Northrop Grumman Corporation (NOC) posted mixed results for the December quarter surpassing the Zacks Consensus Estimate on the bottom line but missing the consensus at the top. Looking forward, the company offers a strong program portfolio positioned to take advantage of focus areas in the defense space, an improving balance sheet and an ongoing share repurchase program. Our bullish outlook for the company is supported by favorable projected revenue, diversified revenue and earnings streams, and discounted relative valuation metrics.
However, our bullishness would be tempered by apprehension regarding defense cutbacks on high-cost platform programs, over-exposure to the DOD budget, lower backlog, cost over-runs and reductions in the Afghanistan and Iraq operations.
Northrop Grumman is the fourth largest U.S. defense contractor behind The Boeing Company (BA); Lockheed Martin Corporation (LMT); and General Dynamics Corporation (GD) in terms of fiscal 2011 revenue, with a major platform-centric focus. The company has a strong presence in Air Force, Space & Cyber Security programs. Northrop’s product line is well positioned in high priority categories, such as defense electronics, unmanned aircraft and missile defense. Revenue and earnings growth continue to be driven by its strong presence in the current focus areas of cyber security, modernization of defense and homeland security assets, intelligence, surveillance and reconnaissance systems, advanced electronics and software development.
The positive case for Northrop Grumman stems from revenue growth across the board, a broad diversification of programs, and an order backlog of approximately $39.5 billion after the end of 2011. The company’s backlog is expected to see further upside in the near future through unmanned aerial vehicle (UAV) platforms, including Broad Area Maritime Surveillance (BAMS), Fire Scout and Navy Unmanned Combat Air System (UCA). Also, the company has a sizable presence in the Joint Strike Fighter F-35 (JSF) program and would benefit greatly with successful negotiation for further F-35 follow-on orders.
Northrop Grumman’s strong balance sheet and cash flows provide substantial financial flexibility and a cushion through an incremental dividend, ongoing share repurchases and earnings accretive acquisitions. In 2011, the company repurchased more than 40 million shares for approximately $2.3 billion. At the end of 2011, Northrop still had approximately $1.7 billion remaining under its share repurchase authorization. At the end of 2011, the company had a low long-term, debt-to-capitalization of 25.1%. Total long-term debt was approximately $3.9 billion, of which $13 million is due in the near term, along with cash holdings of $3.0 billion.
On the flip side, a large percentage of Northrop Grumman’s business is generated within the U.S., where products and services ultimately sold to the U.S. government accounted for 90.5% of sales in fiscal 2011. The proportion is highest among the defense large-caps. Budget deficits and political uncertainty make future U.S. defense budgets vulnerable to cutbacks. Going forward, any cuts in U.S. defense spending will affect the company most among its large-cap peers.
Going forward, the U.S. economic fundamentals are basically being kept on a leash as the Euro-crisis continues to cast its spell over the financial markets, keeping risks of further cutbacks in future defense budgets at a high level. The Zacks forecast for GDP growth for the first half of 2012 is now at just around 2.0%. This culminates into a GDP growth rate of 2.3% for fiscal 2012. Our apprehension is fueled by $15 trillion of national debt and an unemployment rate hovering around 8.3% which would lead to the Budget Control Act’s dictum of automatic cutbacks across the board going forward.
Northrop’s fortunes are heavily tied to missile defense-related programs. These programs are tempting targets for those seeking ways to reduce the budget deficit. Northrop Grumman’s order backlog declined to $39.5 billion at the end of 2011 from $46.8 billion at the end of fiscal 2010. This was due to the impact of lower U.S. Department of Defense (DoD) investment outlays including announced force reductions in overseas contingency operations, termination of certain space programs, and reduced participation in the Nevada National Security Site (NSTec) joint venture. Going forward, order backlog and revenue growth would be affected by changes in a number of large programs, including the Defense Weather Satellite System (DWSS) program termination, the transition from F/A-18 multi-year 2 to multi-year 3, the wind down of B-2 upgrade programs, lower in-theater sales and lower Intercontinental Ballistic Missile (ICBM) volumes.
Northrop Grumman generated approximately 41% of its sales in fiscal 2011 from fixed priced contracts. As a result, the company will only be able to make a profit on such contracts if costs stay within the contracted cost.
Of Northrop Grumman’s cumulative revolving credit facility of $2 billion, $500 million will expire in September 2012. Failure to renew the facility could pose a short-term liquidity crisis for the company since it uses the credit facilities to meet short-term and working capital needs.
Going by the pulse of the economy and given the pros and cons, we prefer to maintain our long-term Neutral recommendation on the stock. Moreover, Northrop Grumman holds a Zacks #3 Rank that translates into a short-term Hold rating.
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