This is not how "earnings beats" are supposed to work.
Last week, defense contracting heavyweight Northrop Grumman (NYSE:NOC) reported "beats" on both Q2 revenues and earnings. Sales of $6 billion for the quarter exceeded analyst estimates by a small fraction of a percent, while profits of $2.85 per share soared right past analysts' $2.53 prediction -- largely because of stock buybacks that concentrated a smaller net profit among fewer shares outstanding.
And yet, despite beating on earnings (and raising guidance for future earnings), Northrop Grumman stock fell nearly 1% to close the week below $217 per share. Why?
Q2 by the numbers
In fiscal Q2 2016, Northrop Grumman reported:
- Sales growth of 2%.
- A 50-basis points lower operating profit margin -- 13.3% -- that reduced net profits.
- A lower share count, which permitted per share earnings growth of 4%.
- Free cash flow was only $431 million -- a 16% decline from last year's $511 million.
Nonetheless, Northrop Grumman is doing better on the cash front this year than it was doing at this point last year. Q2's cash haul more than made up for Northrop's cash-burning quarter in Q1, with the result that free cash flow at the company totals $73 million for the first six months of this year, versus 2015's Q1 cash burn of $260 million.
Management characterized the quarter as "solid," and with $3.6 billion remaining unused in its stock buyback authorization -- money that can be used to boost per-share reported profits no matter whether total net income rises or falls -- Northrop raised guidance for the year. The company now anticipates reporting per-share profits of somewhere between $10.75 and $11 at year end.
Importantly, Northrop continues to anticipate a strong year for free cash flow. Management's guidance for cash profits remains unchanged at $1.5 billion to $1.8 billion.
Valuing Northrop Grumman stock
What does that work out to, valuation-wise? Giving Northrop management the benefit of the doubt (as they deserve, having just beat estimates), let's assume Northrop Grumman stock ends the year with $11 per share in net income and $1.8 billion in free cash flow.
At today's stock price of $216 and change and today's market capitalization of $38.6 billion, that works out to a price-to-earnings ratio of about 19.6 for Northrop Grumman stock, and a price-to-free cash flow ratio of 21.4. Judging from data provided by S&P Global Market Intelligence, both numbers are historically high for the company, as is the company's price-to-sales ratio of 1.6 (based on forecast revenues ranging as high as $24 billion).
Additionally, although Northrop Grumman's continued stock buybacks have the beneficial effect of boosting earnings per share and lowering the P/E ratio, they have been taking a toll on the company's balance sheet. With free cash flow insufficient to pay for all the shares Northrop has been buying back, the company has taken on increasingly large chunks of debt to finance its buyback spree. Total debt at the company now stands at $6.4 billion -- $5.2 billion higher than cash reserves. Factoring that into the mix, the company's debt-adjusted P/E is 22.1, its debt-adjusted P/S ratio to 1.8, and its EV/FCF ratio becomes 24.2.
The Foolish bottom line
Are these valuations as extreme as investors have become accustomed to seeing in, say, some of the market darling tech stocks? No -- but they are rather large for a cyclical defense business, and especially worrisome for a defense business that's growing sales only in the low single-digits, while watching its profit margins erode. Viewed in this context, I think investors are right to be shying away from Northrop Grumman stock. It's overpriced and doomed to go down -- probably sooner rather than later.