A Defense Play with a Little Offense

In an economy where growth is hard to come by, the current multiple contraction in the defense/aerospace sector may offer a decent opportunity to invest in an historically sound industry poised for respectable growth.

Take, for example, Northrop Grumman , one of our nation's leading aerospace/defense providers. For the type of business you are getting, the valuation makes Northrop one the best growth investments at a reasonable price (GARP) in the industry, in my opinion.

Northrop has a hand in some our nation's most strategic defense-related production. By far the most significant is the company's role in F-35 fighter-plane production. Northrop accounts for more than 25% of the parts involved in the F-35, and the increase in F-35 orders should bolster Northrop's bottom line going forward.

In addition to aerospace systems, the company continues to turn around its shipbuilding business, which currently accounts for about 14% of the company's revenues. Aerospace, which includes the F-35 business, constitutes just over 30% of the company's business. The remaining bulk of the business stems from the electronic-systems and information-systems division, each accounting for less than a quarter of the revenue stream, while the fast-growing technical-services division makes up the remaining 9-10%.

While having more than 90% of the company's $30 billion-plus in annual revenues coming from the U.S. government may look risky, Northrop caters to some of Uncle Sam's most vital defense needs. In the past decade, Northrop sales have increased every single year, save for one, in which sales dipped to $30.1 billion from $30.7 billion -- hardly a cause for concern.

This morning, Northrop turned in a respectable second-quarter performance, which saw sales increase 3%, while EPS from continuing operations more than doubled to $2.34 a share from $1.13. The company upped its full-year EPS guidance to $6.60 or more. This implies a 2010 multiple of just 9x forward earnings. The last time Northrop traded at such a low multiple was in 2000, when the P/E was 8x. Prior to 2010, the multiple ranged from 12x to 19x earnings.

The disconnect between a 3% sales increase and a doubling in EPS is another way Northrop has created shareholder value over the past number of years. In the past five years, the company has spent no less than $1 billion buying back stock. In the second quarter, it retired 6.5 million shares. Today, the company has 303 million shares outstanding, compared with more than 360 million in 2004. Northrop has effectively bought back nearly 20% of the company in the past five years.

Despite both top- and bottom-line growth in recent years, Northrop's shares, along with shares of other leading aerospace/defense companies, have not posted the kind of performance one would expect. Northrop's profit has increased from $1.3 billion in 2005 to what looks like will be $1.8 billion in 2010. The share price is up less than 10% during that time, however. The same dynamic holds for other leading industry firms, like Lockheed Martin, Raytheon and General Dynamics. Raytheon, for example, has seen its net profit more than double since 2005, while the stock is up just 20% over the five years.

While it may be true that the high-growth-rate days are over for these multi-billion-dollar defense conglomerates, it certainly isn't a decaying industry. A business like Northrop, through a combination of share buybacks and top-line growth of 3-5% a year, looks capable of growing EPS by 10% a year. Add in the attractive 3.5% dividend yield, and there is good reason to believe that valuation multiples have likely bottomed and are capable of expanding.

Northrop has averaged nearly $2 billion in annual free cash flow over the past three years. At a $20 billion EV, that's a healthy 10% free cash-flow yield. Such prodigious cash generation, its attractive dividend yield and continued aggressive share buybacks, coupled with its historically low earnings multiple, suggest that Northrop today is a conservative defense bet, with a little offensive growth.