Valuation and financial analysis of Northrop Grumman Corporation

Northrop Grumman

Corporate History & Situation

Northrop Grumman is the #3 defense contractor in the United States. U.S. government and DOD contracts are worth an estimated $16.1 billion (Rohrlich, 2010), or 47% of the company's revenues. A substantial portion of the remaining revenues comes from other governments and militaries, as well as some civilian commercial work.

Northrop Grumman was formed in 1994 by the merger of Northrop Aircraft and Grumman Aerospace. Northrop traces its history to 1939 and Grumman to 1930. The company builds military aircraft and aircraft systems, missile systems and aerospace technology. There were significant synergies between the Northrop and Grumman businesses at the time of the merger. Also under the same ownership is Westinghouse, manufacturer of defense systems (radar, for example) and civil aviation systems. It was acquired by Northrop Grumman in 1996. Logicon Corporation provides information systems to both military and commercial customers and was acquired in 1997. Teledyne Ryan is a maker of unmanned aircraft and was acquired in 1999. Litton Industries specializes in naval vessels and technologies and was acquired in 2001. Newport News Shipbuilding produces nuclear submarines and aircraft carriers and was acquired in 2001. TRW makes space systems and satellite payloads and was acquired in 2002. While the company has slowed the pace of major acquisitions in recent years, it has continued with a general strategy of expansion by acquisition that began with the Northrop-Grumman merger (Northrop Grumman.com, 2010).

Brief Analysis of Future Plans/Corporate Goals

It appears as though Northrop Grumman's emphasis on expansion through acquisition has slowed in recent years. The acquisitions that the company has undertaken in recent years have been much smaller than in the 1990s and early 2000s. These acquisitions have also become more tactical in nature, with the last five all being firms acquired to bolster the company's information systems expertise to capitalize on the growing need for IS integration in weapons, aerospace and naval hardware.

The general trend in the industry has also been to maintain the status quo. The acquisition growth was the result of industry conditions in the early 1990s, but those conditions have changed. The industry is in a state of maturation, but remains profitable due to ongoing investment by the U.S. government and persistent military action in various locations around the world. The political climate is such that the federal government is unwilling to cut programs, as those cuts may result in job loss during a time of high unemployment. Firms in the industry are currently either milking cash cow projects or they are scaling back their operations somewhat in response to slow growth and limited M&a potential.

Northrop Grumman has used this period to focus on internal process improvements. This internal focus is the result not only of the stability of the external environment but of the fact that the company now has a new CEO, Wes Bush, after Ronald Sugar retired following 29 years of service. With the change of leadership the company is in a holding pattern, seeking direction. One recent strategy has been to divest the firm of underperforming assets, with the TASC group being of the largest on the table (Ratnam, 2009).

In the past three months, there have been some changes in the company's focus. One is that the firm has moved its corporate office from Los Angeles to the Washington, DC area in order to be near its biggest customer. The move highlights the importance of the U.S. federal government and DOD to the company (Hedgpeth, 2010). 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 a whole, there are no red flags to be found in the company's financial statements. The main strengths are the company's overall stability, including of both revenues and costs; its increasingly lower cost of capital; and its stock performance.

While there are no glaring weaknesses in the performance of Northrop Grumman, there are a few areas where improvement could be beneficial to the company. For example, the company's margins are lower than the industry average. This indicates that while Northrop Grumman has some pricing power, it perhaps has less than its competitors. Given the high-end technology with which the firm works, it is reasonable that it should have higher margins than it does. Another weakness in the firm's finances is with respect to the need for share buybacks to prop up the share price and the dividend payout per share. The company's relatively flat performance and declining asset base is essentially being masked by this policy.

Deviations

The company's stock has outperformed the market significantly. However, this success has been driven as much by the firm's buybacks as it has by the relatively slow level of organic growth. As with many firms in mature industries, Northrop Grumman is using its free cash flow and proceeds from divestitures to prop up the value of its shares. The company's total equity base, however, is declining. As a result, the firm's performance and value may not justify its current share price.

The current share price is $61.13, which indicates a price/earnings ratio of just 11.58. This P/E is low for the company. From 2004 through 2007 the company's P/E ranged between 14.3 and 17.5. Before that, the P/E was 22.1 in 2003 and 30.4 in 2002 (MSN Moneycentral, 2010). These multiples were justified only somewhat by the firm's growth at the time. The company was not far removed from its major acquisition phase and the U.S. was in one war and leading up to another. However, once all information was known Northrop Grumman settled into a stable P/E range indicative of a firm with modest growth prospects and a reasonably priced stock.

