Northrop Grumman Stock Undermined By Low Quality of Earnings, Shrinking Backlog

The stock looks cheap on first glance, but the longer you look, the less you'll like it.

Jul 23, 2014 at 5:45PM

It's earnings season for defense contractors this week. Northrop Grumman (NYSE:NOC) took its turn at bat on Wednesday morning.

Global Hawk
Northrop Grumman's most famous product, the Global Hawk UAV, is nearly as ugly as Northrop Grumman's cash flow statement. Photo: Wikimedia Commons.

After the company reported earnings before the market opened, Northrop Grumman stock traded up, traded down, but ultimately ended the day mostly unchanged -- despite financial results that were broadly positive. For its second quarter of 2014, Northrop reported:

  • A modest 4% decline in sales to $6 billion
  • Eighty basis points' worth of improvement in operating profit margin, which came in at 13.6%
  • A 5% improvement in net income and, thanks to a smaller share count from buybacks, earnings per diluted share that were up nearly 16% year over year to $2.37

Perhaps best of all, Northrop Grumman showed better than 62% growth in free cash flow from the year-ago quarter. Cash profit for the fiscal second quarter of 2014 reached $456 million -- enough to almost bring the company back to free cash flow positive for the year to date.

So why aren't investors reacting more positively to the news?

Caveats and quibbles
The answer is probably that while the second-quarter results were great, the future for Northrop Grumman stock looks a lot less certain. Total backlog at the company is now just $35.6 billion, down nearly 6% from last year. The company won just $5.3 billion of new business in the quarter -- not enough to replace even the lower revenue booked in the three-month period.

As for guidance for the rest of the year, Northrop basically doubled down on what it has already told us, with little "good news" to report. Sales are still expected to range between $23.5 billion and $23.8 billion. Operating profit margin should approximate 13%. Free cash flow will be somewhere between $1.7 billion and $2 billion. Really, the only guidance number moving up is net income, where Northrop now sees itself earning a minimum of $9.15 per diluted share this year, and perhaps as much as $9.35.

Unfortunately, that may not be enough to support the stock, because the quality of the earnings that Northrop has already reported looks iffy. Free cash flow, while almost positive for the first half of this year, still isn't there yet. Northrop's negative free cash flow number for the first half of the year is also much less than the $511 million in "net income" the company said it earned in the second quarter, and much, much less than the $1.1 billion in profit reported earned so far this year.

Long story short, at a share price that's just 13.1 times trailing earnings, and paying a tidy 2.3% dividend yield, Northrop Grumman stock looks cheap at first glance. Weak prospects for growth in earnings, however, and the low quality of earnings, mean I just can't recommend the stock, despite its seemingly attractive price.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of 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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