Northrop Grumman: This Old Dog Has Some New Tricks, Shares Look Like A Bargain
Thesis
Northrop Grumman (NOC) conducts most of its business with the U.S. government, principally the Department of Defense. NOC also transacts with foreign governments and makes commercial sales both domestically and overseas. In January 2009, the company reorganized its reported business segments into five, from seven. Its shipbuilding operations were spun off to shareholders in March 2011. The Information & Services segment (23% of 2010 revenue and 21% of segment operating income) provides products and services in the areas of command, control, communications, computers and intelligence (C4I); air and missile defense; airborne reconnaissance; intelligence processing; decision support systems; cybersecurity; information technology; and systems engineering and integration. It consists of three business areas: Defense Systems, Intelligence Systems, and Civil Systems.
NOC is a well run defense company that continues to demonstrate improving operating performance in a difficult environment. The management has been constantly finding ways to create value through a variety of measures including portfolio shaping. Demand for NOC’s military electronics is primarily driven by growth in the U.S. defense budget, which accounts for about 40% of global military weapons spending. Based on U.S. Department of Defense statistics from fiscal 2000 (Oct.) through fiscal 2010, the (weapons) procurement and R&D segments of total U.S. defense budget authority rose at 7.6% and 9.0% compound annual rates, respectively. However, one of the reputed industry analysis firms expects growth in defense budgets to flatten or decline going forward, due to pressure resulting from high U.S. budget deficits and increased entitlements spending.
While the defensiveness will ultimately be the overriding theme for defense stocks in 2012, there are plenty of industry-specific issues at play. The two largest visible catalysts this year are the resolution of sequestration and November’s presidential election. While both have clear implications for defense, the former is largely already priced in and the latter’s influence on defense performance will be more a function of its impact on the broader market than the defense industry itself given the stance that defense stocks will act defensively in 2012.
This year’s relatively weak top-line outlook is offset somewhat by the company’s forecast for ~11.0% segment operating margin. While this margin level represents a 60 bps decline from 2011, it is still ~30 bps higher than the segment operating margin implied by the company’s long-term margin targets for each segment in the context of management’s segment revenue guidance for this year. Operating margin guidance for 2012 for each of the segments is anywhere from 0-100 bps higher than the long-term targets (Aerospace Systems – 11%, Electronic Systems – 13%, Information Systems – 9%, and Technical Services – 8%). In the past, management has noted that its margins could fall below the long-term goals temporarily in a declining sales environment as it restructured and took cost out, and this is therefore a possibility in 2013-2014.
NOC is guiding to GAAP EPS of $6.40-6.70 on sales of $24.7-25.4 bn and a segment operating margin of ~11.0% in
2012. The midpoint of management’s sales guidance implies a 5% y/y sales decline in 2012. Revenue pressure is most acute in NOC’s Technical Services segment, where the midpoint of management’s sales guidance of $2.6-2.7 bn implies a 17% y/y decline. Revenue guidance for the Information Systems and Electronic Systems segments implies 5% and 4% y/y declines at the midpoint, respectively, while the company sees the most support in the Aerospace Systems segment which management is only guiding down 1% y/y at the midpoint.
Q4 EPS of $2.09 exceeded Bloomberg consensus estimate by 42 cents. However, Sales of $6.5 bn in the quarter were down 4% organically y/y, and resulted in a total organic sales decline of 4% for 2011. The sales miss in the quarter was more than offset by segment operating margin of 11.9%, which was 90 bps higher than consensus estimate of 11.0%. Non-operating items including a lower tax rate, $36 mn of other non-operating income, and a lower share count also contributed to the beat. Within the segments, Technical Services was the lone segment to exceed streets’ sales expectation, while the other three segments each missed the sales forecast with the most pronounced miss (-4%) coming in the Aerospace Systems segment. However, operating margins exceeded estimates in every segment with the largest outperformance (+126 bps) occurring in the Information Systems segment. The company was awarded $7.1 bn of new orders in the quarter, resulting in a book-to-bill of 1.09x. However, at the end of the quarter, the total backlog stood at $39.5 bn, down 6% sequentially and 12% y/y.
Management & Stewardship
Northrop boasts of an enviable management with industry stewards from reputed organizations. Wes Bush is the Chairman and CEO of the company. He was elected as the chairman in July 2011 and was named CEO in January 2010. Bush had a long employment history with TRW and moved to Northrop when TRW was acquired by Northrop. Lewis Coleman is a lead independent director with NOC and is the president and CFO with Dreamworks Animation SKG (DWA). His past experience spans across leading financial institutions like Bank of America (BAC) and Wells Fargo (WFC). Kenneth Bedingfield is the VP finance with NOC. Prior to joining NOC, Ken has a 17 year stint with KPMG LLP. Ken leads all aspects of corporate accounting operations including maintenance and enforcement of corporate accounting policies and procedures in accordance with Generally Accepted Accounting Principles (GAAP) and Securities and Exchange Commission requirements, ensuring the integrity of the company’s financial data and reporting. Some of the other key executives include Sid Ashworth, Mark Caylor, Sheila Cheston, Gary Ervin, and Gloria Flach. The insiders of the company hold less than 1% of the company.
Valuation:
NOC is trading at 10x 2013E PAEPS (Pension adjusted EPS) estimate, which remains the richest valuation in the large cap defense coverage universe by a wide margin and represents a 16% premium to the average valuation of its large cap defense peers. The primary driver of the stock’s premium valuation is NOC’s unique position among its peers as a generator of pension income. This attribute leads some investors to pay for NOC’s GAAP EPS and, on that basis, NOC looks much more fairly valued. On 2013E EPS, NOC trades at 9.2x, in line with the 9.2x average of its peers. However, pension-adjusted EPS is a better valuation metric, especially considering investors should pay for pension income. Given NOC’s absolute level of valuation compared to the market, it’s dividend growth rate, and high ROIC we believe the shares are a buy at current levels.
Based on a DCF analysis the intrinsic value of NOC is around $87.
Disclosure: I am long NOC.
Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.
