Generating Income From Northrop Grumman's Lock On Defense
Summary
- Aerospace and Defense is one of the best historical performers in the market.
- Oligopolies make for terrific investments.
- Northrop Grumman is one of the all-time great American companies that can be had for a value price.
- Selling naked puts against it is a fine way to generate income and possibly have the stock put to you below intrinsic value.
Thesis
Let's talk aerospace and defense.
The sheer complexity of every element of these sectors, in terms of actually building stuff that works and has no margin of error for failure, is impossible to conceive for us mere mortals.
All of the things that go into making a plane fly, a missile soar, and spaceships launch are truly miracles of human ingenuity that remain unparalleled achievements in human history.
Engineering, physics, mathematics, construction, metallurgy, logistics… it's impossible to name all the disciplines and expertise that create these strange objects that transport people and wage war.
Which is why this sector is effectively an oligopoly, although it has a few more players than most oligopolies. That also means there is an extraordinarily high barrier to entry. It's also far too late for new players to enter the game in any large way. Only small firms with expertise in a niche can get in.
Defense and aerospace are an essential part of every developed nation. In America, national security eats up a huge part of the federal budget even in peacetime and even with dovish administrations. Simply put, America does not exist without these sectors.
We've learned that while it stinks not to be able to go to restaurants, we don't need them. We will always need aerospace and defense.
Northrop Grumman (NYSE:NOC) is an 81-year-old company that specializes in security and defense. Remember a few paragraphs ago where we described, in general, the complexity of this business. Read this description of everything NOC does and be awed:
Northrop Grumman Corporation provides various systems, products, and solutions in autonomous systems, cyber, space, strike, and logistics and modernization, as well as in command, control, communications and computers, intelligence, surveillance, and reconnaissance (C4ISR). It designs, develops, integrates, and produces manned aircrafts, autonomous systems, spacecraft systems, high-energy laser systems, microelectronics, and other systems and sub-systems for use in the areas of intelligence, surveillance and reconnaissance, strike operations, communications, earth observations, and space science. The company also designs, develops, integrates, and produces flights, armaments, and space systems to enable national security, civil government, and commercial customers in achieving their critical missions. Its space systems include launch vehicles and related propulsion systems; missile products and defense electronics; precision weapons, armament systems and ammunition; satellites and associated space components and services; and aerospace structures. In addition, it offers C4ISR systems; radar, electro-optical/infrared, and acoustic sensors; electronic warfare systems; cyber solutions; space and intelligence processing systems; air and missile defense integration systems; navigation systems; and shipboard missiles and encapsulated payload launch systems. Further, the company provides life-cycle solutions and services in support of networks and systems, including sustainment, modernization, training and simulation, software, engineering services, cyber, rapidly-deployable global logistics, and information technology.
Now sit back and just think about how mind-numbingly brilliant all of NOC's employees must be to make all this… stuff. Then think about the fact that it all works. Then you'll understand why NOC has generated over $140 billion in revenues over just the past five years, and some $13 billion in profit.
So, when it comes to owning a sector, aerospace and defense is the one to own. Over the past 14 years, including the financial crisis and the recent crash, the iShares Aerospace and Defense ETF (ITA) has increased four-fold. NOC stock has increased six-fold.
NOC also produces a lot of free cash flow - about $3 billion in FY19. Unlike Boeing (BA), with its self-inflicted wounds, NOC is not in a liquidity crunch. While it has $14 billion in long-term debt, the interest expense is about $528 million annually, or under 4%. It also has $3.28 billion of cash on hand.
Valuation
Normally, we consider a stock a value play if it has a PEG ratio of less than 1.0. However, when it comes to oligopolies, members of that esteemed class tend to trade at much higher premiums for the very fact that competition is limited.
Thus, we consider an oligopoly stock to be a value play if it has a PEG ratio of 2.0 or less on next year's earnings growth.
With TTM earnings of $13.29 and Tuesday's closing price of $342, NOC's P/E ratio is 25. Analysts show 14.4% growth in earnings next year. NOC fits the profile with a PEG ratio of 1.6.
Risks
As we've seen with Boeing, even what appears to be a minor flaw in design and engineering can snowball into a massive problem. It is always possible that one of NOC's systems has a flaw that results in catastrophe or a complete overhaul of expensive equipment. We've seen what that can do to faith in a company.
83% of NOC's revenue comes from the US government. NOC points out two major problems with this arrangement:
"The U.S. government has been implementing significant changes and spending levels have fluctuated and may continue to fluctuate over time. We cannot predict the impact on existing, follow-on, replacement or future programs from potential changes in priorities due to changes in defense spending levels, the threat environment, procurement strategy, military strategy and planning and/or changes in social, economic or political priorities. The U.S. government also has the ability to delay, modify or cancel ongoing competitions, procurements and programs, as well as to change its acquisition strategy."
and also:
"U.S. government programs are subject to annual congressional budget authorization and appropriation processes. For many programs, Congress appropriates funds on an annual fiscal year basis even though the program performance period may extend over several years. Consequently, programs are often partially funded initially and additional funds are committed only as Congress makes further appropriations. If we incur costs in excess of funds obligated on a contract, we may be at risk for reimbursement of those costs unless and until additional funds are obligated to the contract. We cannot predict the extent to which total funding and/or funding for individual programs will be included, increased or reduced as part of the annual appropriations ultimately approved by Congress and the President or in separate supplemental appropriations or continuing resolutions, as applicable".
There are also risks with foreign customers, because their laws differ from ours. Changes in US foreign policy and the ever-shifting sands of political and global alliances could severely damage the company's contracts both with the US and with other countries.
The company depends on tremendous amounts of raw material, meaning the supply chain must stay intact and commodity prices can affect the many products they create. That is to say, metal prices are subject to extreme volatility.
Actionable Conclusion
The July 24th $325 puts are selling for right about $10 per contract. That means you can collect about 3.1% in about 6 weeks, or a cool thousand bucks. It's not an incredibly generous premium considering the length of time involved, but you are trading that off for the 5% buffer zone between the current price and the strike price.
If NOC shares are put to you, you will be buying NOC stock at the equivalent of $315 per share, which is about an 8% discount from even this low price. You also own the stock and pick up a 1.66% yield going forward.
For those who want to wait a little bit longer to see how the election environment shakes out, the November $300 puts are going for about $12.50.
If put to you, you will be buying NOC stock at the equivalent of $287.50 per share, a discount of more than 18% from this already cheap price point, and you'll own NOC stock at a PEG ratio of 1.28.
Finally, for the most conservative choice, the January 2022 $270 puts sell for about $20 each.
You first earn a solid 7.6% on your money, and in the process, you'd be hedging your NOC stock bet all the way down to $250 per share. That is actually below its $263 bottom during the March market crash.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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