Northrop Grumman Adjusts Guidance; Still Expects To Outpace Industry Growth

Summary

• Northrop Grumman reported healthy 2020 first-quarter results on April 29th. Revenue and free cash flow improved 5+% year over year. "Restricted work" revenue contributed 28+%, indicating growth in market share.
• Expecting an impact from the COVID-19 pandemic in the second quarter, the company adjusted 2020 guidance for revenue and mark-to-market adjusted earnings per share.
• Though Northrop adjusted its revenue guidance range by approximately 1%, it still expects year-over-year revenue growth of at least 3.4%, outpacing industry growth expectations of 2.9%.

With so much uncertainty swirling around the actual impact from the COVID-19 pandemic, most companies are withdrawing 2020 annual guidance. At this point, investors may find it reassuring to find a company willing to offer guidance... even if the numbers are lower than original guidance. For that matter, a decrease less than 25-30% could appear promising.

Northrop Grumman (NYSE:NOC) initially projected sales for 2020 in a range of $35.3-35.8 billion. Its range on MTM-adjusted EPS was $22.75-23.15. Free cash flow was projected to fall in a range of $3.15-3.45 billion.

Northrop Grumman reported 2020 first-quarter results on April 29^th. The company did not withdraw full-year guidance, most likely because it is one of the country's top defense contractors. But it did downgrade pieces of the guidance, though only minimally and much less than 25-30%.

2020 First-Quarter Results

Northrop's first-quarter revenue in 2020 was $8.62 billion, 5.3% greater than the $8.19 billion generated in the first quarter of 2019. Each of the company's four segments - Aeronautics Systems, Defense Systems, Mission Systems and Space Systems - posted year-over-year gains. Northrop expected its Space Systems segment to be its fastest-growing in 2020. In the first quarter, sales in this segment at $1.95 billion increased 8.2% year over year, followed by Defense Systems at 6.4%, Mission Systems at 6.2% and Aeronautics Systems at almost 1%.

Northrop Grumman considers the contribution of “restricted work” as a good measure of success and an indicator that the company is capturing market share. In 2019, it reported restricted work contributed more than 25% of total sales. In the 2020 first quarter, restricted work contributed over 28% of total revenue. The company expects the percentage to grow throughout 2020.

A 60-basis point decline in operating margin resulted in Northrop's total operating income being relatively flat year over year - $934 million in the 2020 first quarter compared to $936 million in 2019. In the Aeronautics Systems and Defense Systems segments, operating income decreased year over year. In the Mission Systems and Space Systems segments, operating income improved year over year.

On the bottom line, diluted earnings improved 1.8%, from $5.06 per share in the 2019 first quarter to $5.15 per share in 2020. A portion of the improvement is attributable to a decrease in the outstanding share count from 170.7 million in 2019 to 168.4 million in 2020. But the bottom line also saw a negative impacted related to the market decline resulting from the COVID-19 pandemic.

Free cash flow of $1.27 billion increased 5.7% compared to $1.2 billion in the 2019 first quarter.

Updated Guidance

As already mentioned, Northrop Grumman did downgrade pieces of its 2020 full-year guidance. The company currently expects the majority of the negative impact related to the COVID-19 pandemic to fall in the second quarter. It expects to offset any increased costs related to the pandemic by other cost reductions. But Northrop does anticipate that there will be pressures in its supply chain related to volume due to pressures on employee attendance and productivity. The company is actively focusing on assisting its smaller to mid-sized suppliers.

We are advancing approximately $30 million of payments per week to critical, small and mid-sized suppliers and we expect these payment advances will exceed $200 million. In addition, with the actions taken by the Department of Defense to increase progress payments, we are flowing that full supplier benefit to our suppliers in a timely fashion.

Northrop's updated guidance incorporates the second-quarter impact. However, the update does not include any potential impact resulting from delays in governmental processing that could occur relative to either the pandemic or the upcoming election.

The timing of appropriations and the occurrence of an extended continuing resolution and/or prolonged government shutdown, as well as a breach of the debt ceiling, can impact the company's ability to achieve guidance or meet expectations.

