Boasting annual revenues north of $24 billion, Northrop Grumman (NOC -1.56%) belongs to the top tier of American defense industry companies. It's not as big as a Boeing or Lockheed Martin, but it's big enough. With strong franchises in the EA-6B Prowler and EA-6G Growler electronic warfare aircraft, the B-2 Spirit stealth bomber, and E-2D Hawkeye airborne early warning aircraft, Northrop remains one of the leading aerospace and defense industry contractors building warplanes for the military.
The Northrop Grumman X-47B Unmanned Combat Air System -- the future of military airplanes? Source: Northrop Grumman.
Lately, Northrop Grumman stock has won even more investor attention for its role in producing unmanned aerial vehicles -- Fire Scout robotic helicopters, Global Hawk surveillance aircraft, and its newest product, the X-47B carrier-based, unmanned combat air vehicle. If all goes as planned, these are the aircraft that will keep Northrop Grumman relevant through the 21st century and beyond.
The fact is, its leading position in the UAV industry probably explains why investors have bid up Northrop Grumman stock by more than 36% over the past year -- while the broader S&P 500 has risen just 20%. And yet, for all the pluses surrounding Northrop Grumman stock, the company has a few minuses as well -- minuses that, in time, could begin eroding the stock's recent outperformance. Here are three of them.
The Air Force has second thoughts about drones
The U.S. Navy is a big fan of Northrop Grumman's efforts to build it a robotic warplane that can take off from and land on an aircraft carrier. But over at the Air Force, where these robo-planes have been flying the longest, they're starting to have second thoughts about the whole "drone" idea. Last month, outgoing Air Combat Command chief Gen. Mike Hostage complained that "there's a love affair out there in the aviation world with the concept of unmanned [aerial vehicles]." But when comparing drones to their piloted aircraft equivalents, Hostage argues he'd much prefer the latter.
While Hostage agrees that drones have been useful when combating lightly armed foes who lack their own air forces (Iraq and Afghanistan being the implied parties), the general has serious reservations about a remotely controlled drone's ability to survive in a "contested airspace." Simply put, the general doesn't believe "a Predator... a Reaper" (or from Northop Grumman's perspective, a Global Hawk or Fire Scout) would survive very long in an environment where MiG-29s and Su-27s are trying to shoot it down, or where enemy electronic warfare specialists are actively working to jam its communications.
Until Northrop Grumman, or someone else, figures out a way to secure the lines of communication between drones and their controllers, that worry -- the fear that drones are susceptible to electronic jamming, or even hijacking -- will continue to act as a drag on the industry. It will continue to hold back Northrop Grumman stock, too.
A one-trick pony?
Northrop Grumman's high profile position in the drone industry may tempt some investors to think of the company as a "one-trick pony." That, however, would be too harsh an assessment. With business lines in military information systems, electronics, and infrastructure -- in addition to its drones and piloted warplanes -- Northrop Grumman isn't putting all of its eggs in the drone basket. It remains a pretty well-diversified defense contractor.
And yet, it's undeniable that this pony lost one very important trick from its repertoire in 2011, when Northrop Grumman fatefully decided to spin off its Huntington Ingalls (HII 0.36%) shipbuilding division.
Granted, things have worked out pretty well for owners of Northrop Grumman stock since the spinoff, with the shares roughly doubling in value since March 31, 2011. But looking at Northrop Grumman stock as it stands today, well, analysts polled by S&P Capital IQ seem to agree that its growth prospects from here on out are rather limited. Most think earnings will struggle to grow at even 8% annually over the next five years. That's significantly slower than the rest of the defense industry, which analysts say will grow at better than 12%.
Meanwhile, at Huntington Ingalls, the division that Northrop spun off, S&P Capital IQ analysts are projecting a 24% rate of compound earnings growth (or even a little bit better than that). With business lines ranging from nuclear aircraft carriers to submarines to surface warships to Coast Guard cutters -- all products likely to benefit from a U.S. military that's "pivoting to the Pacific" on one hand, while preparing to set more sails in a melting Arctic Ocean on the other. It makes you wonder -- if Northrop had hung onto Huntington, might it be selling today for something closer to the 17 P/E ratio that Huntington Ingalls fetches, rather than the 14 P/E of Northrop Grumman stock?
Revenues are falling
Indeed, things could get even worse for Northrop Grumman stock than just not growing as fast as investors might hope it would grow. Northrop Grumman could actually... shrink.
Since cresting in 2010, revenues at Northrop Grumman have fallen for three straight years, from $28.1 billion in 2010 to $24.7 billion in 2013. Most recently, S&P Capital IQ clocked the company doing just $24.2 billion in revenue over the past 12 months. If things keep proceeding as they have been, 2014 will be the company's fourth consecutive "down" year.
Granted, management at Northrop has done an admirable job of cutting costs as revenues fell. In proof of which, operating profit margins at the company have grown steadily over the past five years, recently topping out at 13.3%. But there's a limit to how much a company can cut costs, and a limit to how large profit margins can grow -- especially with the Pentagon urging its contractors to cut costs if they want to continue receiving contracts. Ultimately, for Northrop Grumman stock to hit even the 8% growth target that Wall Street has set for it, the company simply must get its revenues growing again.
And if it can't?
Caveat investor.
The Northrop Grumman MQ-8B Fire Scout is a marvel of engineering. But Northrop needs to sell more of them if it's to get its revenue growth back in gear. Source: Northrop Grumman.
