Northrop Grumman Corporation Crushes Earnings Expecations, Investors Cheer

And yet, a close look at the valuation tells us there's a better bargain out there.

Apr 24, 2014 at 6:05PM

Investors reacted poorly to Lockheed Martin Corporation's (NYSE:LMT) prediction of a 6% decline in U.S. military sales when the company reported, and the company's revelation that sales actually declined 4% in Q1 alone added fuel to the stock-burning fire. But they're having the exact opposite reaction to news that Northrop Grumman Corporation's (NYSE:NOC) sales... also fell 4%. Why?

In Q1 2014, Northrop Grumman reported:

  • Sales declined 4% to $5.8 billion.
  • Operating profit margins grew by 60 basis points, to 12.9%.
  • Per-share earnings surged 30%, to $2.63 per share -- well ahead of analyst estimates.

In many respects, Northrop's quarter was therefore like Lockheed's. Improving profit margins offset declining revenues in each case, and in each case, the defense contractors outperformed analyst estimates handily. Backlog is shrinking at both defense contractors, with the implication that revenues will probably continue to shrink, and that profit growth will therefore depend on further cost cutting. The deciding difference in investors' minds, it seems, is the fact that while Lockheed Martin missed revenue estimates ever so slightly, Northrop just as slightly edged out the expectations for Q1 sales.

But is that a good enough reason to prefer Northrop Grumman stock over that of Lockheed Martin? Investors clearly think so, as they bid up shares of Northrop Grumman in early Wednesday trading, but I disagree, and I'll tell you why.

The differences are in the details
Whereas at Lockheed Martin, free cash flow was quite strong in Q1 -- $2 billion for the quarter, or more than twice GAAP "profits" -- Northrop Grumman saw negative free cash flow in the quarter, and a pronounced plunge in such cash profits against the year-ago quarter.

Free cash flow at Northrop in Q1 2014 was negative $462 million, a huge deterioration from the $39 million in cash burnt in Q1 2013. And based on trailing-12-month results, Northrop Grumman is now generating just $1.7 billion in annual free cash flow, which is also below reported GAAP earnings. In contrast, Lockheed Martin's trailing free cash flow is a healthy $3.7 billion. That's 18% better than the company's GAAP financials make its profits appear -- and Lockheed is forecasting improved cash production throughout the year --$3.9 billion for all of 2014.

Northrop Grumman -- worse by comparison
The advantages of Lockheed Martin stock over Northrop's only gets more apparent the longer you look. Valued on free cash flow, Lockheed Martin shares cost just 12.8 times projected free cash flow; Northrop costs 15.5 at the current rate of free cash flow production, 13.2 if absolutely everything goes right for it this year, and the company tops out its latest projections at $2 billion in free cash for the year.

Growth-wise, analysts give Lockheed Martin the edge over Northrop as well, with 8.5% projected profits growth, to Northrop's 7.9%. And topping it all off, the 2% dividend yield that Northrop pays its shareholders is just 60% of the payout at Lockheed Martin -- a robust 3.3% dividend payout.

Long story short, while both of these defense contractors appear to be managing the downturn in defense spending quite well, the better bargain -- to my Foolish eye -- is in Lockheed Martin stock.

Good stocks aren't as good as better stocks
As every savvy investor knows, Warren Buffett didn't make billions by betting on half-baked stocks. He isolated his best few ideas, bet big, and rode them to riches, hardly ever selling. That's key when weighing an investment between two very similar stocks like Northrop Grumman and Lockheed Martin. One might be a good company -- but you want to own the better one. And which stocks are better than the rest? As luck would have it, legendary value investor and The Motley Fool co-founder Tom Gardner recently revealed his own list of three such "better" stocks in "The Motley Fool's 3 Stocks to Own Forever." These picks are free today! Just click here now to uncover the three companies we love. 

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Lockheed Martin and Northrop Grumman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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