The current P/E ratio can indicate that one of two things has changed. The first is that the company's growth prospects have changed. A case for this can be made -- organic revenue growth has been sluggish over the past five years and the firm is actively divesting assets to focus on core businesses. The industry is mature and there is little indication that the defense industry is going to receive a substantial boost in spending in the near future. Indeed, the political mandate is to wind down operations in Iraq, the prospect of which was partly responsible for the firm's high P/E ratio early in the previous decade.

The other thing that could have changed is that the price of the stock could be too low. Northrop Grumman's stock price is off its 52-week high but that high was achieved just a few weeks ago. The current low P/E ratio, therefore, is not likely to derive from an undervalued stock. Indeed, the firm's unexpectedly strong performance vs. The broad market in the past five years, combined with its resiliency to recession, should be expected to increase the value of the stock, and that appears to have been the case.

The company's book value per share is $42.02 (MSN Moneycentral, 2010) so there is still a fair bit of growth built into the share price. The dividend discount model implies a value of around $35. The stock appears to be significantly overpriced at present. This likely lies with the high earnings per share. The dividend payout is a relatively low percentage of the earnings per share, so a high EPS is not going to be reflected in a high dividend discount model valuation.

The high value of the current stock price is likely to derive in part from unwillingness on the part of investors to bring the P/E ratio too low. With strong profits, Northrop Grumman is going to have a high stock price regardless of dividend policy. There may also be an assumption built into the market price that the firm is going to increase its dividend as a consequence of its high EPS and maturing business.

The impact of future share buybacks is also going to be factored into the share price. In late 2009, the company authorized a further $1 billion in share buybacks for the year 2010 (2009 Annual Report). If the company's current profit growth track holds, the book value of the firm's equity may increase in coming years, not counting the share buybacks. What this means is that the share buybacks are going to increase the value of each share and that increase will amplify the expected increase that results from the firm's operational strength. In addition, the dividend payout ratio will also increase as a result of the buybacks, further amplifying the impact on the share price.

Thus, it appears that investors have driven the stock price higher than one might expect based on two key factors. The first is that fact that Northrop Grumman has performed better than average over the past five years. A beta that is weighted by recency will be much higher, meaning that the expected increase in share price (assuming the market is expected to increase) is going to be higher than the long-term beta of 1.05 would imply. In addition, the market may also be pricing in the impact of a further $1 billion in share buybacks, which will influence not only the share price but the dividend payout as well. The firm's high earnings also contribute to the price -- the P/E is actually at a low level for this company, even though the share price appears high.

Overall, Northrop Grumman is a fairly well-performing company that is stable and has a low level of risk. This is reflected in a fairly low P/E, despite what is a historically high price for the stock. Expectations of further internal performance improvements, another $1 billion in share buybacks and other initiatives has increased the stock's value and delivered higher than expected returns to shareholders in recent years.

Works Cited:

Datamonitor. (2009). Northrop Grumman divests TASC business for $1.65 billion. Trading Markets. Retrieved May 24, 2010 from http://www.tradingmarkets.com/.site/news/Stock%20News/2645115/

Hedgpeth, D. (2010). Q&a with Northrop Grumman chief executive Wes Bush. Washington Post. Retrieved May 24, 2010 from http://www.washingtonpost.com/wp-dyn/content/article/2010/04/29/AR2010042903716.html

MSN Moneycentral: Northrop Grumman. (2010). Retrieved May 24, 2010 from http://moneycentral.msn.com/detail/stock_quote?symbol=NOC&ww=1

Northrop Grumman 2009 Annual Report. Retrieved May 24, 2010 from http://www.northropgrumman.com/pdf/2009_noc_ar.pdf

Northrop Grumman website, various pages. (2010). Retrieved May 24, 2010 from http://www.northropgrumman.com

Ratnam, G. (2009). Northrop's Sugar to retire; Wesley Bush named chief. Bloomberg. Retrieved May 24, 2010 from http://www.bloomberg.com/apps/news?pid=20601103&sid=awNvIV4IfBdk

Rohrlich, J. (2010). For defense contractors, the lobbyists still rule. Minyanville. Retrieved May 24, 2010 from http://www.minyanville.com/businessmarkets/articles/defense-contractors-lobbyists-military-generals-mentors/2/12/2010/id/26838

Yahoo! Finance: Bond Screener. (2010). Retrieved May 24, 2010 from http://reports.finance.yahoo.com/z1?is=northrop+grumman