When searching for superior investment opportunities one of the criteria used is the effectiveness of management. I view investing in a company as forming a partnership where I am expecting to receive gains on the sum invested. Having a board of directors and a CEO who share this view and look to reward shareholders helps smooth out the natural volatility of the stock market and allows one to compound gains over time. I believe an investment in Northrop Grumman (NOC) exemplifies the above statement. The article below will further elaborate on why I hold NOC in high regard along with its excellent CEO Wes Bush.
Mr. Bush is the current CEO and Chairman of the Board of NOC. Mr. Bush assumed the CEO Mantle in January of 2010 and I will use the 2010-2013 time frames to examine the company's performance under his leadership.
Earnings per share
Dividends per share
Shares Outstanding in millions
As we can see from the chart above the shares of NOC have almost doubled during the tenure of the CEO. To say the least this is an outstanding performance especially in a slow growth defense/aerospace industry. The key to this outperformance in my opinion is the willingness to think outside the box and make tough decisions.
One of the major decisions made was to spin-off Huntington Ingalls Industries (HII) to existing NOC shareholders. Shipbuilding tends to be a lower margin capital intensive industry. By spinning it off to existing shareholders, significant value was unlocked. The spin-off was completed in March 2011 with existing shareholders of NOC receiving one share of HII per every six shares owned of NOC. As we can see from the chart below, HII has appreciated over 30 percent since the spinoff.
The second major decision made was to streamline operations and increase net profit margin. In the five years before Mr. Bush's tenure net profit margin averaged roughly 5%. By reducing headcount and inefficiencies net profit margin has increased into the 7% range. The roughly 2%+ increase in net profit provides a nice tailwind to earnings allowing them to accelerate at an enhanced pace.
The rapid increase in earnings allows the company to reward shareholders via higher dividends and share repurchases. By consistently reacquiring outstanding shares especially when the shares are undervalued creates a virtuous cycle as earnings accelerate higher due to fewer shares outstanding. The math behind this concept is quite compelling if viewed from an abstract point of view. The formula is quite simple as earnings per share equals net profit divided by shares outstanding. If the denominator keeps shrinking (shares outstanding) even with the numerator staying steady, earnings growth will be achieved. The mechanism here is similar to what IBM (IBM) is currently employing. Share repurchases have to be made however when the shares are undervalued to achieve the desired effect. Cisco Systems (CSCO) is a great example of a company that consistently bought back shares yet the stock went sideways. The issue here is twofold. First, the shares weren't undervalued for most of the time frame and second the shares repurchased where made to reabsorb shares issued due to the exercise of options. NOC issues restricted shares in lieu of options so a similar comparison would be to IBM.
The third and in my view the most important view from a shareholder's perspective is what will the company do with the excess free cash flow it generates? NOC has deployed the cash to reward shareholders via increased dividends and aggressive repurchase of shares outstanding. The following quote by Mr. Bush sums up the company's capital deployment. "We also monetized assets to create value for shareholders. Over just the past 3 years, we've generated free cash flow of $7 billion, including the $1.4 billion contribution from the HII spinoff. More than 90% of that cash has been distributed to our shareholders, $4.8 billion to repurchase shares and another $1.6 billion for dividends. In addition, we increased the dividend in each of these 3 years." From the companies Q4 earnings transcript courtesy of Seeking Alpha.
NOC recent track record under Mr. Bush has been exemplary however money isn't made by looking into the past. The key to further gains is what does the future hold for the company? It seems the answer is to aggressively shrink its share count as evidenced by the recent share repurchase announcement. The board of NOC decided to augment its current share repurchase plan with an additional pledge of $4 billion dollars. The company looks to repurchase approximately 25% of all the shares outstanding by the end of 2015.
The company expects earnings per share of roughly $6.85-$7.15 for 2013 giving the company a P/E of roughly 12 using the midpoint of the guidance. The company currently has a book to bill ratio of 1.05 worth roughly $40.8 billion dollars. The risk here is the federal government is successful in significantly cutting the defense department's budget which would have an impact on the company's future growth. The country currently operates in a sequester where defense cuts were made a priority. I won't hold my breath waiting for the government to ever cut spending. In my lifetime I have yet to see any sort of meaningful cuts emanating from the Federal government. The best they can do is cut the rate of future growth. I fail to see the political will for massive spending cuts and am quite willing to wager against it. The more likely outcome is some minor trimming to some programs in lieu of wholesale changes.
I am basing my investment thesis instead on NOC successfully implementing its share repurchase agreement and retiring roughly 20% of all shares outstanding. With a current 235 million shares outstanding as of Q1 2013 that would leave the company with approximately 188 million shares outstanding. Using the lower free cash flow number provided by the company of 1.7 billion should net out earnings of roughly $9 per share in 2015. I will place a below market multiple of 12 netting a share price of roughly $108 excluding dividends. At a current quote of roughly $82 the gain would work out to roughly 31% which is quite compelling. The above scenario is based on revenue remaining static which may prove to be pessimistic.
In summary I find a current investment in NOC to be quite compelling. Management has proven itself to be quite adept in rewarding shareholders and I expect more of the same into the future. I thank you for reading and look forward to your comments.
Additional disclosure: The article is intended for informational purposes only.