DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc. or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.
This is a Cestrian Capital Research "Initiating Coverage" note.
As we've noted in our earlier notes, prospective investors in the New Space Race have to contemplate investing in corporations that have non-space operations too. Space is an early-stage market and that means that there are few pure plays with tradeable securities. The largest public companies in the space market, measured by space-related revenues, tend to be aerospace & defense sector corporations. The A&D sector isn't to everyone's taste but it does have its own investment appeal at a time of increasing global tensions and protectionism, over and above the growth from the space sector itself. Indeed the second leg of our New Space Race investment thesis is the re-emergence of space as a strategic theater for the major governmental powers. (For the basics of our New Space Race thesis, see Investment Strategy Statement - Cestrian Capital Research).
As we continue to build out our New Space Race service on Seeking Alpha, we are putting out a series of these "Initiating Coverage" notes on the major Aerospace & Defense players with a space-sector angle. Our most recent note covered Raytheon Company (RTN) - see Long Range Growth Opportunity - The Raytheon Company.
We now move on to Northrop Grumman (NOC). This is a longstanding player in the space market - the then-independent Grumman Aircraft built the moon lander used in the Apollo 11 mission - and remains a key US Government contractor today across multiple aspects of space and military operations. Last year, it completed what is probably the largest space-sector acquisition to date, buying Orbital-ATK in September 2017.
Over the last five years, NOC has significantly outperformed each of the S&P 500 and Dow Jones. Indexing to zero, the relative price performance is as below.
Looking at the price performance over the last 12 months, the stock is rebounding with the market after the market-wide Q4 2018 selloff. It has pushed up past its 50-day SMA and is heading for its 200-day SMA.
For the reasons set out below, we rate NOC a solid Buy - Long-Term Hold.
We think there is a range-bound trading opportunity to consider, but we believe investors would be well served to watch stock price developments in the coming days should they wish to contemplate such a trade.
To Boldly Go… NOC's Recent Big Move Deeper Into The Space Business
The company made a bold acquisition in the space market, its $9.2bn cash-and-assumed-debt deal for Orbital-ATK (prior ticker OA) announced in September 2017 (the deal closed in Q2 2018), which makes it a key provider for International Space Station resupply missions amongst other things. Based on NOC's financial reports so far, we think this is shaping up to be a very good acquisition. The OA business is growing much faster than the rest of the NOC group, and NOC bought it at lower multiples of revenue and operating income than NOC itself was valued at - and they paid for it with cash and assumed debt, so it wasn't dilutive. So, in short - NOC bought in faster growth at lower earnings multiples than its core business, without diluting shareholders and without over-levering the business. If the growth in OA holds up then that is going to end up looking like a very well executed deal. Kudos to NOC management in that event - it is not an easy thing to succeed with big acquisitions.
It's difficult to say precisely how much revenue and income NOC achieves in the space sector - the company doesn't report it that way. Space business crops up in multiple divisions and isn't broken out separately. Our very rough ballpark estimate is that some $3-4bn of revenue is space-related in some way, and we know of no particular reason why the group operating margin of c.10% would not apply to this revenue. So absent better information we will work on the basis of $3-4bn revenue and $3-400m operating income from space. That makes NOC a big player in the space sector and a core stock for us to cover.
The Challenge of Analyzing Acquisitive Companies
Acquisitive companies can be challenging to analyze because it's harder to look past headline numbers to see what is really happening underneath the hood. Usually one has to factor in some future developments into historic numbers to get the full picture.
The key method we use here is "pro-forma'ing". Given that the term "pro forma" is used to mean many things, and we use the term a lot in this article, we should be clear as to what we mean by it. When we say "pro forma for OA" we mean "as if NOC had owned OA for the full period to which we refer". So although NOC completed the deal in June 2018, so its reported revenue will include only about 6 months of OA revenue, when we say something like "TTM revenues at 31 Dec 18, pro forma for OA" we mean "TTM NOC+OA revenues for the calendar year 2018 as if the OA deal completed on 1 January 2018". We use the "pro forma" lens as a way to look at the NOC group as it is today as if it had existed that way forever so that we can compare like with like. Otherwise, acquisitive companies show big jumps in revenue mid-year, growth rates that make no sense, dilutive share issues, changes in net debt, which are hard to stitch together and make sense of. Pro-forma'ing is a way to clarify what is going on under the hood. If anyone isn't clear on this method or our explanation of the method, please post comments to this article or message us directly and we will expand upon this, because it's key to our analysis and conclusion on this stock - and it's a method we will turn to time and again when covering acquisitive businesses.
