Northrop Grumman (NYSE: NOC) beat estimates on earnings when it reported its fourth-quarter 2018 results in January. The company's $8.16 billion in quarterly sales only narrowly edged out analyst predictions, but profits did much better: At $4.93 per share pro forma, they came in nearly $0.50 ahead of expectations.
Granted, guidance was a little light, with management raising the possibility that Northrop might see very little profit growth in 2019. Shareholders weren't initially enthused about that, but seem to have come around to the feeling that Northrop, which often underpromises but overdelivers on earnings, may end up doing better than expected. Northrop's stock price is up 5% since earnings as a result.
Is this optimism justified? Let's listen in on management's post-earnings conference call and find out.
Northrop Grumman told us a lot last month, but was more than a little vague on drones. Image source: Getty Images.
What makes Northrop Grumman grow?
2019 guidance. We expect double-digit sales growth in 2019 to approximately $34 billion ... reflecting mid single-digit organic growth along with the full year of Innovation Systems. Assuming continued strong support for national security spending and the capabilities outlined in the national defense strategy, we currently expect mid-single digit sales growth to continue in 2020. -- Northrop Grumman CEO Kathy J. Warden
So here's the crux of the matter on sales growth: Northrop Grumman was growing sales in the mid-single digits before buying Orbital ATK. After enjoying a brief surge of "inorganic" sales growth from its new prize, Northrop should return to mid-single digits growth. Thus, for earnings to grow faster, the company must grow profit margins and/or buy back shares.
In regard to repurchases, Warden noted that the company spent $1.3 billion on share repurchases in 2018, including a "$1 billion accelerated share repurchase that we announced in November," which "was completed in early January. The ASR retired 3.84 million shares at an average price of approximately $260 per share." The company generated $2.8 billion in free cash flow in 2018, and expects to roughly maintain that rate of cash production in 2019 -- meaning free cash flow of $2.6 billion to $3 billion, which should permit additional repurchases should management think this advisable.
For the full year, we achieved a strong 10.8% margin rate ... [In 2019,] we expect our total operating margin rate will be in the mid to high 10% range. -- Northrop Grumman CFO Kenneth Bedingfield
As with sales, so too with margins. Northrop Grumman appears to be looking for steady-state growth in sales over the long term, and to maintain its historically high operating profit margin for at least another year. In this regard, it's worth pointing out that while overall operating profit margins for the company (14% in 2018) have fallen a bit from the 17.1% margin achieved in 2017, S&P Global Market Intelligence shows Northrop's operating profit margin from continuing operations remains very close to the historical high (11%) hit in 2017.
So, steady sales growth and continuing historically high profit margins? That's a pretty promising forecast if you ask me.
How is the Orbital ATK merger working out?
I'm very pleased with where we are on integration [of Orbital ATK as Northrop's new "Innovation Systems" division] both the cultural integration that's occurring as well as the integration of our operations. As Ken noted, we are on track for the cost synergies that we defined going into '19 and expect to largely have recognize those in early 2020. -- Warden
Of course, better profit margins would by definition be even better news. In this regard, CFO Kenneth Bedingfield noted earlier in the call that "our guide for [Innovation Systems, the division formed from Northrop's purchase of Orbital ATK] is kind of consistent with where they were for the full year of 2018." So synergies, even if on track, aren't yet generating any improvement in profit margins, nor are they expected to in 2019.
Bedingfield attributed this to the fact that Innovation Systems' "mix is trending a little bit higher toward development work ... particularly in their ... national security space business as well as hypersonics. So that drives the margin rate down just a touch." On the other hand, the CFO argued that this development work "positions [the IS division] well for new future production."
If you can't have rapidly rising revenue and expanding profit margin, then the next best thing is getting one or the other.
It takes more than just Lockheed to build an F-35
The F-35 program. All four of our sectors participate in this program either through production or sustainment. In 2018, F-35 revenue across the Company totaled nearly $3 billion, approaching 10% of sales with a vast majority of that coming from AS and MS. At Aerospace ... we delivered 121 units which was 47 more than in 2017. At Mission Systems, we delivered 125 multi-function radar arrays, 830 DAS sensors and approximately 4,400 CNI modules ... At the Company level, we expect the F-35 sales will grow in a mid-to high-single digit rate in 2019. -- Warden
Speaking of things that help Northrop keep its revenue growth up, everyone knows that Lockheed Martin builds the F-35 Lightning II stealth fighter jet. Fewer people may realize that, as a member of Lockheed's F-35 production team, Northrop Grumman also helps build the F-35 -- 10% of the F-35, in fact, as Warden makes clear.
Now, earlier this month we discussed how well the F-35 program is progressing for Lockheed, which has orders for some 400 airplanes in its backlog -- and just grew its F-35 deliveries 40% between 2017 and 2018. So when Lockheed said it had "a real good cadence" on F-35 production, that's good news for Lockheed Martin, but it's also good news for Northrop Grumman.
Drones aren't supposed to be seen, necessarily -- but they're not supposed to be invisible, either
We certainly see growth opportunities across the portfolio of Autonomous Systems ... I think E-2D has nice growth in 2019 and beyond Triton is in production and we see that progressing nicely on a growth profile. -- Bedingfield
Of course, the thing that I tend to like most about Northrop Grumman is its leading role in the production of unmanned aerial vehicles -- UAVs or drones, depending on your term of preference.
Between its Fire Scout robo-helicopter and its Global Hawk surveillance birds, its ground-breaking (and late-lamented) X-47B carrier-launched combat drone prototype, and its vertical launch-and-landing Tern, which could soon begin appearing on the flight decks of everything from Navy destroyers to Littoral Combat Ships, I've always thought Northrop Grumman was the best publicly traded drone stock to own.
That's why it's a bit disheartening to note that in its end-of-year conference call with analysts Northrop really didn't have a lot to say about its drones program at all. A vague reference to "growth opportunities" and a few words about how the Triton (a maritime-focused offshoot of the Global Hawk program) is "progressing," and Northrop basically called it a day.
Don't get me wrong -- spaceships and stealth fighters are cool and all. I just would have liked to see a bit more evidence that Northrop Grumman is maintaining and expanding its lead in the evolving world of hi-tech military drones. Unfortunately, Northrop failed to provide that evidence last quarter. Hmm.
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