Shares of Northrop Grumman Corporation (NOC, Financial) are higher by nearly 23% since the last time I looked in depth at the company. Back in February, the stock was trading well below its intrinsic value as calculated by GuruFocus.
The stock isn’t as undervalued as it was back then due to the strong returns over the last six months. However, the company remains one of my favorite picks in the aerospace and defense sector and has several long-term positives going for it that make Northrop Grumman a buy even at current levels, in my opinion. Let’s look closer at the company to see why I feel Northrop Grumman can still be bought even after the rally in the name.
A rundown of earnings
Northrop Grumman reported second-quarter earnings results on July 29. Adjusting for the company’s divestiture of its IT services business, revenue grew 3% to $9.2 billion, topping Wall Street analysts' expectations by almost $400 million. Net earnings of $1.04 billion, or $6.42 per share, were up slightly from net earnings of $1.01 billion, or $6.01 per share, in the same period a year ago. Adjusting for revenue attributed to the sale of its IT business, organic sales grew 10% in the second quarter.
Revenue for the company’s Aeronautics Systems segment, the largest within Northrop Grumman, was $2.9 billion for the quarter, essentially flat from the prior year. Continued strength in the E-2 program, which is an early warning and command and control aircraft system, along with higher volumes in restricted programs was offset by lower production of the A350 aircraft. Also acting as a headwind was lower volumes on the B-2 Defensive Management System as this program nears completion. The operating margin fell 30 basis points to 10.3%, mostly due to a government accounting benefit in the second quarter of last year.
Space Systems grew 34% to $2.7 billion with organic sales higher by 37%. Much of this was due to growth in the Launch & Strategic Missiles and Spaces businesses. Driving gains was the ramp up in production for the Ground Based Strategic Deterrent (GBSD). Commercial Resupply Service and hypersonics also had improved volumes. The operating margin was up 80 basis points to 11%.
Missions Systems improved 6% to $2.6 billion with gains across the segment’s array of businesses. This segment did see a reduction in IT related business as a result of the divestiture, but organic sales were up 12%. Demand for the Navigation, Targeting and Survivability program remains robust due to an increase in volumes for the GBSD. Radar continues to see strength in demand as does electronic warfare programs. The operating margin increased 160 basis points to 15.8% due to a spike in volumes and a change toward more fixed-price contracts.
Defense Systems was the lone segment to decline year-over-year as revenues fell 24% to $1.4 billion. Much of this decline was again attributed to the IT services divestiture. Organic sales improved 3%. This segment had higher volume for its Guided Missile Launch Rocket System. A ramp up in production for the company’s electronic fuze program also aided results. The operating margin improved almost a full percentage point to 12.4% due to better mix following the sale of IT.
Following net awards of $6.5 billion in the quarter and $15.4 billion for the year, Northrop Grumman’s backlog remains robust at $76.6 billion even if it sits slightly below the company’s record of $81.3 billion at the end of the third quarter of last year. This would take the company more than two years to work off based on 2020 revenue totals. Currently, 43% of the backlog has been funded.
Following second-quarter results, Northrop Grumman raised its guidance for the year and now expects earnings per share in a range of $24.40 to $24.80, up from $24.00 to $24.50 previously. This would be a 4% improvement from the prior year.
Takeaways and valuation analysis
Northrop Grumman turned in a rather good quarter, even considering the impact that its recently closed divestiture had. Organic sales grew in the double-digits, with each segment seeing year-over-year gains. Each of the company’s segments are seeing demand in many different areas, speaking to the strength of Northrop Grumman’s business overall.
The company’s backlog remains large, even if more than half of it is not yet funded. While this could be an issue if customers, especially the U.S. government, were to not come up with appropriate funds, it is unlikely to come to that.
Military programs often take multiple years to complete. Consider the GBSD program that was awarded to Northrop Grumman. The Ground Based Strategic Deterrent program's development contract was first awarded in 2017. It took until mid-July 2019 to announce that Northrop Grumman had won the contract following the Boeing Company’s (BA, Financial) decline to bid.
The development of the GBSD program remains in the early stages and the program won’t be in service until 2029 at the earliest. It will then take an additional decade to replace the current missile system. The lifespan of the program is expected to be 50 years and could cost at least $260 billion over this time. This includes the actual delivery of the program as well as maintenance. It is highly unlikely that Congress won’t continue funding this program even at this cost as doing so would leave the GBSD incomplete, ineffective at carrying out its mission and a waste of dollars already invested. For these reasons, this program, as well as the rest of backlog, is likely to find the vast majority of its funding eventually.
According to Yahoo Finance, Northrop Grumman is expected to earn $24.94 per share this year, above the company’s guidance. This is likely due to the company’s theme of “under promise and over deliver” on results. The company has beaten both revenue and earnings per share estimates in all but five quarters since 2016 by consistenlty providing low-end estimates.
Northrop Grumman is also a serial repurchaser of its own stock. The company shrunk its share count by slightly more than 4% annually between 2011 and 2020, helping to provide a boost to earnings per share. Factoring this in, it can reasonably be assumed that Northrop Grumman is likely to deliver earnings per share for the year that is more in-line with analysts are expecting.
Using the current share price of $366, Northrop Grumman trades with a forward price-earnings ratio of 14.7. The stock has five- and 10-year average price-earnings ratio of 17.2 and 14.2, respectively.
I believe a valuation target of 15 to 17 times earnings per share for Northrop Grumman is a reasonable range due to the stock’s historical valuation, recent results, backlog and leadership in the aerospace and defense sector. Applying this to earnings estimates results in a price target range of $374 to $424.
Investors could be looking at returns of nearly 16% from current levels on top of the gains already seen since the start of the year. Factoring in the dividend, which has a market beating yield and has been increased for 18 consecutive years, total returns for Northrop Grumman could reach the high teens. Because of this, I continue to believe that Northrop Grumman to be a solid investment for those looking for exposure to the aerospace and defense sector.
