Northrop Grumman Offers Tremendous Value

The stock has struggled over the last year, but looks to be very undervalued

Jan 14, 2021

While the S&P 500 has railed almost 16% over the last year, the aerospace and defense sector has struggled. One of the worst performers in the group is Northrop Grumman Corp. (NOC, Financial), which is down by more than 20% over the last 12 months.

There is a lot to like about Northrop Grumman, including higher defense spending, a record backlog for the company and nearly two decades of dividend growth. These are some of the reasons I have been so bullish on the stock. While the recent stock performance has been very weak, shares now trade at a price that offers the potential for tremendous gains.

Company background and historical performance

Northrop Grumman is one of the largest aerospace and defense contractors in the country. The company is comprised of four reportable business segments, including Aeronautics Systems, which provides manned and unmanned aircraft and UAVs, Mission Systems, which produces radars, sensors and surveillance and targeting systems, Defense Systems, which provides sustainment and modernization services and tactical weapons, and Space Systems, which manufactures missile defense and space systems.

Northrop Grumman has a market capitalization of almost $50 billion and generated revenue of nearly $34 billion in 2019. The company had a record backlog of $81.3 billion at the end of the most recent quarter.

As you can see from the 30-year chart above, Northrop Grumman generally had steady revenue growth until early in the last decade. This is a largely a result of the company spinning off of its ship building business, Huntington Ingalls Industries Inc. (HII, Financial), in 2011. As such, revenue is down slightly from 2010 through 2019. Revenue has grown at a rate of 7.5% over the last half-decade.

Despite this loss of revenue from its shipbuilding business, the decline in profits wasn't that steep. In fact, the company's net profits grew with a compound annual growth rate of 7.5% over the last decade. Removing the ship building business helped for an improvement in profit margin, which grew from 5% in 2010 to 10.7% in 2019.

As a result, Northrop Grumman ranks higher than many of its peers in terms of profitability.

The company receives an 8 out of 10 according to GuruFocus. Northrop Grumman's net margin of almost 7% currently is at the low of its historical range, but outpaces more than two-thirds of the 254 companies in the aerospace and defense industry. Three-year revenue growth is better than 82% of the industry and the company also tops more than 89% of its peer group in return on cost.

Even though its current profit margin is at the low end of 10-year history, I believe Northrop Grumman's favorable comparison to its industry is a positive. The company may not be performing up to its historical standards at the moment, but it is still outperforming its competitors.

Dividend analysis

Northrop Grumman has one of the longer dividend growth streaks among companies in the aerospace and defense sector. The company is also one of the more consistent dividend growers. The Dividend Investing Resource Center, which maintains a database of companies that have at least five consecutive years of dividend growth, says the company increased its dividend by an average of:

13.3% over the past three years.
12.8% over the past five years.
13.1% over the past 10 years.

All of the company's average growth rates for the listed periods of time are very much in line with each other. Northrop Grumman raised its dividend 9.9% for the June 17, 2020 payment. A nearly double-digit increase is a solid raise given the uncertainty of the Covid-19 pandemic's impact on business. The company has now increased its dividend for 17 consecutive years.

Northrop Grumman's scores fairly well on its capital returns.

Northrop Grumman's dividend tops 58% of the stocks in its industry, though it is on the lower end of its 10-year range. Unsurprisingly, the company scores well on its three-year dividend growth rate, which is better than 60% of peers and at the high end of its own historical range.

The company is also a notorious repurchaser of its own stock. The three-year buyback is better than 90% of peers. Northrop Grumman did slow its share repurchases following its 2018 purchase of Orbital ATK, but the share count was reduced by an average of 5.4% per year over the last decade.

The company's shares currently yield 1.9%, 40 basis points better than the 1.5% average yield for the S&P 500. While this is at the low end of the stock's 10-year range, it is close to a five-year high. This is one benefit of the selloff the stock has experienced over the last year.

A dividend isn't sustainable if a company cannot fund it. This hasn't been much of an issue for Northrop Grumman over the long term. There have been a few times over the last three decades where earnings per share did not cover the dividend, but those periods were short-lived. The story is mostly the same for free cash flow as well. There was really only one year (1996) where free cash flow suffered a severe decline. As you can see in the chart, free cash flow provided ample coverage the very next year.

Let's examine dividend coverage in the more recent term.

Northrop Grumman distributed $5.67 in dividends per share over the last four quarters while producing earnings of $22.66 per share for a payout ratio of just 25%. This is lower than the 10-year average payout ratio of 29%.

The free cash flow payout ratio almost matches the earnings per share payout ratio. The company paid out $933 million in dividends over the last year while generating free cash flow of $3.9 billion for a payout ratio of 24%. The company has a three-year average free cash flow payout ratio of 33%.

