Earnings Scorecard: Northrop Grumman

May.24.10 | About: Northrop Grumman (NOC)

Los Angeles-based leading shipbuilder and defense contractor Northrop Grumman Corporation (NYSE:NOC), subsequent to reporting impressive first quarter 2010 results on April 28, 2010, had raised its quarterly dividend by 9.3%. In the first quarter the company reported earnings of $1.53 per share compared to $1.17 in the year-ago quarter and Zacks Consensus Estimate of $1.32.

First Quarter Highlights

Northrop Grumman’s quarterly sales increased 8.5% to $8.6 billion from $7.9 billion in the year-ago period. Product sales increased by $956 million, or 21% to $5.5 billion driven by strong sales at Aerospace Systems, Electronic Systems and Shipbuilding.

Service revenues decreased by $281 million or 8% to $3.1 billion, primarily due to programs previously characterized as service revenues transitioning into product sales programs. Lower sales volume on Defense Integrated Military Human Resources System (DIMHRS) and New York City Wireless (NYCWiN) programs in Information Systems also contributed to the decrease.

Overall in the reported quarter, operating income increased 24% to $765 million from $619 million in the year-ago period. The improvement reflects a decrease in net pension expenses, higher operating income and lower unallocated corporate expenses. Northrop Grumman’s earnings from continuing operations increased to $462 million from $366 million in the first quarter of 2009.

(Read our full coverage on this earnings report: Northrop Surpasses Zacks Ests)

Agreement of Analysts

Analysts covering the stock are by and large in agreement in raising their long-term earnings estimates following the earnings release. As the chart below shows, there is a consensus among analysts who have raised their fiscal 2010 estimates for the company in the last 30 days. This high level of agreement among covering analysts primarily reflects expectations of strong earnings growth following solid first quarter results.

However in line with Northrop Grumman’s peers like Lockheed Martin Corporation (NYSE:LMT) and L-3 Communications Holdings Inc. (NYSE:LLL) the market is apprehensive about its near-term fortunes. For the ongoing quarter analysts are clearly divided, with 8 upping their estimates while 5 lowering theirs over the last 30 days. Such a downward revision clearly depicts the analysts’ apprehension about a shrinking order backlog base and lower margins in the Electronic Systems business.

Magnitude of Estimate Revisions

Northrop Grumman’s long-term estimate revisions’ direction has clearly been positive and favorable. The current Zacks Consensus Estimates for fiscal 2010 and 2011 are $6.00 and $6.85, respectively. Over the last month, estimates have gone up by 14 cents and 12 cents for fiscal years 2010 and 2011, respectively.

However, the story reverses for short-term estimate revisions. For the ongoing quarter the magnitude of those revisions has been less than impressive, with the estimate reducing by a cent over the last 30 days.

Our Take

We believe that Northrop Grumman is a fundamentally sound company and has a strong market position, but we are cautious about near-term bumps. The company currently is trading at a discount to both the peer group and the S&P 500, based on forward earnings estimates. The company is one of the best-positioned companies among large-cap defense players due to its diversified portfolio of programs, strong order bookings and order backlog, strong cash-flow generation and focus on shareholder value.

The company ended the first quarter of 2010, with a low long-term debt-to-capitalization of 21.4% (Zacks industry average was 93.2%). Total long-term debt was $3.4 billion, along with cash holdings of approximately $2 billion.

Northrop Grumman’s strong balance sheet and free cash flows provide substantial financial flexibility and cushion in matters of incremental dividend, ongoing share repurchase and earnings accretive acquisitions. In fiscal 2009 the company generated $1.4 billion in free cash flows from operations.

Northrop Grumman currently has a high dividend yield of 2.8%. This is higher compared to other large-cap defense companies like General Dynamics Corporation (NYSE:GD) and Boeing Company (NYSE:BA) who have yields of 2.5% and 2.6%, respectively. The company on May 19, 2010 raised its quarterly dividend by 9.3% to $0.47 per share from $0.43. This is the seventh consecutive annual increase in its quarterly dividend.

All these positives, however, are already accounted for in the company’s valuation, leaving little room for any upside from the current level.

The above positives would be offset by lower backlog, loss of key contracts and substantial exposure to missile-defense-related programs. Its order backlog declined to $67.5 billion at first quarter-end 2010 from $69.2 billion after the end of fiscal 2009.

The decline from the year-end is almost entirely due to a $1.4 billion decline in ship building backlog due to irregular flow of the size and duration of contract awards. The company also withdrew its bid from the $40 billion U.S. Air Force tanker contract in March 2010. Northrop Grumman in 2008 had won the contract which was rescinded after rival Boeing protested the award.

Consequently, we maintain our Zacks #3 Rank and Neutral recommendation on the stock.