Northrop Grumman Corporation (NOC) provides systems, products, and solutions in aerospace, electronics, information systems, and technical service areas to government and commercial customers worldwide. Northrop Grumman has raised dividends for 10 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 368 million in 2003 to 237.5 million in 2013. The company has an open buyback facility to repurchase approximately 25% of outstanding shares by 2015. Analysts expect that this dividend achiever would earn $7.78/share in 2013 and $7.99/share by 2014. In contrast, it earned $7.81/share in 2012.
The past decade has been great for defense contractors in the US, with two major wars going on, and an increase in Federal spending. However, the next decade might look different, which is why I am not going to look at the past decades trends in earnings per share, dividends per share, payout ratios or returns on equity for Northrop Grumman.
I discussed that US defense spending is likely to contract in the near future, meaning in the next five years or so. However, in the long-run, it is quite possible that defense spending will be higher in 20 years. Actually, per the Sequester agreement in early 2013, defense spending is expected to fall by 6.40% in 2013 and 5.5% in 2014. After that, it is expected that increases will match increases in inflation through 2023, which is about 2% or so. Check this document for more information.
In an interview, famous investor Mohnish Pabrai discussed some of the three strategies for investment success by Charlie Munger. One of them was to focus on carnivores, or companies which have managed to repurchase a substantial amount of their shares. If a company manages to retire 20 – 25% of outstanding shares, and manages to maintain a consistent level of profits after that, it should deliver good returns to shareholders. With Northrop Grumman, the company has managed to consistently implement and execute programs to repurchase stock. If the company can maintain the level of sales and income, shareholders could reasonably expect another massive buyback program after this one is completed in 2015. While I usually prefer dividends over buybacks, I am open to companies regular repurchasing shares at attractive valuations.
When I looked at Northrop’s statement of cash flows, I uncovered a hidden gem. It looks like the company is drowning in cash. For example, in 2012 the company generated 2.64 billion in cash flow from operating activities, while Capex amounted to 331 million. The Capex figure was the lowest in the past five years however, as it was as high as $770 million in 2010. The lowest cash flow from operating activities over the past five years was in 2011 at $2.115 billion.
At the same time, the total amount paid on dividends distributed back to shareholders has been very stable in the range of $525 - $545 million per year. Despite the fact that dividends per share increased in each of the past five years, Northrop has managed to keep the total amount spent on distributions by repurchasing massive amounts of shares.
In fact, the company has managed to decrease the total number of shares outstanding from 354 million in 2007 to 237.50 million in 2013.
Northrop Grumman has managed to spend anywhere from $1.1 billion on share buybacks in 2009 to $2.3 billion in 2011. The company spent $1.3 billion on share buybacks in 2012.
Either way you look at it, the management of Northrop Grumman looks like a very shareholder friendly oriented management. Currently, the stock is attractively valued at 12.20 times earnings and yields 2.30%. This is a lower yield than Lockheed Martin's (LMT) over 4% yield, but it seems more sustainable. Although there is uncertainty over the US defense budgets, the consistent nature of share repurchases could translate into very good dividend and capital gains returns for investors who snap up these cheap shares today. I would consider adding to the stock on dips below $98/share ( equivalent to a 2.50% yield).
What is your opinion on the company?
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DGI,
ReplyDeleteThis is an insightful analysis, especially the information provided about the buy-backs and cash flow. My opinion of the company is from a different point of view because I have at times worked in coordination with them, and regularly met with executives. The trend I have seen over the past few years is a shrinking of margins on a contract basis, following the same trend affecting most gov contractors. The government is looking to save money wherever it can. So each contract bid is scrutinized more heavily on price. Re-Bids made by incumbent contract holders must come in at lower rates than the previous contract period, or else the company is at risk for being underbid. At the same time, it is hard for them to cut salaries of skilled workers. The result is the company needs to hire more junior employees with lower salaries to compensate for the new rates. This lowers the quality of service to the customer, opening the door for a competitor to come in an take the contract. Contracts are usually longer term, so the margin risk I believe is more significant today than quality of service.
-RBD
RBD,
ReplyDeleteThat is a very insightful comment. Things like that are what has kept me from LMT, GD etc over the years. But for all those years, all those things seem to have been priced in.
In the grand scheme of things, I doubt the government will cut military spending in absolute dollars much from here. It would likely grow at slightly below rate of inflation. Therefore, it is possible that even with flat revenues, companies like NOC can still generate very good returns to shareholders, particularly if stock prices remain undervalued.