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Northrop Grumman Offers the Potential for Solid Returns

GuruFocus.com

The aerospace and defense companies continue to rank among my favorite investments because spending on defense continues to increase. In addition, contracts tend be multiyear, making them difficult to pause or cancel.

While Lockheed Martin (NYSE:LMT) is my favorite company in the sector, I believe that Northrop Grumman Corp. (NYSE:NOC) could be a candidate for purchase.

Quarterly highlights


On Thursday of last week, Northrop Grumman reported second-quarter earnings results. Revenue increased 5.1% to $8.9 billion, coming in $220 million ahead of what Wall Street analysts had expected. Adjusted earnings per share improved 95 cents, or 19%, to $6.01. This was 73 cents above estimates. Net earnings increased 17% to $1 billion as a lower share count helped with earnings. The segment operating margin declined 10 basis points to 11.6%.

All but one segment had higher revenue totals than the previous year and each business had an increase in operating income.

Aeronautics Systems grew 7% to $2.9 billion due to strength in manned aircraft and autonomous systems. This segment also enjoyed an increase in volumes on restricted programs. Covid-19-related shutdowns for F-35 production were a slight headwind to results. Margins were down 40 basis points to 10.6%.

Revenue for Defense Systems decreased 2% to $1.9 billion, though operating income was higher by 2%. Volumes declined for battle management and missile systems as several programs are nearing completion. Certain missile systems, including Guided Multiple Launch Rocket Systems and Advanced Anti-Radiation Guided Missile programs, saw higher demand during the quarter. Restricted programs helped drive better results for mission readiness programs. Segment margins were higher by 40 basis points to 11.5%.

Mission Systems was up 2% to $2.4 billion primarily due to strength in airborne sensors and network programs. Higher airborne radar experienced an increase in demand. Cyber and intelligence mission solutions sales were lower as a program is nearing completion. Margins for the quarter were 14.2%, up 10 basis points from the prior year.

The Space segment was the star of the quarter, as sales increased 15% to more than $2 billion. Space and launch and strategic missiles both enjoyed higher demand. Space benefited from higher volumes for, among others, its Artic Satellite Broadband Mission program. Hypersonics remain in high demand and launch vehicle programs performed well. Delays in production for certain commercial space components caused a 60-basis point decrease in margins to 10.2%.

The company received a net awards totaling $14.8 billion during the quarter, giving Northrop Grumman a book to bill ratio of nearly 1.7. This caused the company's backlog to swell to $70 billion. This is an 8% increase from what the backlog was at the end of 2019. Much of the growth in backlog is due to a 48% increase in the backlog for Space Systems. Using last year's revenue total, this gives Northrop Grumman more than two years of backlog to work off.

Northrop Grumman's free cash flow increased 53% to $2.1 billion for the quarter, with a total free cash flow expectation of at least $3.2 billion for 2020. The company has repurchased $490 million worth of stock while distributing $469 million in dividends during the first half of the year. In total, $959 million of capital has been returned to shareholders so far in 2020.

Northrop Grumman's quarterly results were solid nearly across the board, but the company is also set up for the future with its massive backlog, nearly half of which is already funded. Shares are down 5.5% for the year, but I believe the stock is likely to go higher as business results have been good and the stock trades with a low valuation.

Valuation analysis

Northrop Grumman also offered revised guidance for the year during the conference call. Adjusted earnings per share are expected in a range of $22 to $22.40, up from $21.80 to $22.20, on revenue of $35.3 billion to $35.6 billion, up from $35 billion to $35.4 billion.

Shares closed Friday's trading session at $325, giving the stock a forward price-earnings ratio of 14.6 based off of the midpoint for updated earnings guidance.

According to Value Line, Northrop Grumman has averaged price-earnings ratio of 13.9 over the last decade and 17.7 for the last five years. I have a price-earnings target range of 15 to 17 on shares due to company performance and higher amounts of defense spending.Therefore, my price target range for the stock is $333 to $377, which would be a 2.5% to 16% potential return from current levels.

Added to this would be Northrop Grumman's 1.8% dividend yield. The yield is low, but the company has increased its dividend for the past 17 years and at annual rate of nearly 11% since 2010.

Final thoughts

Northrop Grumman saw revenue growth in three out of four segments in the second quarter and operating income was higher for each component of the company. Northrop Grumman continues to see a growing backlog, giving the company plenty of work. And as defense spending continues to grow, so too should the backlog.

Northrop Grumman also raised its top and bottom line guidance for 2020. Shares trade with a forward valuation below the five-year average and just above the 10-year average multiple. I feel that the market undervalues both the company's business and aerospace and defense sector spending. This gives investors who are looking for a solid aerospace and defense company a chance to purchase shares that offer a solid potential return. For these reasons, I find that shares of Northrop Grumman are a buy.

Disclosure: The author has a long position in Lockheed Martin.

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This article first appeared on GuruFocus.