By Mark Bern, CPA CFA
Northrop Grumman (NYSE:NOC) is primarily a defense and aerospace contractor with over 90% of revenues derived from sales to the U.S. government in 2010. The stock price has recovered somewhat and the current yield is now 3.4% with the stock at $58.48 per share. Revenue growth had been trending higher until the spinoff of the shipbuilding unit in March 2011. Earnings per share were hit somewhat in 2009 falling about 8.5% and then resuming the upward trend in 2010. The company is not recession-proof, however, and has two obstacles, in my opinion, either of which could provide investors with an opportunity to enter at a bargain price.
First, there is Europe and the uncertainty surrounding the potential contagion effect that could tip the U.S. economy back into recession if the leadership of the eurozone falls short of expectations. This one may be a coin flip as to probability, at least in the short term.
The second is potential for reductions to the U.S. defense budget. This too is not likely to affect existing contracts for at least another year. But the interesting side of this one is that reality is not in the driver’s seat: Perception is that defense contractors will suffer with the impending withdrawals from Iraq and Afghanistan. The nice thing about NOC is that it has an order backlog of nearly $42 billion at the end of the September quarter while estimated total revenue for 2011 will come in around $27 billion. That’s a nice cushion. But regardless of all the positives it is generally the perception in the market that will drive short-term movements in the stock price.
For that reason I expect that there could very well be an opportunity to pick these quality shares with a dividend of 4%. The current dividend is $2.00, so all we need is to pick up shares with a cost basis of $50 or less to create a yield of our targeted 4%. There are two ways to go about this. The first is to wait for the price to drop all the way down to $50 and then buy the stock. Of course, you’ll need to keep the cash available, probably earning less than 1% while you wait.
The second way, my preferred method, is to sell put options that will provide a cost basis of $50 and collect the premium up front so that we earn a nice yield on our cash while we wait. There is no telling how long the perception will last or when the threat of cuts will make the front page and seem real. But when it happens I believe there will be plenty of people trying to sell their stock and we want to be ready. I have checked the put options available for all expirations out through January 2014 and there are several that could work well. But the one that would give us the target price if exercised is the January 2013 put option with a strike price of $55 and a premium of $5.50. You may be able to get a better premium if you try. The last trade was for a premium of $7.70. But the bid at the close on Friday, December 30, 2011, was $5.50, so I am using that as a conservative and attainable price.
If the stock falls below $55 and the option gets exercised (no guarantees unless it is under $55 on the expiration date) an investor who sold the put would be obligated to purchase 100 shares of NOC at $55, but would have a cost basis of $49.50 ($55 less the premium collected of $5.50 equals $49.50). If the price does not drop enough or stay low through expiration, the option would expire worthless and the seller of the put would keep the premium earning 9.8% on the cash in their account required to be held to secure the option.
So, let’s see: If I sell the put I either get the stock I want at a discount and earn a 4% yield on my cost or I don’t get the stock and all I’m left with is the $550 which represents a 9.8% yield for the year and I can try again. So, what’s not to like?
As always, please do your homework and make certain that NOC is appropriate for meeting your needs and fits well within your portfolio. In other words, do your due diligence because an informed investor makes better decisions. Good luck to all!