Another factor one has to bring into analyzing big acquisitions is promised cost savings. When NOC bought OA they promised to achieve $150m of annualised cost savings in the first full year following the acquisition, which would be the twelve months ending June 30, 2019. (Source: Northrop Grumman to Acquire Orbital ATK for $9.2 Billion | Northrop Grumman). During its Q4 2018 earnings call, the company stated that it was on track to achieve this cost-saving target. So we have to find a way of giving management some credit for this and bringing it into our numbers.
Below we apply the above tools to our analysis of NOC's operating performance, and to its valuation. Again, if anyone is unclear about how the analysis below works, please do message us or provide comments and we can expand. Needless to say, there is a good deal more judgment involved in looking at acquisitive companies than those which simply grow organically. We don't claim the below is accurate to seven decimal places but we do believe that is broad-brush valid analysis.
NOC has four operating divisions, as follows:
- Aerospace Systems
- Mission Systems
- Technology Services
'Innovation' is a new business unit and it consists of the acquired OA business. The unit is run by the former COO of the OA business. We take this to mean that the OA line of business will be relatively little-integrated in the near term, promises on cost savings notwithstanding. That is probably beneficial on the revenue side since the unit will be representing itself rather than being a list of products on the corporate price list; but it probably means that the maximum level of cost synergies won't be extracted quickly - in other words, there is probably more than $150m of cost savings to come but it will take a number of years.
Overall we think this is the right approach - large acquisitions are notoriously difficult to integrate and we think going slowly to preserve revenue growth in the former OA business, taking longer to maximise margins, is going to benefit long-term investors by delivering consistent earnings growth over a number of years. We would highlight that in the coming 4-6 quarters there could be earnings surprises from the OA acquisition, of the good and bad kind, as NOC gets into the weeds of the OA business. So far the operating performance of OA looks good as we note below, but investors should be prepared for post-acquisition wobbles at some point - this just goes with the territory when adding approximately 20% to group revenues via a single acquisition.
A couple of observations before turning to the divisional breakdown table. First, we have not included inter-division eliminations, so that we can show the raw operating performance of the divisions. Second, we show the impact of the OA deal on the group growth rate. We think the OA deal is looking strong so far. From a growth perspective this is why: pro-forma'ing for full year 2018 and 2017 (see above for definition - basically - imagine that NOC had owned OA since 1 Jan 2017 all the way through to 31 Dec 2018), it transforms group revenue growth from 2.9% to 5.0%. If that doesn't sound much, we are talking about a fairly big company here - $34bn of revenue before eliminations is a good chunk of change and it is hard to move the growth needle in companies of this size. If NOC had not acquired OA, it would have added just $814m of new revenue in 2018. As a result of the acquisition, pro forma'ing as if it had owned the unit throughout, NOC added $1.7bn of revenue year to year - in other words, it added twice the amount of new revenue as a result of the OA acquisition. That is a big statement in a company of this size. We'll talk about the effect of that on valuation in a moment.
Note, the impact on operating income growth is minimal. (The company did not break out full year 2018 operating income for the OA division, so we have made an estimate from its other statements on full-year margins, etc.). It looks like margins probably fell a little in OA between 2017 and 2018 and given the small amount of earnings from the division (just 14% of group operating income before eliminations), the earnings growth rate is more or less the same at 6% with or without the OA unit. But when factoring in the planned cost savings - imagining for a moment that they had been achieved in 2018, earnings growth goes way up from 6% to 10% per annum. Now that is imagined, it's not real … but it should mean that earnings growth in 2019 receives a considerable boost and that, all other things being equal, the cost savings should be a positive catalyst for the stock.
NOC - Divisional Revenue and Operating Income Breakdown - Before Eliminations
Source: Company reports, Author's analysis
We will repeat our earlier comment - acquisitive companies are tricky to analyze. On the one hand, one wants to dig out hidden value if it exists, or hidden risks in the alternate - on the other, one does not wish to come up with so many spreadsheet adjustments that one loses sight of reality.
We now turn to try to strike this balance on NOC's valuation below as we have tried to find the balance with NOC's operating performance above.
At the time of writing (12 Feb 2019), NOC is valued at 1.7x TTM revenues and 15.4x TTM Operating Income, pro-forma'ing for the OA acquisition.
Taking management at their word, one could add back $150m of operating income to the acquired OA business in 2018 to try to assess the "underlying" earnings and therefore "underlying" valuation. If we do so (meaning, we assume for the purposes of analysis that the $150m additional income was there all along) - we get a valuation of 14.8x TTM 'Adjusted For OA Cost Savings' Operating Income. Now to be clear this is based on the speculative achievement of those cost savings - it's not a hard and fast valuation yet and so the reader should treat it with the appropriate degree of caution. But why this matters is … if indeed they achieve the $150m cost savings, then the effective operating income growth between 2017-2018 goes up from 6.1% to 10.1% and that means that the valuation as a function of growth becomes considerably more attractive. And that makes NOC look a little better vs. its peer RTN, as we show below.
