Why Northrop Grumman Is Undervalued Right Now

| About: Northrop Grumman (NOC)

This article is part of an ongoing series that highlights specific companies that are on sale. It helps me to document my thought processes when I add to my holdings or initiate new positions. Please provide your feedback in the comments section below.

Northrop Grumman (NYSE:NOC) is currently offering investors an opportunity to buy portions of the company at about $95/share. This is 5% off the 52 week high, just hit about two weeks ago at over $99 per ownership interest. Northrop Grumman has been rising steadily for the past nine months. This recent pullback provides long-term investors with a good opportunity to initiate a position.

NOC has a business model that is sustainable. It provides systems and products for government and commercial groups worldwide. When most people think of Northrop Grumman, they tend to dismiss it as only a defense contractor for the U.S. government. According to the 2012 Annual Report, NOC is focusing on key markets where it believes its customers will make investments for the future, including unmanned systems and cybersecurity. I believe that the key to unlock future growth for NOC will be in winning new contracts from existing customers.

The payout ratio remains very strong at about 27%. By having a relatively low payout ratio, your dividend income stream is safe and has room to grow. Should future earnings stagnate or decline, dividend growth can still come in the form of payout ratio expansion. Additionally, the company is sitting on $21 per share in cash, creating quite a reserve buffer in case future orders were to dry up. What this illustrates is that the company is not necessarily dependent on new orders to be awarded in order for NOC to continue paying its steady dividend.

Speaking of the dividend, Northrop Grumman is a Dividend Contender, meaning that it has increased its annual dividend every year for a decade. All indications would suggest that NOC will continue this practice for the foreseeable future. It's most recent increase was by 11 percent. When is the last time you received an 11 percent raise? Currently, the yield is over 2.5%. This yield acts as a floor for the stock price. If the price were to decline further, the yield would increase, enticing investors to bid the price back up.

Further, Northrop Grumman has been buying up its outstanding shares. It might surprise most investors to know that there are currently less than 240 million shares outstanding. At the beginning of 2011, there were over 290 million shares outstanding! The total shares outstanding have declined by 55 million shares, or about 18% of the total in less than three years! This further adds to shareholder gains.

NOC currently sports a P/E under 12x trailing twelve months (TTM) earnings. I would expect to see multiple expansion in the coming months due to the catalyst that I mention below. There may be a small window here to acquire additional shares before the price increases further. Northrop Grumman earns about $10 per share in free cash flow, according to the 2012 Annual Report ($2.5 billion divided by 253 million shares). This more than sufficiently covers the annual dividend of $2.44 per share. If earnings were flat, it would still earn $8/share over the next twelve months, buy back shares outstanding, and continue paying its dividend with the earnings or the cash it's sitting on. Additional orders will only increase future earnings.

That's where the catalyst for Northrop Grumman comes in. On Friday, September 27th, the U.S. Department of Defense awarded Northrop Grumman eleven defense contracts that were worth a total of $1.3 billion. This has huge implications for investors. This is the catalyst that I believe will unlock the next wave higher for NOC.

TTM revenue for NOC was $25 billion, and it was just awarded over 5% of that in one day! Northrop Grumman actually took home more awards by far than any of the competitors. These contracts are for the next 2-5 years, for the most part. What this means for investors is that revenue for the next few years is already being locked in. This $1.3 billion represents over $5 per share in revenue. As more shares are bought back over the next few years, the actual revenue per share realized will be much higher. At NOC's 7.8 profit margin, this $5.20 in revenue translates into $0.41 in EPS per share. That's almost an entire quarter's dividend payment!

I believe that this pullback in NOC is short-lived and presents a brief opportunity for long-term shareholders to initiate or add to a position. As the fulfillment of these contracts comes online over the next year, the revenue will start flowing in from the DoD. Now is the time to pick up some ownership shares.

As always, this article represents my opinions at the time of writing. You should do your own due diligence before making any decisions. However, I believe that NOC represents a quality company that is trading hands at a discount.

Disclosure: I am long NOC. 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.

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