. Republicans were divided, and stubbornness prevented an early decision.
While I don't get involved in political matters, something needs to be pointed out. As part of a deal to get more votes, McCarthy proposed to cap spending, something Republicans are, generally speaking, attracted to. At least more than Democrats.
As reported by Bloomberg :
Part of the agreement being discussed would be to cap fiscal year 2024 discretionary spending across government at 2022 levels, according to three people familiar with the discussions. National defense spending, which primarily funds the Pentagon, was about $782 billion in fiscal 2022 and rose $75 billion to $857 billion in fiscal 2023.
Lawmakers would have to contend with a $130 billion cut to discretionary spending, including a potential $75 billion cut to national security, if not more, as defense hawks want to increase the budget above this year’s l evels.
With that said, while Mr. McCarthy is now Speaker, nothing has been decided.
What we're dealing with here are risks that growth in defense spending in the years ahead might be subdued. While I have 24% defense exposure, I'm not saying this out of greed but because defense companies depended on a boost in funding due to supply chain issues and high input inflation. Smaller companies in the supply chain were at risk of going out of business.
It also does not help that the US has hit its debt ceiling. However, the US is not shutting down. It can utilize the Treasury General Account to fund operations. That's the government's checking account. It had close to $300 billion in early January, which means both parties in Washington will have to work on a deal until they run out of cash. It's estimated that this could be somewhere between July and September.
So, on top of defense spending uncertainty, we get even more political uncertainty as both parties have their eyes on the 2024 General Election, which means both will have to find a way to "win" the debt ceiling negotiations.
My point of view is that this situation is far from perfect. However, I'm not worried. Lawmakers of both parties know the importance of defense spending growth. Moreover, after having spent hours listening to politicians in Washington, it seems that *if* cuts are being made, they will be targeting cuts to non-essential defense spending.
To circle back to what I said at the start of this article, the reason why most aren't talking about this is that nobody knows what will happen to defense spending. It's not talked about a lot in Washington or financial markets.
Now, with that said, Northrop Grumman continues to be in a good spot.
Here's What Happened In 4Q22
The Virginia-based defense giant reported adjusted EPS results of $7.50 in its fourth quarter. This beat estimates by $0.93. This marked the biggest earnings surprise of 2022 after missing two consecutive estimates. This beat was supported by easing supply chain bottlenecks, including labor availability, which allowed the company to turn orders into finished products more efficiently.
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Revenue came in at $10.0 billion, which is $390 million higher than expected and 16.6% higher compared to the prior-year quarter.
Sales guidance wasn't bad either. The company sees between $38.0 and $38.4 billion in full-year sales. Consensus expectations are $37.9 billion.
Cash flow is expected to grow by over 20% per year through 2025. This is what that looks like using free cash flow estimates:
The company is now expected to do $3.1 billion in FCF in 2025, which implies a 4.6% free cash flow yield. That's a very decent number.
Unfortunately, the stock didn't get support as management sees full-year EPS in the $21.85 to $22.45 range, which is below the consensus midpoint of $22.62.
With that said, the company ended 2022 with $79 billion in backlog, which reflects strong demand for its products and services. As revenue growth was 16% in 4Q22, we see that the company is increasingly capable of turning its backlog into finished products.
On a full-year basis, the company's book-to-bill ratio was 1.07, which indicates that the company's new order intake is moderately higher than its ability to turn backlog into sales. It's indicative of higher future growth.
The company noted higher defense spending and its ability to deliver what governments are looking for. This includes next-gen missiles and missile defense, space program hardware, and new sensors for the F-35.
[...] 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. Our portfolio and the capabilities we offer are well supported by the administration and Congress. Growing security challenges will test our resolve in ways not seen for a generation, and we are confident this administration and the new Congress will find ways to work together to meet them.
We expect the President's fiscal year 2024 budget request to support robust funding for the highest priority capabilities outlined in the National Defense Strategy.
Moreover, I need to add that European defense spending is expected to increase by EUR 70 billion ($77B) over the next three years.
Japan has increased this year's defense budget by 26%.
In light of these numbers and comments, the company is not expected to grow its book-to-bill ratio this year. While the 5-year aggregated book-to-bill ratio will be above 1, 2023 is likely to be less than 1.0.
According to Chairwoman, CEO, and President Kathy Warden:
So we had projected book-to-bill to be light in 2022, and it turned out to be 1.07. We are projecting it to be light again in 2023. I've noted before, we look at this over a multiyear period. We've been running at 1.2 for the last 4 years aggregated across those 4 years. So we still expect to be well over 1 when we think about a 5-year aggregated book-to-bill, but we do expect 2023 to be less than 1.
A book-to-bill ratio below 1 isn't a reason to celebrate - even if the longer-term outlook remains good. However, I'm not concerned. The company is now accelerating revenue growth, which pressured the ratio going into this year.
These are the growth and (expected) revenue growth rates for the next few years:
- 2021: -3% (supply chain problems)
- 2022: 2.6% (slowly fading supply chain problems)
- 2023: 4.7% (likely back to normal by 4Q)
- 2024: 5.5%
- 2025: 5.8%
I believe new orders will eventually exceed sales growth. For now, we'll monitor if the company can normalize production faster than expected.
Valuation
NOC is trading at 14.8x 2023E EBITDA. This is based on its $67.7 billion market cap, $9.8 billion in 2023E net debt, and $1.2 billion in pension-related liabilities.
It's not deep value, but I believe it's a fair valuation to start buying - or add to existing positions.
I would be a buyer if I didn't have so much exposure already. I'm looking to buy stocks in other sectors first.
Takeaway
Northrop Grumman crashed. The company was punished as investors started to price in elevated risks of subdued defense spending growth in an environment where most expect defense spending growth to pick up.
While I believe that defense spending growth will remain high, it's a risk worth taking into account.
Other than that, NOC continues to do well. Supply chain issues are quickly fading, allowing the company to accelerate both revenue and free cash flow growth in the years ahead. It benefits from strong order growth and exposure in the right areas.
The valuation has become attractive. While it needs to be seen whether NOC has hit rock bottom, I have been buying shares for accounts that I manage/advise.
(Dis)agree? Let me know in the comments!
For further details see:
Northrop Grumman Has Crashed