Northrop Grumman: Strong Dividend Cushion But Yield Could Be Better

| About: Northrop Grumman (NOC)


Though recent top-line trends have not been positive, Northrop Grumman's focus on margins has led to solid earnings per share and operating margin growth.

Investors should be careful not to fall in love with positive trends in earnings per share given the pace of share buybacks, however.

Management points to superior program performance and portfolio shaping coupled with an ongoing reduction in its cost structure as reasons to be optimistic.

Let's take a look at the firm's investment considerations as we attempt to uncover the drivers behind its Dividend Cushion ratio.

By The Valuentum Team

As with many of its defense peers, Northrop Grumman has a very nice dividend growth profile.

Northrop Grumman (NYSE:NOC) is a leading global security company providing innovative systems, products and solutions in unmanned systems, cyber security, C4ISR, and logistics and modernization to government and commercial customers worldwide. Technology and innovation form the backbone of the company.

Though recent top-line trends have not been positive, the firm's focus on margins has led to solid EPS and operating margin growth. In 2014, for example, earnings per share grew ~17%, and the company realized a record pension-adjusted operating margin despite a decline in revenue.

Northrop Grumman's business quality (an evaluation of our ValueCreation and ValueRisk ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

The company has positions on a number of large, long-term franchise programs: F-35, E-2D, F/A-18, EA-18G, B-2 and 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.

Two of the more interesting things to know about Northrop Grumman is that shares outstanding have been reduced by a third since 2008 while its annual dividend has advanced at a 9% CAGR over the same time. The firm is very shareholder friendly.

Note: Northrop Grumman's annual dividend yield is below average, offering a ~1.7% yield at recent price levels. We prefer yields above 3% and generally don't include firms with yields below 2% in the dividend growth portfolio. We love Northrop Grumman's bottom line performance and dividend potential, but sometimes a yield is not high enough, all things considered. Let's take a look at the company's dividend health nonetheless should managment turn up the gears on the payout.

Dividend Strengths

You're not going to hear us say many bad things about Northrop Grumman. The company has a solid position across a number of defense platforms, and we're particularly fond of its opportunities in unmanned systems, cyber and C4ISR. Technology and innovation remain its core, and while revenue, adjusted cash flow from operations and free cash flow have faced pressure in recent years as US security spending has been reduced, the company's cash-generating capacity remains top notch. Investors should be careful not to fall in love with positive trends in earnings per share given the pace of share buybacks, however.

Dividend Weaknesses

There's something to be said about an executive suite that can take a sales decline of 13% from 2009 to the end of 2014 as a result of a reduction in US government spending and turn that difficult environment into an ~18% increase in absolute segment operating income. Management points to superior program performance and portfolio shaping coupled with an ongoing reduction in its cost structure as reasons to be optimistic. We like Northrop Grumman's international opportunities, and a return to top-line growth would ensure the dividend is on solid ground, if a Dividend Cushion of 2.4 doesn't already speak to substantial resilience already. Buybacks will be forthcoming in any case.

From the Comments Section: How to Interpret the Dividend Cushion Ratio - A Ranking of Risk

As for how to interpret the Dividend Cushion ratio itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions entities often need to shore up cash, and that means the dividend becomes increasingly more risky.

We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.

Dividend Safety

We think the safety of Northrop Grumman's dividend is good. Please let us explain.

First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.

That has led us to develop the forward-looking Dividend Cushion ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.

As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend payer has in boosting the dividend in the future. For Northrop Grumman, this ratio is 2.4, revealing that on its current path the firm should be able to cover its future dividends and growth in them with net cash on hand and future free cash flow.

Dividend Cushion Ratio Cash Flow Bridge

The Dividend Cushion Cash Flow Bridge, shown in the image, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Northrop Grumman's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's five-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is greater than the sum of the next five years of expected cash dividends paid.

Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the five-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.

Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the "blue bar" to the right is in the positive, the more durable a company's dividend, and the greater the "blue bar" to the right is in the negative, the less durable a company's dividend.

Dividend Cushion Ratio Deconstruction

The Dividend Cushion Ratio Deconstruction, shown in the image to the right, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Northrop Grumman's numerator is larger than its denominator suggesting strong dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next five years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.

Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative five-year forecasted distributable excess cash after dividends paid, ex buybacks."

Dividend Growth

Now on to the potential growth of Northrop Grumman's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent, which is the case for Northrop Grumman.

Because capital preservation also is an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Northrop Grumman's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low.

Wrapping Things Up

We've been impressed by management's ability to continue to grow earnings per share in the face of falling revenue in recent years. This has helped Northrop Grumman's dividend potential despite US security spending having fallen. The company's cash-generating capacity remains strong, and we like its international growth opportunities. Though we feel the firm's dividend is already on solid ground, a return to top-line growth will provide additional stability. However, we are not interested in the firm from an income standpoint at this point - its yield is below average, and shares are overvalued, in our opinion.

Breakpoints: Dividend safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we 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.