Recent Underperformance Makes Northrop Grumman An Interesting Opportunity – Northrop Grumm…

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Since peaking near all-time highs in April, shares of Northrop Grumman (NYSE:NOC) have dropped almost 19%.

Not only has the stock underperformed the S&P 500, but it’s also lagged other major defense contractors like Lockheed Martin (NYSE:LMT). The result is that Northrop now trades at a forward P/E of 17.24, slightly below that of the market at 17.29. Although, as we’ve written in a previous article, pension accounting issues mean earnings multiples are not always the best way to judge defense contractors. Still, it’s an easy way to show how far valuations for the company have come down. So what are the reasons for this, and is Northrop a good buy?

Short of interviewing every single person who’s traded NOC over the last few months, it’s impossible to know for certain why the stock is down, but to the best of our knowledge, it appears to be a combination of issues.

Reasons for Underperformance

First, Northrop is a prodigious user of steel and aluminum and tariffs. and trade war fears have impacted stocks of many companies that use significant quantities of those goods. However, as we wrote in the past, defense contractors have a unique business model that could alleviate raw material cost pressures.

Second, it may be that guidance was a bit disappointing for some investors. While Northrop raised EPS guidance from between 16.20 and 16.45 to between 16.60 and 16.85, it did not raise FCF guidance by a similar amount, only from between $2.3-2.6 billion to between 2.4-2.6 billion. This is about a 2% boost from midpoint to midpoint in FCF, compared to 2.5% in EPS. It’s also worth noting that Lockheed Martin raised sales guidance the day before, while Northrop did not.

Third, investors may have been disappointed with the company’s cash flow priorities. On the earnings call, the outgoing CEO stated that paying down debt (Northrop just bought Orbital ATK) and funding its pension plan will take precedence over dividends or buybacks.

If you are thinking many of those things seem like little nitpicks and not major issues, we’d agree. With valuations down and defense spending set to rise, things look better investments in defense contractors, especially Northrop, then they did about three months ago.

The Future of Defense Spending

The major defense contractors receive a majority of their revenue from the Procurement and Research, Design, Testing & Evaluation (RDT&E) line items in the defense budget. In the past, the Overseas Contingency Operations (OCO) budget line item has been used as kind of a slush fund in roundabout ways to cover for budget shortfalls elsewhere. For this coming year, defense spending has picked up significantly, as shown below.

Procurement

RDT&E

OCO

Overall

FY16-17

+.7%

+1.4%

+10.3%

-.3%

FY 17-18

+4.8%

+18.7%

-.6%

+8.9%

While defense spending is projected to grow between 2.6% to 5.7% over the next five years, long-term defense spending forecasts are borderline worthless. Defense spending budgets are ultimately set by Congress, and elections every two years mean the make-up of Congress can change radically. Remember, it was only about five years ago that Congress was cutting the defense budget.

Perhaps the biggest risk to defense contractors over the next few years is Democrats gaining control of the House (the Senate seems unlikely given the make-up of the electoral map) in the 2018 midterm elections, followed by gaining the Senate and Executive branch in the 2020 elections. So, long as things continue on their current path, this seems the most likely outcome. Indeed, FiveThirtyEight.com currently projects a 3 in 4 chance of the Democrats winning the House.

(Graphic via FiveThirtyEight.com)

While 2020 might sound like it’s a ways away, remember that the market is forward-looking, and a strong mid-term showing by the Democratic party could produce a narrative change around defense contractors.

Summary

We’ve added a bit more to our position in Northrop recently, since we think the recent underperformance is a bit overdone. We still think defense contractor valuations are a bit on the high side. A reverse DCF model with a 10% discount rate, 3% terminal growth rate, and 5-year variable growth period shows Northrop needing about 13.5% working capital-adjusted FCF growth to justify its current valuation. That number is roughly in line with analysts’ average growth predictions. However, long-term political risks may still cloud the future of defense contractors.

Disclosure: I am/we are long NOC, LMT, GD, RTN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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