Summary
- Northrop Grumman had a tremendous 2022 but shares are down over 19% in January.
- The defense giant is benefiting from increased geopolitical tension which I do not think will ease any time soon.
- Its latest earnings results are also decent with a strong free cash flow outlook for the coming years.
- However, a potential cut in the defense budget and elevated valuation may weigh in the near term.
- I rate the company as a hold.
Investment Thesis
Northrop Grumman's ( NOC ) performance has been spectacular in 2022. The company was up over 40.96% during the period, significantly outperforming the S&P 500 index which declined by 19.44%. This was no surprise as it benefited from the unprecedented Russia-Ukraine war and the increased tension between China and Taiwan, which I believe will provide ongoing tailwinds. The latest earnings results are also strong with Space Systems leading the pack in growth.
However, the recent sentiment seemed to have shifted due to the potential $75 billion cut in the defense budget, which caused shares to decline by over 19%. Despite the drop, the current valuation is still stretched compared to its historical average. I like Northrop Grumman but these temporary headwinds will likely limit the potential upside in the near term. Therefore I rate the company as a hold at the current price.
Growth Drivers
I think a higher international defense budget and Space Systems will be the main two growth drivers moving forward. As geopolitical tension heated up in 2022, countries are again turning their focus to the defense budget. Most countries, other than the US, are actually spending quite little on defense. In 2022, only 5 NATO countries met the organization's target of spending 2% of GDP on defense, while a lot is nowhere near. According to NATO Secretary General Jens Stoltenberg , NATO countries will soon discuss their defense spending as some countries propose making the 2% target a minimum. The underspending on defense will likely turn into a tailwind as countries start to ramp up on orders in order to meet the target.
Kathy Warden, CEO, on international defense budget
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. We are meeting their urgent needs in areas such as air and missile defense solutions, medium and large caliber ammunitions and armaments, advanced radar capabilities and global surveillance to name just a few. And we are partnering to expand our opportunity set and positioning our international business for future growth. We clearly saw increased demand in 2022, and we continue to expect to grow our international business over the next several years.
Space Systems is another strong growth driver. Space has been a hot industry in the past few years with companies like SpaceX gaining massive popularity. While mostly known for defense, Northrop Grumman actually also has a strong presence in the space industry. For example, the company launched the infamous James Webb Space Telescope with NASA last year. Space Systems now account for roughly 30% of total revenue. The TAM (total addressable market) for space is massive. According to Forbes , the space industry grew 7% to $469 billion last year. The spending from the government and military alone amounted to $59.6 billion, or 12% of total spending. I believe we are only in the early innings and the industry's expansion will provide strong tailwinds for the company.
Q4 Earnings
Northrop Grumman reported its fourth-quarter earnings last week and it breezed past estimates with a double beat, as demand remains strong. Total sales for the quarter were $10 billion, up 16% YoY (year over year) compared to $8.64 billion. The growth was mainly driven by the growth in Space Systems which was up 23% from $2.66 billion to $3.28 billion. Defense Systems was also up 20% from $1.38 billion to $1.66 billion. Missions Systems increased by 16% to $2.93 billion while Aeronautics Systems increased by 5% to $2.76 billion.
The bottom line was also impressive as segment operating income increased 17% YoY from $970 million to $1.14 billion. Transaction-adjusted EPS was $7.5 compared to $6.0, up 25% YoY. The company also forecasts adjusted FCF to grow at a CAGR (compounded annual growth rate) of 20%+ from 2022 to 2025 thanks to strong operational performance. It expects to return 100% of the adjusted FCF to shareholders therefore I believe we will see larger share buybacks over the year which should further boost the EPS figure moving forward.
Defense Budget Cut
The strong momentum of Northrop Grumman was interrupted by the potential defense budget cut proposed by Kevin McCarthy as he was elected as the House Speaker in January. If the cut were to happen it would reduce the fiscal 2023 defense budget by roughly 10% from $857 billion to $782 billion. The situation was also worsened as the US recently hit the debt ceiling again and White House officials have said they will not negotiate over raising the debt ceiling. Their tone has softened in recent weeks as Yellen warns of serious economic consequences but huge uncertainty remains and discussion could take a long time. A US defense budget cut impacts Northrop Grumman the most among peers as 86% of its sales are from the US, higher compared to Lockheed Martin ( LMT ) with roughly 70%.
Investor Takeaway
I believe Northrop Grumman should do well in the long term, but now is not the time to buy yet. As geopolitical tension remain elevated, the international defense budget should gradually rise over the long run. NATO countries may also need to ramp up orders to meet the spending target which should boost demand. Space is a massive and growing industry that should continue to provide significant growth opportunities. This is made evident in the latest earnings with Space System leading all segments in growth rate. Outlook for FCF is also strong which should support bigger dividend increases and share repurchases.
However, a potential cut in the defense budget may significantly impact Northrop Grumman's outlook as most of its sales come from the US. I believe this and the debt limit will eventually be resolved but it may take a while. Besides, the company's valuation is still quite expensive, even after the recent drop. It is currently trading at an fwd PE ratio of 20.1x, which represents a 21.1% premium compared to its 5-year historical average of 16.6x. This is also above peers like Lockheed Martin which has an fwd PE ratio of 17.2x. I believe these two subjects will weigh on the company in the near term, which limits the potential upside. Therefore I rate Northrop Grumman as a hold.
For further details see:
Northrop Grumman: Potential Defense Budget Cut May Weigh In The Near Term