Is its dividend growth worth it?
Northrop Grumman Corporation (NOC) is an international aerospace and defense company specializing in providing a broad range of products and services to the United States Department of Defense (DoD) and other international government entities.
The company’s diverse operations are aligned to help national security priorities and equip its customers with the capabilities they need to protect and advance society.
Northrop Grumman’s core operations include the provision of space systems, advanced aircraft, missile defense, advanced weapons, mission systems, artificial intelligence, advanced computing and cybersecurity.
In my opinion, Northrop Grumman is one of the highest quality companies in the aerospace and defense industry, with a decades-long track record of creating impressive shareholder value.
Society stands to benefit from the ongoing war in Ukraine, as Western governments provide the country with relevant weapons and equipment. As Western governments replenish their own arsenals amid these deliveries, Northrop is expected to experience a growing backlog.
However, investors have likely fully appreciated these tailwinds as the stock’s valuation has risen significantly over the past couple of months. While Northrop Grumman could still be a solid long-term investment, I’m neutral on the stock.
Recent financial performance
Northrop Grumman’s latest results demonstrated the company’s resilience. Although its numbers are a little weaker compared to last year, the company’s order book and profitability outlook remain very strong.
Fourth-quarter revenue fell 15% to $8.6 billion, while adjusted earnings per share fell 9% to $6.00. Specifically, sales were down in all segments except Space Systems.
Aircraft systems revenue was down 25% to $2.6 billion from a year ago due to lower volumes in manned aircraft and autonomous systems. Defense Systems revenue fell 28% to $1.4 billion due to the sale of the company’s IT services business, reduced working days and the termination of the contract at the factory Army ammunition in Lake City.
Mission Systems sales were also down 8% to $2.52 billion, driven by fewer business days, but offset by higher volumes in ground systems and infrared countermeasures which boosted performance. Finally, Space Systems saved the day for Northrop, with its revenue growing 4% to $2.7 billion, supported by strong sales in Launch & Strategic Missiles and Space.
Northrop won $9.8 billion in contracts during the quarter despite relatively disappointing results, bringing its total backlog to $76.0 billion. With Northrop’s manufacturing capabilities capable of supplying approximately $35 billion worth of goods and services per year (i.e. its fiscal year 2021 revenues), the company has an order-to-bill ratio north of two years.
This implies that the company’s short to medium term cash flow should remain robust. The ongoing macro-geopolitical landscape should further strengthen the company’s order book. For context, it’s estimated that the company will reap $59 billion over six years from a new bomber and intercontinental ballistic missile, assuming the US Air Force’s new spending plan is realized.
Dividends, redemptions and valuation
Since Northrop’s future revenues are based on the underlying order book, the company’s performance has always been fairly stable and predictable. As a result, the company has been able to gradually return increasing amounts of capital to shareholders over the years.
Specifically, Northrop has an 18-year dividend growth track record. The company has been increasing its dividend at a rapid pace, with a 10-year dividend per share CAGR (compound annual growth rate) of 12.3%. Its latest rise was also a satisfying 8.3% to a quarterly rate of $1.57.
Along with its fourth quarter results, the company provided its outlook for fiscal 2022, including expected revenue between $36.2 billion and $36.6 billion for the year and EPS between 24.50 and $25.10.
The midpoint of the management forecast, along with Northrop’s DPS execution rate, points to a comfortable payout ratio of 27%, implying that the company should be able to easily sustain strong dividend increases.
Additionally, the midpoint of management’s forecast also implies a forward PER of around 18.2 at the stock’s current levels. While the valuation looks quite reasonable, it simultaneously assesses most of the tailwinds ahead that the company stands to benefit from, in my view. It is also significantly higher than the stock’s historical average PER of around 15-16.
It should be recalled that the company’s buybacks should be less effective following the recent increase in valuations. Northrop has consistently repurchased shares throughout the year, delivering value to its shareholders and gradually increasing its EPS.
Last year, the company repurchased $3.74 billion worth of stock. To give some perspective, the company has bought back and retired about 57% of its common stock since 2004, which is nothing short of impressive. However, buybacks should have less incremental value at an expanded valuation (because the company would be slightly overpaying for its shares), which is worth noting.
The Taking of Wall Street
As far as Wall Street is concerned, Northrop Grumman Stock has a moderate buy consensus rating based on three buys and seven takes given over the past three months. At $456.89, Northrop Grumman’s average price target implies 1.1% upside potential.
Overall, Northrop Grumman is a quality company with a long history of creating shareholder value. The company is expected to see its order book increase in the coming years, driven by the ongoing war in Ukraine, which is pushing up international defense budgets.
Nonetheless, the stock’s recent rally has likely fully priced in the upcoming benefits of the current circumstances, limiting the potential for extraordinary returns to come.
Still, I think Northrop should be able to adequately serve dividend growth investors, as its bottom line could comfortably support DPS growth in the high single digits to double digits going forward.
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