Northrop Grumman has a long history of dividend growth and has a very consistent growth rate. The earnings per share and free cash flow payout ratios are extremely low, making it likely that the company can continue to raise its dividend for years to come. Northrop Grumman has also greatly reduced its share count over the last 10 years. The company is one of the better shareholder-friendly names in the market.

Recession performance

Northrop Grumman wasn't immune to the impacts of the last recession. Listed below are the company's earnings per share results before, during and after the last recession:

2006 earnings per share: $4.44
2007 earnings per share: $5.04 (13.5% increase)
2008 earnings per share: $5.32 (5.6% increase)
2009 earnings per share: $4.87 (8.5% decrease)
2010 earnings per share: $5.80 (19.1% increase)
2011 earnings per share: $7.41 (27.8% increase)
2012 earnings per share: $7.81 (5.4% increase)

Northrop Grumman did see a dip in earnings per share in 2009. Share buybacks masked somewhat how much the decline actually was as net profit fell more than 12% from 2008 to 2009. However, the company did make a new earnings per share high the very next year and has seen its earnings increase every year since with the exception of 2017.

At the same time, Northrop Grumman's dividend continued to grow. Listed below are the company's dividends paid before, during and after the last recession.

2006 dividends: $1.16
2007 dividends: $1.48 (27.6% increase)
2008 dividends: $1.57 (6.1% increase)
2009 dividends: $1.69 (7.6% increase)
2010 dividends: $1.84 (8.9% increase)
2011 dividends: $1.97 (7.1% increase)
2012 dividends: $2.15 (9.1% increase)

Even during a difficult economic period, the company continued to raise its dividend, often at a high single-digit rate. This provided some reassurance to income investors that the company's dividend is recession tested.

Northrop Grumman's business did feel the impact of the Great Recession, but held up much better than many companies during this period of time. The company also returned to growth the very next year and has largely produced higher earnings per share in the ensuing years. The dividend also continued to grow despite the effects of the recession on the business. This gives me confidence that Northrop Grumman's dividend is likely to survive the next economic downturn.

Financial strength and debt analysis

Northrop Grumman received solid scores from GuruFocus on its profitability and shareholder returns, but its financial strength rating isn't as strong.

The company recieves a rating of 5 out of 10, with weak results in many areas. For example, the cash-to-debt rating is at the low end of its historical range and lower than 64% of peers. Northrop Grumman's interest coverage is also less than nearly two-thirds of peers and at the very bottom of its 10-year range. The company does receive a 7 for Piotroski F-score, which indicates that Northrop Grumman's financial situation is typical for a stable company.

Northrop Grumman's balance sheet is on solid ground. The company ended the most recent quarter with total assets of $44.8 billion. Included in this is $14.6 billion of current assets, of which almost $5 billion was in cash and cash equivalents and $7.7 billion of receivables. Total liabilities stood at $34.3 billion, with current liabilities at just over $10 billion. Northrop Grumman has total debt of $17.4 billion, but just $1.8 billion of debt is due to mature within the next year.

Interest expense was $154 million in the most recent quarter, which equates to a weighted average interest rate of 3.5%.

Northrop Grumman's free cash flow was more than enough to cover dividend payments and interest expenses in the most recent quarter. In fact, free cash flow over the last year would have been enough to cover dividend payments, interest expenses and current debt. The company's profitability ranking might be below optimal level, but debt doesn't appear to be a major headwind.

Valuation

Analysts surveyed by Yahoo Finance expect Northrop Grumman to earn $22.77 per share in 2020. With shares trading around $307, the stock has a forward price-earnings ratio of 13.5. This is below the 10-year average price-earnings ratio of 13.9. This is also below my target range of 15 to 17 times earnings, which I feel is more appropriate given the recent increases in defense spending and the company's recent results.

GuruFocus appears to agree with me that the stock is undervalued.

Northrop Grumman has a GF Value of $383.47. Using the current share price, the stock has a price-to-GF Value of 0.80. This earns the stock a rating of modestly undervalued from GuruFocus. Northrop Grumman shares would increase 25% if it were to trade with its GF Value. Add in the dividend yield and total returns could be nearly 27% for the stock.

Final thoughts

Northrop Grumman's stock has had a difficult year, but the company is highly profitable, held up better than most during the last recession and has a long dividend growth streak. Shares also appear cheap compared to their historical valuation and are well off their GF Value. Investors looking for a deep value play in the aerospace and defense sector could do well buying Northrop Grumman at the current price.

Disclosure: The author has no position in any stocks mentioned in this article.