Source: YCharts, RTN company data, NOC company data
You can see that, ignoring the OA cost savings, RTN is the more attractively valued stock, even after its recent runup - this is the point we made in our recent note on RTN (Long Range Growth Opportunity - The Raytheon Company).
The absolute multiple of operating income is lower (11.3x RTN vs. 15.4x NOC) and as a function of growth, it is more attractive still (1.6x RTN vs. 2.5x for NOC). But bringing to bear the planned, confirmed cost savings, NOC's operating income valuation as a function of growth falls to 1.5x, a touch below RTN's.
We hesitate to bake in all these adjustments or to claim they are real or certain. Life is rarely like that and all large acquisitions throw up unexpected problems along the way. But we do think it is safe to say that there is value hidden in NOC, tucked away in the OA acquisition, which makes the stock look more attractive than it first appears.
The Beneficial Impact of the OA Valuation
NOC acquired OA for a valuation substantially less than its own, despite the fact that OA was growing considerably more quickly. This was a nice move by NOC.
On the day the deal closed, 6 June 2018, NOC was valued at 2.4x TTM revenues and 19.5x TTM operating income - rich for a company with c.10% margins and only c.3% revenue growth.
Source: YCharts.com, Company Data, Author's analysis
Here's what NOC paid for OA on a multiple basis.
Source: YCharts.com, Company Data, Author's analysis
Bearing in mind that OA actually grew its revenues in 2018 by 17.5% (see divisional breakout above) and the rest of NOC was growing at some 2.9%, the OA deal looks very good value. It was bought for 13.0x 2018 operating income post synergies, cheaper than the 19.5x operating income applied by NOC at the time, despite the big differential in growth rates.
The benefit to the valuation of the group is clear. Even taking the share price at the (higher) level when the deal completed on 6 June 2018, group valuation is down to an EV/TTM pro-forma operating income of 17.6x and, indeed, 17.0x factoring in the $150m cost savings. And at the current share price, EV/TTM pro forma revenue and operating income are at 1.7x revenue and 15.4x operating profit before cost savings - and 14.8x EV/TTM operating profit factoring in cost savings.
Source: YCharts.com, Company Data, Author's analysis
Opportunities for Investor Success
Within our long-only, equity-only purview, we see two possible ways for investors to profit from NOC going forward.
Possibility (1) - Long-Term Hold
Overall taking into account its core growth, growth in the old OA business, and cost savings being extracted from OA, we think NOC is a solid Buy - Long Term Hold and we have 3-year price targets of $345/share, $399/share (bull case) and $280 (bear case).
To reach our 3-year price targets, we use the same high level method as our note on RTN. Readers can find detailed EPS analysis in many other places and we don't see much value in repeating those here. In any event, the outcome of EPS analysis is pretty much down to the p/e ratio one chooses and that is luck as much as judgment. Three years is a long time in securities analysis. What we are trying to do is to say … NOC is operating in two growth markets (space and defense), it's a leading player, it just boosted its growth rate with a smart, big acquisition, it is careful with its cash, it doesn't dilute stockholders willy-nilly, and we think growth will continue at or around the current pro-forma'd rate. And if it does, and if the market doesn't collapse or boom, then we think the stock has a good future.
Here's our logic:
- Assume revenue growth rate of 3% (bear - it's the pre-OA growth rate), 5% (base - it's the current group rate) and 7% (bull - assume space race in full flight and a boost from missile and other military aerospace business)
- Assume constant operating and net margins and tax rate
- Assume no further cost savings achieved from the OA integration beyond those currently contemplated
- Assume running dividend yield of 1.65% (the same as the actual TTM yield) on the current share price of $280.62
- Assume that the bear case results in a p/e reduced by 15%, the base case no change in p/e, and the bull case results in a p/e increased by 10%
- Assume no major project failures or overruns and no major unforeseen project wins
This gives us the following outputs:
- 3-year Base Case >> multiply current share price by 5% compounded over 3 years >> $329/share >> add 3 years of dividend at 1.65% yield on current share price >> $14/share >> total return of $343/share including dividends vs. current price of $284/share = c.21% gain.
- 3-year Bull Case >> multiply current share price by 7% compounded over 3 years >> $348/share >> increase by 10% for improved p/e resulting from higher growth >> $383/share >> add 3 years of dividends at 1.65% yield on current price >> $14/share >> total return of $397/share including dividends or a gain of 40%
- 3-year Bear Case >> multiply current share price by 3% compounded over 3 years >> $310/share >> decrease by 15% for reduced p/e resulting from lower growth >> $264/share >> add 3 years of dividends at 1.65% yield on current price >> $14/share >> total return of $278/share including dividends or a slight loss from the current share price.