At year-end 2019, the company's backlog totaled $64.84 billion. Because awards in the 2020 first quarter totaled $7.9 billion and revenue was $8.62 billion, the book-to-bill ratio was less than 1. However, awards on restricted work resulted in a book-to-bill ratio of 1.3. Thus, backlog decreased to $64.17 billion. Of the company's four segments, the Space Systems segment saw the only increase in backlog at 3.2%. Of the $64.17 billion in backlog, over half, or $32.5 billion, is “funded”, meaning authorized and appropriated.

Northrop Grumman continues to expect to be awarded the next phase of the Air Force's GBSD (Ground-Based Strategic Deterrent) program. The program is developing a replacement for the Minuteman III IBMS (Intercontinental Ballistic Missile System). The Minuteman III has been in operation since the 1960s. The new design will feature greater functional range and warhead capability. The target date for replacement is 2028.

The GBSD program award was originally scheduled for third quarter 2020. In mid-April, the Air Force's acquisition executive, Will Roper, mentioned the contract could be awarded sooner “the [classified work] installations are open to allow that work”. Northrop, however, is not expecting substantial change.

But it would be a modest acceleration. We anticipate the award was already planned for the third quarter of this year. And, what we see is that it would likely be only a month or two of acceleration if acceleration happens. We don’t expect that to have a material impact on 2020. But, certainly getting started more quickly derisks the program to some extent and allows us to be more confident in meeting those milestones along the path to the 2029 IOC dates for the program.

Regardless of award date, the program is not expected to contribute materially to Northrop's 2020 revenue.

For all of 2020, Northrop adjusted its revenue guidance from a range of $35.3-35.8 billion to a range of $35-35.4 billion, a decrease of approximately 1% on both ends. Initially, the company reported the average growth for the industry in 2020 would be 3%. The 2019 National Defense Authorization Act authorized a budget of $717 billion in 2018. In December 2019, the 2020 National Defense Authorization Act authorized a budget of $738 billion, resulting in a year-over-year increase of 2.9%. As a result of the revenue guidance update, Northrop Grumman is now projecting sales growth of 3.4-4.6%, which would still outpace overall industry growth.

The company's free cash flow projection remained steady in a range of $3.15-3.45 billion.

Northrop Grumman added $2.25 billion in debt in the first quarter to provide “additional flexibility to support customers, employees and suppliers”. It added senior notes of $750 million paying 4.4% due in 2030, $500 million paying 5.15% senior notes due in 2040 and $1 billion paying 5.25% due in 2050. As well, the company has $1 billion in debt at a rate of 2.08% maturing in 2020 and $700 million at a rate of 3.5% maturing in early 2021. Proceeds from the new debt may also be used to retire the debt maturing in the near term. The next debenture due is $1.5 billion at a 2.55% rate due in 2022. Full-year interest expense for 2020 is now projected at an additional $90 million over the original guidance of $500 million.

(Source)

As a result of the decrease in sales, increased interest expense and the loss in value of the company's marketable securities, Northrop decreased the range on MTM-adjusted (mark-to-market) EPS just over 4% from a range of $22.75-23.15 to a range of $21.80-22.20. At $22, the midpoint of the updated range, the 2020 MTM-adjusted EPS represents a 3.7% improvement over the 2019 MTM-adjusted EPS of $21.21.

Price Action

Northrop Grumman's share price has fallen nearly 7% from $344 to $322 since it reported 2020 first-quarter results. It is trading approximately midway between its 52-week low of $263.31 and its 52-week high of $385.01.

Based on the projected MTM-adjusted EPS midpoint of $22, the forward P/E ratio for 2020 is 14.66.

On a dividend rate of $5.28 per share, Northrop Grumman is yielding 1.64%. Historically, the company has bumped its dividend in mid-May. Its track record for annual increases is 16 years. If the pandemic were not a factor, shareholders could likely expect a rate increase to $5.48 per share, which would bump the yield to 1.7% on prices in the $322 range.

Takeaway

Northrop Grumman reported a healthy first quarter. This may not be considered such an accomplishment, as many companies are reporting healthy first quarters.

However, unlike most companies, Northrop did not pull its guidance for 2020, though it did decrease some of its projections. The company did maintain its typical disclaimers for risk. Of course, it also included disclaimers relative to the COVID-19 pandemic.

At the very least, investors should note the company has enough confidence in its outlook to continue offering guidance. And even considering its guidance adjustments, Northrop anticipates healthy growth in 2020 inclusive of outpacing industry growth.

Analyst’s Disclosure: I am/we are 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.

I belong to an investment club that owns shares in NOC.