Northrop Grumman: Ridiculously Undervalued, But Doing Everything Right

Northrop Grumman (NOC) is on a roll.

The Northrop-built USS New York was commissioned on Saturday. The ship's bow "contains 7.5 tons of steel recovered from the World Trade Center and the ship is named in honor of the victims and heroes of the 9/11 terrorist attack."

If that were not enough, the company just announced the sale of its advisory services business (TASC) for $1.65 billion. One can imagine that government consulting is a growth industry and Northrop is selling while the market is hot.

What do you do when your stock is ridiculously undervalued? Northrop knows. In the process, they are putting on a clinic for wayward capital allocators.

NOC is using its cash to fund stock buybacks/dividends and engaging in transactions that will force the market to reevaluate. They have repurchased $650 million worth of stock year-to-date and the $1.1 billion in proceeds from TASC are earmarked for share buybacks too.

Northrop knows that you sell ancillary businesses in negotiated transactions (TASC was pursued by a number of private equity groups) and repurchase your shares when the investing public is ignorant of unrealized intrinsic value. Most companies choose the opposite approach, selling shares cheap and pursuing acquisitions at negotiated rates.

Our friends at Interdigital (IDCC) seem determined to horde cash and do just that! I sure hope they are paying attention to Northrop?!!?

Northrop has 321 million shares outstanding for a $16.8 billion market capitalization. This despite clear statements that structural free cash flow is between $1.9 billion and $2.4 billion annually.

Is Northrop really only worth 7 to 9 times free cash flow?

The company's underlying fundamentals may be obscured for those who don't look below the surface. There was a large goodwill write-off last year. Who needs those pesky cash flow statements anyway? This year, Northrop is filling a hole in its pension plan. For the first nine months of 2009, the company $800 million in discretionary contributions to its pension plans.

To be clear, none of this detracts from the long-term earnings and free cash flow potential of Northrop.

I'm frankly glad these issues are being put to rest.

Northrop could easily become an acquisition target. By cleaning up its balance sheet, selling off non-core businesses, and clearly illustrating its massive cash flow generation, they may actually be working towards that goal.

Northrop may actually be putting its shareholders first! Perish the thought. Still few investors seem to notice.

One exception: Bruce Berkowitz. Northrop is a top holding in the Fairholme Fund.

As a standalone firm, Northrop is worth at least $65 a share. In a takeover, Northrop will garner $80 or more. For obvious reasons, it is my favorite company in the aerospace/defense industry with strategic assets and enticing exposures to unmanned aerial vehicles and more.

Investors will come around sooner or later, but managers worldwide should start taking notes now.

CEO Ronald Sugar is leaving behind quite a legacy.

Disclosure: The author owns shares of Northrop and Interdigital.

Comments

[bindlepete:]

We can not afford war nor can we borrow to wage it any longer which may be a very good thing. Got a lot of slightly used war machines to sell. Any buyers out there. Lets hope not after all we sold our nerve gas bombs to Saddam did we not?

Tenet knew this and hence the " slam dunk" statement - since only a few were used on the Kurds.

Nov 09 08:24 AM

[The Lonely ...:]

I fail to see how this conspiracy theory has any bearing on the investment value of Northrop.

That said, I find the use of the word "we" quite curious.

Nov 09 10:50 AM

[Spin:]

Yes, Northrup is only worth 7 to 9 times free cash flow.

I will not be surprised to see many more good corporations trading at this level by the end of 2010.

Nov 09 03:08 PM

[The Lonely ...:]

Given that compelling argument, Spin, I concede. I see your logic clearly. Thank you for setting me straight. Oh, and you misspelled Northrop.

Who are these people?

Nov 09 03:50 PM

[endisnear:]

In 5 years Northrups products will be made in China.

Will the last one out please turn off the lights?

Nov 09 05:29 PM

[Spin:]

Northrop is selling for 7 to 9 times price to free cash flow because that is all the professional investors are willing to pay for the stock.

I like NOC. I follow the company because my son-in-law flies a EA-6B (made by Grumman).

I will not buy the stock at this price because their Achilles heel is that they are at the mercy of Congress. One misstep by them or Congress and their stock dives like it did last November when it lost over $10 a share in two weeks. I do not believe that Congress or the President has defense as a high priority.

Nov 09 07:04 PM

[Dr.Bhabha:]

Northrop is losing over $3.80 a share, gives out $1.72 dividend per share to over 300 million holders, expects to have a better than 4% decline in income, and still one is expected to get excited about a paltry $15 million Navy deal? The fundamentals stink, while the stock trades at a 52-week high!

Nov 09 11:14 PM

[The Lonely ...:]

<img class="authors_reply" src="static.seekingalpha.co...">

What did I say about people not knowing how to read a cash flow statement?

That $3.80 a share loss was due to a goodwill write-off!

Anyone can see that the dividend is well covered. It helps to actually look at the financial statements.

I don't recall getting excited about a $15 million Navy deal, but NOC announces all of the contracts they receive. Some small, some large.

I find it amusing that people can unequivocally say that "fundamentals stink" or are good without having done more than a cursory reading of the facts.

NOC is at a 52 week high for a reason!

And yet, it still trades at a ridiculously low valuation. Perhaps because of the kind of "analysis" on display here?

Nov 09 11:34 PM

[The Lonely ...:]

Northrop generated over $2.5 billion in free cash flow last year. They spent $500 million on dividends. I'd say the dividend is well covered.

Nov 10 01:52 PM