Northrop Grumman's Dividend Cushion Score Is Worth A Look

| About: Northrop Grumman (NOC)

One of the reasons our members love us is that we tell the story through the numbers. Every income statement says something; every balance sheet has a history; and every cash flow statement reveals a firm's true intrinsic value. The numbers talk -- and we think every investor should listen to them. Let's see what they say about Northrup Grumman (NYSE:NOC).

For those that don't know us, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to consider buying. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. It's a robust process, but also very simple one to interpret.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Northrop Grumman posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare Northrop Grumman to peers Boeing (NYSE:BA), General Dynamics (NYSE:GD), and Raytheon (NYSE:RTN). In the spirit of transparency, we show how our strategy has stacked up relative to peers:

Investment Considerations

Investment Highlights

• Northrop Grumman earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 82.5% from 78.7% during the next two years.

• Northrop Grumman is a leading global security company providing innovative systems, products and solutions in unmanned systems, cybersecurity, C4ISR, and logistics and modernization to government and commercial customers worldwide.

• Northrop Grumman has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 8.7% in coming years. Total debt-to-EBITDA was 1.1 last year, while debt-to-book capitalization stood at 29.2%.

• The company has positions on a number of large, long-term franchise programs: F-35, E-2D, F/A-18, EA-18G, B-2, JSTARS. Its unmanned platforms include the Global Hawk, BAMS, N-UCAS, and Fire Scout. Northrop also has strong core ISR sensor capabilities and a solid information processing position.

• The firm sports a very nice dividend yield of 2.5%. We expect the firm to pay out about 31% of next year's earnings to shareholders as dividends. Its Dividend Cushion is comfortably north of 2.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Northrop Grumman's 3-year historical return on invested capital (without goodwill) is 58.2%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Northrop Grumman's free cash flow margin has averaged about 6.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Northrop Grumman, cash flow from operations increased about 8% from levels registered two years ago, while capital expenditures fell about 57% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Northrop Grumman's shares are worth between $62.00 - $116.00 each. Why such the large margin of safety? Click here. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $89 per share represents a price-to-earnings (P/E) ratio of about 11.4 times last year's earnings and an implied EV/EBITDA multiple of about 6.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -1.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of - 9.3%. Our model reflects a 5-year projected average operating margin of 13.3%, which is above Northrop Grumman's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Northrop Grumman, we use a 10.7% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $89 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Northrop Grumman. We think the firm is attractive below $62 per share (the green line), but quite expensive above $116 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Northrop Grumman's fair value at this point in time to be about $89 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Northrop Grumman's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $116 per share in Year 3 represents our existing fair value per share of $89 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.