Northrop Grumman: The Premium Valuation Is Here To Stay (NYSE:NOC)

Northrop Grumman Corporation (NYSE:NOC) is one of the best performing large cap investments of the past year and indeed the past decade. It has gained 33% since January 2022 and has increased 700% since January 2013, handily outperforming the S&P 500 by as much as 4x over this period.

As one of the leading defense contractors globally, NOC has been a good bet in recent times amid increased defense spending by the US and other allied countries in the face of Russian aggression in Ukraine, Chinese expansionist ambitions, Iran’s and North Korea’s dangerous nuclear plans, and other mounting threats to peace and stability around the world.

With NOC’s share price hovering close to its 52 week high, and valuations looking optically rich – P/E (FWD) of 21.45x and EV/EBITDA (FWD) of 19.36x – it’s natural for investors to worry about the possibility of muted returns in future.

In my opinion, NOC is unlikely to get meaningfully cheaper over the next few years and the current premium is justified. Two factors inform my view. The first is the fact that, as a business, NOC has been executing notably well over the past decade, growing not only revenue, but also margins, EPS and dividends while investing in the underlying business and maintaining a healthy balance sheet. The second is that, given the current interest rate regime, investors are favoring companies that can deliver consistent profits and cash flow over those with growth potential but limited to no cash today. NOC perfectly fits the former description and is likely to benefit from current market conditions.

Excellent execution

NOC operates across four key verticals: Aeronautic Systems ($11.3 billion revenue in FY 2021), Defense Systems ($5.8 billion revenue in FY 2021), Mission Systems ($10.1 billion revenue in FY 2021) and Space Systems ($10.6 billion in FY 2021).

Its presence in these four areas has helped it align its product portfolio to the evolving and diverse needs of its base of customers in the US and globally, enabling it to achieve strong revenue growth over the years.

Analysts expect FY 2022 revenues of $36.48 billion and FY 2023 revenues of $38.11 billion. In contrast, NOC’s top line was $24.6 billion in 2013, underlining the strong growth it has been able to achieve over the past decade.

Importantly, NOC has been able to grow its margins over time, including during the past year when inflation significantly pushed up costs in the workforce and the supply chain. Its operating income margin for the trailing twelve months is 20.7% vs 17.12% in 2017 and 12.66% in 2013.

NOC’s improved operating results have resulted in increased shareholder value as its EPS has been on a solid upward trajectory, coming in at $43.54 for the trailing twelve months vs $16.34 in 2017 and $8.35 in 2013.

Investors have been rewarded through increased dividends, with the current quarterly payout of $1.73 per share being close to three times the $0.61 pay out in the final quarter of 2013. NOC has been growing its dividend for 17 consecutive years, achieving a growth rate (CAGR) of 11.63% for the last 5 years.

Leaning into tailwinds

Looking forward, I expect NOC to continue performing well from a management execution standpoint as there is a demonstrated commitment to growth, efficiency and creating shareholder value. I also expect it to benefit from industry tailwinds, in particular the fast growth of the space vertical.

Speaking at the Baird 2022 Global Industrial Conference in November 2022, David Keffer, NOC’s CFO noted that the space business has the opportunity to continue being NOC’s fastest-growing business over the next couple of years. Kathy Warden the CEO added: “We do expect space will continue to be both our largest and our fastest-growing business into next year, about $1 billion of incremental sales.”

NOC also has healthy levels of R&D spending that reflect its ambition to position itself as what CEO Kathy Warden described at the Baird Conference as a “highly diversified technology company in aerospace and defense.” Capex to support initiatives that differentiate the business is currently at peak levels of around 4% of sales, the CFO noted in the Baird Conference. One interesting project is the investment in chip design and fabrication, with the company now operating two foundries to enable it to differentiate its systems and take greater control of its supply chain.

With these factors in mind, NOC’s future growth prospects are promising. This further supports my view that the valuation will remain elevated.

Relooking at the valuation in context

Compared with peers, NOC is not that pricey. It is among the cheapest when compared with the likes of General Dynamics (GD), Boeing (BA), Lockheed Martin (LMT), and Raytheon Technologies (RTX), all of which are larger by revenue and number of employees.

The risk in the short term is the aerospace and defense industry correcting due to high valuations. This won’t, however, change the long-term picture for NOC and will in fact be an opportunity to buy as the stock has a lot of support due to several factors.

The current 1.31% yield is low and a drop in the stock’s price could lead to a fresh wave of new buying as investors try to lock in a higher yield in a stock whose dividend is likely to continue growing as it has for 17 straight years.

Expectations of continued growth in defense budgets are also likely to support NOC’s earnings and consequently its share price. NOC’s CEO Kathy Warden has previously noted that its government customers are inclined towards longer term demand signals, which is positive. “The Department of Defense is increasingly talking about multiyear demand signals even if appropriations have to happen annually,” she noted at the Baird Conference.

Finally, NOC has also been employing the clever use of buybacks to boost EPS and is set to continue to do so. Outstanding shares today stand at 156.5 million, a 33% reduction from 233.9 million in 2013. NOC committed $1.5 billion to share repurchases in 2022 with the guidance for 2023 set to be slightly higher. These repurchases are a good use of capital given net debt is at $12.5 billion for the trailing twelve months, which is manageable for a business of the scale of NOC.

Final take

NOC is not a cheap stock for a reason – it’s a safe stock that offers both income and growth and is well positioned to continue appreciating in value given the positive fundamentals of the business and the industry in which it operates. I believe it is a buy, even at current levels, and will use any future weakness to expand my position.