It should have been a lock.
With just a few hours left before Northrop Grumman (NYSE: NOC ) reported its second quarter earnings, investment banker Merrill Lynch (NYSE: MER ) rushed out a flash announcement to investors, declaring the stock "a buy ahead of results."
Um, not so much
Before sticking its foot in its mouth, Merrill might have been best advised to ask investors in rival defense contractors like FLIR Systems (NYSE: FLIR ) and L-3 (NYSE: LLL ) how well Mr. Market reacted to their strong earnings last week. Had Merrill done so, these investors might have told it that great news does not necessarily receive great reception on the Street these days.
And Northrop's news was great. Sales of $8.6 billion beat last year's showing by 10%. Profits of $1.44 per share beat the Street by $0.04. And operating margins, although down year over year for the quarter, were nonetheless ahead of the trailing-12-month trend shown below, coming in at 9.3%.
|
Margins
|
12/06
|
3/07
|
6/07
|
9/07
|
12/07
|
3/08
|
|
Operating
|
8.6%
|
8.8%
|
8.8%
|
9.5%
|
9.4%
|
8.6%
|
|
Net
|
5.1%
|
5.2%
|
5.2%
|
5.7%
|
5.6%
|
5.1%
|
All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.
Problem is, Mr. Market has been manhandling defense contractors all month long. Merrill was right when it said that "all the large cap defense names reported strong earnings across a broad base of programs" the past couple of weeks, and that this boded well for Northrop's earnings news. Right again when it pointed out that "earnings were particularly strong for Army programs with General Dynamics (NYSE: GD ) " (although what that has to do with the price of tea at a Chinese Starbucks, I have no clue).
What Merrill failed to mention, though, is that General D was one of the few defense contractors rewarded for reporting good news (Lockheed Martin (NYSE: LMT ) was another.) But L-3 got pummeled, as did FLIR, despite both reporting boffo earnings. As of this writing, Northrop is down 2%, hewing closer to "the rule" for this month, and not to the exceptions thereto.
Foolish takeaway
Mr. Market is in an unpleasant mood these days. But investors in the defense industry should look past the short-term disappointment, and consider the longer-term possibilities of depressed prices. As of this morning, Northrop Grumman sells for 12 times its trailing free cash flow -- which seems a bargain relative to the 13% annual growth that most analysts predict.
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