Warning: Northrop Grumman's Backlog Continues to Decline


One of Northrop Grumman's products, the X-47B UCAS. Photo: Northrop Grumman.

Northrop Grumman (NYSE: NOC  ) reported its first-quarter earnings on Wednesday, April 23. The good news is that it reported higher than expected quarterly profits, and raised its 2014 earnings per share, or EPS, guidance, to $8.90-$9.15, up from $8.70-$9.00. The bad news is Northrop's backlog declined from $37 billion as of Dec. 31, 2013, to $36.2 billion as of March 31. Further, for this same time last year, Northrop's backlog was $39.4 billion.  Here's what investors need to know.

The good
In its first-quarter 2014 report, Northrop stated that its net earnings increased 18% to $579 million, or $2.63 per diluted share -- this included a tax benefit of $51 million, or $0.32 a share. Plus, Northrop's most profitable business segment, aerospace systems, reported a 20% increase to its operating income. Further, Northrop repurchased 4.8 million shares of its common stock during the first quarter of 2014, and its overall operating margin increased from 12.4% for the same time last year, to 14.4% at the time of reporting.  However, it's not all-good news for Northrop.

The bad
In its first-quarter 2014 report, Northrop reported that all four of its business segments had a decrease in sales. This is undoubtedly the result of defense spending cuts in the current budget environment, but it's still unwelcome news for investors. Further, free cash flow was negative $462 million, compared with $39 million for the same time last year, and Northrop's backlog declined to $36.2 billion, from $39.4 billion for this same time last year.

The importance of backlog
The reason backlog is important, is because it's an indicator of work yet to be completed, as well as a tool investors can use to estimate future earnings. Moreover, it shows demand for a company's product(s). With that being said, $36.2 billion is still a substantial amount of money, and shows that Northrop's not in a situation where it'll go belly up anytime soon. However, that doesn't mean it's not concerning for long-term investors.

What to watch
Thanks to the Budget Control Act of 2011, and across-the-board spending cuts, defense contractors, like Northrop, are feeling a pinch. The good news is Northrop seems committed to shareholder value, and has continued to repurchase shares of its common stock. This makes each stock more valuable -- although it can also be used as a way to manipulate EPS. For example, while Northrop reported an increase to its diluted EPS, its first-quarter 2014 diluted EPS was based on 220.4 million weighted average shares outstanding. For the first-quarter of 2013, Northrop's EPS was based on 241 million shares -- approximately 9% more than in 2014. 

Furthermore, because budget cuts don't show any signs of slowing, and Northrop's backlog continues to decline, investors might want to take a closer look at Northrop. I don't see it going anywhere anytime soon, and it could bounce back when it comes to backlog, but there is cause for investor concern. Consequently, while Northrop will likely be around for the long haul -- and could make a great long-term investment if its stock price drops -- for the near future, things could get ugly if its backlog continues its decline.

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