Northrop Grumman: Combined Business Well-Positioned To Grow

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About: Northrop Grumman Corporation (NOC), Includes: BA, LMT
by: Prometheus Capital LLC
Summary

UAV leader with more to come.

Favorable market position through the B-21 program.

Orbital ATK becomes Northrop Grumman’s fourth business sector.

Investment Thesis

Northrop Grumman (NOC) is a global security company which provides innovative systems, products and solutions in aerospace, electronics, information systems, and technical services to government and commercial customers worldwide. The company is well-positioned for the growth areas of the US Department of Defense budget (including the bomber, F-35, unmanned, space) and the now closed Orbital ATK acquisition should be a catalyst for the shares to move higher.

UAV Leader with more to come

Northrop leads the unmanned aerial vehicle (UAV) market with the highest altitude and longest endurance UAVs, the RQ-4 Global Hawk and MA-4C Triton. As we know, UAVs have an extremely important role in US and global defense markets, particularly for applications in persistent surveillance and strike. UAVs have the obvious benefit of not risking a pilot’s life, making them suitable for missions in highly contested airspace, though this does not make UAVs “expendable” since the highest-end versions like Northrop Grumman’s Global Hawk cost over ~$220 million each. The UAVs are suitable for persistent surveillance given their 24+ hour flight durations which can make them highly useful in places like the Middle East and Afghanistan. The UAVs can be completely autonomous with entire missions pre-programmed and a UAV can operate for more than 24 hours without operator intervention.

One of the UAVs which isn’t covered highly is Triton. Triton entered low rate initial production (LRIP) in September 2016 and is expected to enter into service in 2019 with primary initiation already in place. Margins on the program should improve as it enters into production, partially offsetting some of the margin drag from higher development revenues from the B-21. The Navy expects to procure 68 Tritons at a total cost of ~$13 billion.

In the near term, we think that further incremental opportunities for the company will come from the Global Hawk UAV post which will see incremental growth opportunities from the Triton UAV. The Global Hawk UAV is already being sold directly to NATO and Germany, apart from production for the US.

Last year, the company pulled out of its bid on the U.S. Navy’s MQ-25 unmanned tanker aircraft without providing a specific reason to the move. The general market consensus was that Northrop would be unable to develop a UAV that met specifications and still delivered profit for the company. We highlight this as a positive move for the company which isn’t solely bent on winning projects. On a conference call, Northrop’s CEO mentioned that the company will continue to make significant investments in unmanned technologies, especially those which are becoming more and more autonomous. The company further sees new missions evolving and potential customers gaining interest in the technology.

Favorable Market Position through the B-21 Program

Northrop Grumman is favorably positioned in defense markets with the prime contract on the B-21 bomber that will drive revenue growth through the mid-2020s at the very least. A Northrop Grumman contract to build top-secret B-21 stealth bombers has brought more than a thousand new employees to the Mojave Desert northeast of Los Angeles. The U.S. Air Force contract for 100 of the bat-winged aircraft is estimated to run about $80 billion and the funding has wide support in Congress.

Since Northrop won the contract two years ago, the pace of activity at its Palmdale plant has ramped up and we expect the newer generation fighter to keep adding revenue on the B-21 line. Keep in mind that Northrop is still generating about $700 million of sustainment and modernization sales on its B-2 bomber, though these have been out of production for over fifteen years. The B-21 is slated to replace the B-1 and the B-52 which were manufactured by Boeing (NYSE: BA) from the 1950s to the late 1980s.

While there are few specifics on the B-21 due to a high level of classification, in our opinion, the value of the program over its lifetime could be ~$100 billion reflecting the ~$550 million unit cost expectations for 100 planes, plus RDT&E spending and inflation. Northrop Grumman was awarded the program over competing bids from a team of Boeing and Lockheed Martin (NYSE: LMT), which unsuccessfully protested the award causing a slight delay in Northrop’s development work from late 2015 to early 2016. As with any development program, we think that this too will be a cost-plus project which will dilute Northrop’s margins over time but will eventually lead to profitability as the program begins production.

Orbital ATK becomes Northrop Grumman’s fourth business sector

On September 18, 2017, NOC agreed to acquire Orbital ATK for $9.2 billion including the assumption of debt. OA is the largest supplier of ammunition to the Pentagon and also has contracts with NASA to launch rockets to the International Space Station as well as satellites. We believe that the acquisition is a potential win for both companies because together they could win more government contracts, plus increase Orbital ATK's Army and precision-guided missiles business and work to build more state-of-the-art space rockets. The U.S. Federal Trade Commission recently cleared the purchase and as a condition for the approval of the merger, the company will have to supply solid rocket motors “on a non-discriminatory basis under specified circumstances.” Ensuring competition in the solid rocket motors industry is a key issue for the Defense Department because only two manufacturers remain in the business, Orbital ATK and Aerojet Rocketdyne. We strongly believe that the revenue synergies from both businesses – Northrop is also a leader in space payloads, many of which are classified – will provide improved product offerings for its customers. Post the latest acquisition, we expect the company to reduce its net leverage from the current 2.8x to ~2.6x by the end of the year, especially as the firm has some debt to retire in 2018-19.

Valuation

We derive our price target based on a premium 2018E P/E multiple relative to Defense peers, applying ~21x to 2018E EPS of $17.5. We see upside for the Orbital ATK acquisition and the fact that the company has a strong cash flow and revenue growth profile. We believe the company remains well positioned to benefit from rising defense budgets in addition to its embedded growth on the F-35 and B-21 programs. We expect the shares to trade in the range of $360-375, in the next twelve months.

Recommendation

We believe that the shares warrant this premium as it is the most favorably positioned among defense players because the combined business will be well-positioned for classified space opportunities, hypersonics and other growth areas. We expect NOC to see strong organic growth driven by B-21 and F-35 program growth as well as an increasing US defense budget. The acquisition of Orbital ATK should add to its growth profile. Our target price supports our Buy thesis.

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.