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Nathan Parsh
Nathan Parsh
Articles (52) 

Here's Why I Would Wait to Buy Northrop Grumman

Northrop Grumman has performed much better than its peers in 2020, but the stock offers a low yield and has a mediocre outlook

March 23, 2020 | About:

With markets in free fall due to the economic impact of the novel coronavirus (Covid-19), investors have few places to hide. Many investors are piling into Treasury bills or looking for safety in the more usual recession proof names like utilities, healthcare and consumer staples stocks.

In my opinion, one sector investors with a long-term horizon should consider is the aerospace and defense sector. This group has lost nearly 46% year-to-date. For comparison purposes, the S&P 500 has lost approximately 29%. As I wrote in a recent article on Raytheon Company (NYSE:RTN), this sector has a tremendous amount going for it, even against a very difficult economic backdrop.

The contracts that these companies sign with customers often take years to complete. Customers often pay as the project nears completion, giving contractors steady cash flows over the life of the contract.

The Pentagon is also increasing its progress payments for both large and small companies in this sector, which should help keep the supply chain more stable than other sectors of the economy.

Defense spending is also likely to grow as contractors often contribute to members of both parties, helping to ensure that the funding for defense will be there even if there is a change in who controls the White House come November.

While the Aerospace & Defense sector exchange-traded fund (ITA) has been crushed so far this year, one name that has held up extremely well is Northrop Grumman Corp. (NYSE:NOC). The stock is down 17.4%, vastly outperforming the sector ETF and the S&P 500.

Any stock that is able to hold its own under market-wide duress is attractive to me at this point. That said, I don’t find Northrop Grumman to have as much upside as other defense contractors, and the dividend yield is quite low. Let’s look at closer at Northrop Grumman to see why I feel this way.

Company background and recent earnings

Headquartered in Falls Church, Virginia, Northrop Grumman is one of the largest aerospace and defense companies in the world. The company is composed of four divisions: Aerospace Systems (which manufactures aircraft and space systems), Mission Systems (which produces surveillance and targeting products such as radars and sensors), Technology Services (which houses cybersecurityand IT, logistics and maintenance) and Innovation System (which provides missile defense and space systems as well as hypersonics and space launchers). Northrop Grumman has a market capitalization of nearly $48 billion.

Northrop Grumman reported fourth quarter and full year results on Jan. 30, 2020. The company’s adjusted EPS of $5.61 was $0.84 above estimates and a 47% increase from the prior year. Revenue improved nearly 7% to $8.7 billion, though this was $122 million lower than expected.

The company’s adjusted EPS of $21.21 for 2019 was essentially flat year-over-year. This was $0.98 above the midpoint for Northrop Grumman’s initial forecast for the year. Pension related costs lowered EPS results by $1.64 for the year. Revenue for the year improved 12% to $33.8 billion.

Aerospace Systems had 10% sales growth in the fourth quarter and 6% for 2019. Higher volumes on restricted programs was a key component of growth. Also aiding sales were higher volumes on the F-35 program and other manned aircraft projects. Higher volumes for Autonomous Systems contributed to results as well.

Innovation Systems grew 9% for the quarter and 10% for the year on a prom forma basis. All businesses within the segment saw growth. An increase in volume on national security satellite systems drove growth in Space Systems while Flight Systems benefited from demand for propulsion systems. Defense Systems had strength in tactical missiles and subsystems.

Sales for Mission Systems grew 6% for the quarter and 5% for the year. Advanced Capabilities experienced strength in international markets, but also saw contributions from restricted and marine systems programs. Higher volumes for airborne radar programs helped results for Sensors and Processing.

Technology Services was the lone segment to decline, posting a 4% sales decline for both the quarter and full year. The completion of a state and local service contract in 2018 negatively impacted the year-over-year comparisons. Gains in autonomous platforms were more than offset by a decrease in volumes for manned aircraft programs.

Northrop Grumman quarter and full year were largely a success. Three out of four segmenta showed growth.

Given the company’s backlog, that growth is likely to continue as well. The company added a net total of $9.3 billion to its backlog in the quarter. For 2019, the company added a total of $45.2 billion to its backlog, giving Northrop Grumman a grand total of $64.8 billion in backlog contracts. This is almost two full years of revenue using last year’s totals.