If we sense-check the outputs above we think the error bars around the forecasts include the following factors:
- We have taken no account of any general market collapse, which usually leads to reduced p/e and every other kind of valuation multiple for all companies, regardless of merit. Equally, we have taken no account of any kind of market boom resulting in increased valuations.
- We believe that NOC will, in fact, generate a significant amount of cash on its balance sheet not reflected in the above returns. The dividend payout ratio is low and the yield is only ~1.7% - and we have kept that yield constant on today's share price despite the fact that the company has delivered consistent dividend growth for many years. We would expect the company to do something useful with that cash - another OA-type acquisition (which might boost p/e), a buyback program (which reduces share count so EPS goes up so share price should go up, all other things being equal), or a special dividend.
- We believe the company may be forward-looking in its acquisition focus and its internal product development. It has a new CEO as of January 2019 - Kathy Warden is an internal promote from COO, a position she reached by way of the cybersecurity division. We think this 'new warfare' DNA will be beneficial to the company's product and M&A strategy. That is hard to quantify and we allocate no specific value to it, but all things being equal it should act as a catalyst for the company's revenue growth rate and with that, its valuation.
Finally, if we look around at what others are forecasting for the stock, Morgan Stanley has a 12-month 'base case' price target of $305/share, implying annual growth of not so different to our 3-year base case, so we think we are probably on the cautious side.
In conclusion - we believe this stock may be a good long term hold.
Possibility (2) - Range-Trading Opportunity
In our recent note on RTN, we highlighted a possible range-trading opportunity. We are a little less confident of such a trade with NOC. NOC's stock price has run up a fair way in the last two months and is significantly above its 50-day simple moving average - a different scenario to RTN. At the time of our note, RTN was hovering at around its 50-day. If NOC continues its climb it will soon encounter its 200-day SMA and before we see short-term gains we would like to see the stock break through that and treat the 200-day SMA as a line of support not resistance. So as regards a short-term trade on NOC the risk/reward balance isn't quite right for us at the moment. We do however highlight below how investors might consider a short-term trade in the near future.
Considering NOC relative to RTN more generally - we have to say that we are more comfortable with RTN's business model because RTN sells larger numbers of smaller-ticket items (relatively speaking! - it's hardly nuts and bolts); NOC supplies whole-aircraft for esoteric purposes and that brings with it a good degree of revenue and earnings risk (overrun, program cancellation). But our view here is simply a view on risk. Arguing the contrary, the great thing about large monolithic contracts such as those held by NOC is that when they work, they drive up revenue quickly - so NOC has plenty of upside available to it - we simply view NOC's business model as carrying a wider range of outcomes for the stock than does RTN's business for its stock. We are cautious by nature and tend towards more predictable outcomes.
The stock is more or less at the level it was before the December '18 selloff. The question is where next in the near term. We like to look at simple lines of resistance and support when we consider near-term stock behavior. In the last twelve months, we can see support/resistance lines at around 290 and then again at around 305 and 337.
Our own view is that investors contemplating a short-term range-bound trade should consider waiting to see how the stock behaves around the 290 resistance level (which is also close to the current 200-day SMA of 295). If the stock clears these hurdles as easily as it did the 50-day SMA recently, then investors might consider a short-term trade in the range of 300-330 (this band would leave some room for error within the support/resistance lines). The Q1 2019 rebound has been exceptionally rapid in the market at large and our own view is that it would be aggressive to assume a continued rate of market recovery at this rate.
Finally, as we note in all our analysis - our focus is on simple long-only equity investments. Investors comfortable with derivatives, shorting or other more complex instruments may very well find other ways to make money from NOC, but this is not our remit.
What We Would Say To Management If We Could
Given the opportunity, we would say the following to management:
- Please over-deliver on OA cost savings - that will buy you huge goodwill with your board and shareholders as regards making future large, transformative acquisitions.
- Please go on to make more acquisitions at scale - it appears that you have the skill to do so. Please focus on forward-looking concerns such as the militarization of space - where you have a foot in both domains - and cybersecurity. Don't balk at valuation levels for market leaders in these segments if they offer an operational fit with NOC. Valuations are high because growth is high.
- Please continue to be cautious with cash - buybacks and a progressive dividend policy do wonders for your popularity with shareholders and that popularity buys you some downside protection when an inevitable bad year, bad quarter or bad acquisition hits.
Next Steps in Cestrian's Coverage of NOC
We will keep readers posted on key developments in NOC. Look out for comments we post to this article and on our Instablog and StockTalk channels. If you have thoughts on our work please post them as comments or message us within SA and we will do our best to respond in a timely manner.
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.