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The company seeks to align its core strengths with the Quadrennial Defense Review that sets the course for the country's security initiatives for the coming four years as a means to increase its share of defense contracts (2009 Annual Report). Thus, the company's strategic initiatives are driven by what it expects government defense policy will be in the coming years. As of the fall of 2009, the company did not believe that it had any major holes in its competencies or product offerings that it needed to address (Ratnam, 2009). This is perhaps why Northrop Grumman is focused on internal improvements -- it feels that the company's existing structure, businesses and strengths are sufficient to sustain its size and to build market share in defense contracts. The company has not indicated any desire to seek out new customers in its recent communications.
Policies and Practices
Northrop Grumman's capital structure has increasingly emphasized debt financing in recent years. The company has engaged in share buybacks of at least $900 million in four of the past five years, contributing to a reduction in the book value of the firm's equity. The company has maintained its level of long-term debt and total liabilities over the past five years at a stable level. Due to the decrease in equity, however, debt has become a more important component of the firm's capital structure. In 2005, the company's structure was 50.8% debt and 49.2% equity. In 2007, the capital structure was 47% debt and 53% equity. However, by 2009 this ratio reversed again, with debt comprising 58% of the firm's capital structure and equity comprising just 42% (MSN Moneycentral, 2010).
An increasing emphasis of debt financing is appropriate for firms that have a slower-growing business because the cost of capital is lower. The company's debt is typically long-term, matching the long-term time horizon for its investments. Northrop Grumman issued $850 million in debt in 2009, the first such issuance in five years. The company, therefore, it not increasing its debt in a wanton fashion but in a slow, deliberate fashion in order to lower its total cost of capital.
Northrop Grumman's current dividend payout is $1.88 per share, exhibiting five-year growth of 13.68%. The current dividend yield is 3.08%. The dividend per share payout was $1.01 in 2005 and has escalated steadily over the course of the past five years (MSN Moneycentral, 2010). This figure has been inflated somewhat by the buybacks over the past five years. Without the buybacks, today's dividend per share figure would be $1.48, a lower figure and slower rate of growth. The buybacks, therefore, serve to enhance the return to shareholders both in terms of increasing dividends per share but also be propping up demand for the company's shares.
Despite these efforts, the company's shares have experience mixed performance over the past five years. Five years ago at the end of May 2005, Northrop Grumman shares traded at $55.72. Today, those shares are worth $61.13, an increase of 9.7%. With dividends factored in, the return to shareholders over the past five years has been 22.1%. The return on the S&P 500 over the same time period has been approximately -8%. The company has therefore outperformed the market dramatically. The beta of Northrop Grumman is 1.05, a figure not altogether unexpected given the relative stability of the firm's industry in recent years. This beta implies that Northrop Grumman should have performed roughly in line with the market over this period, but it outperformed the market significantly.
The shift in emphasis that Northrop Grumman has undertaken with respect to its capital structure has served to lower its cost of capital, as debt typically bears a lower cost than equity. This is particularly true of a prolonged low interest environment such as the one that we are currently experiencing. The company issued $850 million in senior unsecured debt in 2009. These included $350 million of five-year notes at 3.7% and $500 million of ten-year notes at 5.05% per annum (2009 Annual Report). The current yield on the five years is 3.43% (Yahoo! Finance, 2010). The company's cost of equity can be estimated using the capital asset pricing model (CAPM) and basic assumptions such as a 7% market risk premium. The risk-free rate, based on one-year treasuries, is 0.4 (Yahoo! Finance, 2010). With these figures and the company's beta, the cost of equity for Northrop Grumman derived from CAPM is as follows:
0.4 + 1.05(7) = 7.75%.
The weighted average cost of capital (WACC) of Northrop Grumman, given the current capital structure, is as follows:
(0.58)(3.43) + (.42)(7.75) = 5.244%
The company has also made adjustments to its working capital policy. Working capital refers to the mix of current assets and current liabilities. The basic working capital calculation is current assets -- current liabilities. For Northrop Grumman, working capital at the end of 2009 was $1.65 billion. This compares to $365 million in 2007 and -$423 million in 2005. The company has, over the past five years, steadily increased its working capital. One of the reasons why Northrop Grumman has undertaken to do this is that it reflects greater financial strength. The firm's liquidity in 2005 was questionable despite otherwise strong performance. The recent steps have improved the company's overall liquidity, which contributes to a lower cost of capital.
The improvement in the company's working capital seems on the surface to contradict the firm's policy of increasing managerial efficiency. This policy, which encourages the reduction in the inventory and receivables turnover ratios, would in theory lower the level of current assets. For this to hold, the cash generated from the faster turnover would need to be reinvested, so the simultaneous improvement in the company's working capital and turnover ratios could be explained by an increase in cash holdings. Indeed, the balance sheet shows that cash increased from $1.504 billion in 2008 to $3.275 billion in 2009. This increase, however, is $1.771 billion, which is roughly equivalent to the cash earned from the divestiture of the TASC subsidiary in November 2009 for $1.65 billion (Datamonitor, 2009). The company has not yet issued its first 10-Q for 2010 so it remains to be seen how this extra cash will be treated and what impact that may have on Northrop Grumman's working capital situation.
In general, however, the company's working capital policy is consistent with a firm that is seeking to accomplish two main things. The first is internal improvement -- increasing working capital is part of that, in particular cash increases to replace the decreases in inventory and accounts receivable. This cash may eventually be reinvested, but a firm seeking internal improvement wants to increase the percentage of cash in its working capital, and that has occurred at Northrop Grumman over the past several years. The second thing that the company is seeking to accomplish is to provide it with the means to either improve liquidity or to take advantage of growth opportunities. It would appear that Northrop Grumman, being oriented more towards divestitures than acquisitions at present, is seeking to improve liquidity. This in turn lowers the cost of capital for the company. The working capital policy, therefore, is likely designed with the cost of capital and long-term organic growth in mind.
Overall, there is very little risk in the Northrop Grumman's operations. The firm's beta indicates a long-term history of being tightly correlated with the broad market. In addition, the company is one of only a few major players in its industry. The U.S. government and DOD deal with only a few firms that have Northrop Grumman's competencies. The learning curve in the defense industry is very high, both in terms of technological development but also in terms of lobbying and building relationships with government officials. This creates a strong barrier to entry in the industry. In addition, the government is likely to see the value in, and have a policy of, spreading the defense contracts around to maintain several strong suppliers. Dependence on a single supplier or oligopoly would be poor national defense policy. This means that Northrop Grumman's size and specific contracts may be adjusted but there is little risk that they will fall out of favor with its main customer altogether.
The company has in recent years demonstrated that it has fairly good control over both its pricing power, based on stable gross margins, and over its cost structure, based on its SGA expense as a percentage of sales. Furthermore, since embarking on a policy to divest businesses and improve internal efficiency, the company has been able to achieve these goals successfully. While Northrop Grumman moves slowly, it moves effectively, indicating that there is very little internal risk to the organization as well. The total risk profile of the company is minimal, and may even be less than the firm's beta might suggest.
Overall, Northrop Grumman is a moderately well-performing stock. While some of its performance metrics are inferior to those of the industry as…[continue]
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