Dividend and valuation

Overall, I am satisfied with Northrip Grumman's business execution, but that isn't what has me pausing on the name. It's the yield and potential return, or lack there of, that makes the stock a hold to me.

Northrop Grumman has increased its dividend for the past 16 years. The company has raised its dividend by a compound annual growth rate of:

  • 9.8% over the past three years
  • 10.7% over the past five years
  • 10.9% over the past 10 years

The company most recently raised its dividend by 10% for the June 19, 2019 payment, which was in-line with the above averages. Northrop Grumman has been incredibly consistent with its dividend growth over the years. I admire the consistency of the company’s dividend growth, if not its current yield.

Unlike when I examined Raytheon, Northrop Grumman hasn’t experienced quite the decline in share price. This means that Northrop Grumman’s yield remains low while Raytheon’s is quite generous. Shares of Northrop Grumman yield 1.9% as of the most recent close, 60 basis points below the average yield of 2.5% for the S&P 500. The stock has averaged 1.6% and 2.3%, respectively, for the last five-year and 10-year periods of time. Due to the lack of a severe price decline, Northrop Grumman has not turned into the accidental high yielder that many other aerospace and defense stocks have.

On the plus side, Northrop Grumman has very low dividend payout ratios, which makes it likely that the company can continue to increase its dividend even under if the economy is contracting.

The company will likely distribute at least $5.28 per share of dividends in 2020. This equates to a payout ratio of just 23% using EPS estimates of $23.34 for 2020. The payout ratio will be slightly higher if Northrop Grumman announces its next dividend increase, which is expected in May. The company has had a payout ratio above 30% just twice, in 2010, and 2015, over the last ten years.

Free cash flow also shows that the dividend is quite safe from a potential cut. In 2019, Northrop Grumman distributed $880 million of dividends to shareholders while free cash flow totaled $3 billion. This gave the company a payout ratio of slightly more than 29%. The company averaged a free cash flow payout ratio of 35% for the time period of 2016 through 2018.

In addition to an attractive dividend payout ratio, Northrop Grumman’s valuation is also appealing. Shares closed Friday at $284. The trailing price-earnings ratio is 13.4 based on EPS of $21.21 for last year. The forward price-earnings ratio drops to 12.2 using estimates for the current year.

Let’s assume that economic conditions cause Northrop Grumman to realize just 80% of expected EPS for 2020. This would result in EPS of $18.67 for the year, giving the stock a forward price-earnings ratio of 15.2. This compares to the respective five-year and 10-year average price-earnings ratios of 13.9 to 17.7.

Using these valuations, shares of Northrop Grumman are worth $260 to $330 based on a 20% discount to expected EPS. Investors buying at the current price could be risking 8.5% downside, but could see 16% upside potential. This isn’t a terrible trade off, but due to uncertain market conditions, I would prefer to see much more upside potential in any stock that I purchase.

Final thoughts

Northrop Grumman has a lot to like. The company finished up 2019 on solid footing, as three out of four segments grew for both the quarter and year. Northrop Grumman also has a vast backlog that should continue this growth into future years.

Shares of Northrop Grumman haven’t fallen nearly as far as its peers. By my calculations, the stock does offer up double-digit upside potential. In a normal market, I’d be willing to bet on that upside potential if the downside risk was in the single-digits.

But this is no bull market. The fact that Northrop Grumman hasn’t fallen as much as its peers means that the stock could soon face trouble if investors continue to liquidate positions. Whereas Raytheon was offering a higher than usual yield to go along with greater upside potential, Northrop Grumman is closer to its long-term average.

If the potential return was higher and/or the stock’s yield was above average, I would be much more tempted to add the name to my portfolio. Since the potential return and yield are mediocre, for now I will pass on Northrop Grumman.

Disclosure: The author is long Raytheon Company

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About the author:

Nathan Parsh
I was originally born in Detroit, Michigan, before moving to Maryland to begin a career as an educator. This is my 14th year teaching. My wife and I have two young children who keep us on our toes.

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