Northrop Grumman stock is more than just Global Hawks. Image source: Getty images.
Shares of defense contractor Northrop Grumman (NOC 2.14%) slumped last week despite the company reporting stronger than expected earnings. Was the sell-off deserved?
Well, sales growth was anemic at just 2%, profit margins contracted, and the company suffered a 16% decline in free cash flow produced in Q2. So to an extent, the sell-off was deserved. But was that the whole story?
For a bit more color on what's happening at Northrop Grumman these days, we listened in to the company's post-earnings conference call for you. Here are a few things we thought you'd like to know.
Thing 1: Air superiority reestablished
At Aerospace Systems, we're reaching an inflection point, where new programs and the planned ramp-ups on production programs are beginning to outpace declines on mature legacy programs. [...] The programs driving sales include our restricted programs, the production ramp-up on F-35, Triton and volume in Global Hawk [...] These growing programs are more than offsetting the expected declines in AS programs such as NATO [Alliance Ground Surveillance drones], F/A-18 [and in space] Advanced EHF and the James Webb Space Telescope. -- CEO Wesley G. Bush
On Defense News Guru, the "professional" Facebook page I've set up to track major Pentagon weapons purchases, we've seen numerous signs of the Navy slowly preparing to introduce Northrop's MQ-4C Triton aircraft, ranging from contracts to secure "diminishing manufacturing sources" needed to build the drone, to extensions of funding to support the Broad Area Maritime Surveillance-Demonstrator aircraft that predates Triton, to setting up bases for the aircraft to operate when ready. While not in operation yet, Northrop says the Navy intends to buy as many as 68 of the drones eventually.
We've also seen hundreds of millions in contracts awarded to service U.S. Air Force Global Hawks, and even a big $657 million contract to sell the drone to U.S. ally South Korea. Some of these contracts were announced years ago, others just months ago, but all of them support Northrop's contention that it has plenty of new products to replace old aircraft as sales in the latter slow down.
Thing 2: And the F-35? Doesn't Lockheed build that?
In terms of F-35 margin, I would say that, yes, in fact, the margin rates we're realizing on that program is not what we expect at this level of maturity. We're talking about LRIPs 9 and 10 moving into full rate production, and we would expect that the margin would be a bit higher than where it is today. -- Kenneth L. Bedingfield, CFO
Northrop's mention of the F-35 as a profit contributor is interesting, because Lockheed Martin (LMT 3.08%) is actually the prime contractor on that one. But Northrop plays a valuable role as a member of Lockheed's "team" building the F-35, building the plane's center fuselage, its tracking and fire control radars, and even its avionics suite.
One valuable bit of information here is that while Bush says his company is relying on sales of the F-35 to help offset slower sales of F-18s, NATO drones, and so on, the margins Northrop is earning on the F-35 work it does for Lockheed Martin currently aren't as high as he'd like them to be. That means that just replacing revenues might not be enough for Northrop. To keep profits steady, they need to find a way to boost margins as well -- and margins were in fact a weak spot in last week's earnings report.
Speaking of margins, let's speak a bit more about margins...
Thing 3: Margins
Total operating margin rate was 13.3% for the second quarter and 12.8% year-to-date. We now expect a low 12% total operating margin rate for the year versus our prior guidance of approximately 12%. -- Bedingfield
Profit margins were weaker in Q2 2016 than in Q2 2015, but they still improved sequentially from Q1 2016. That's a good thing. A better thing is that management's full-year forecast appears to be inching up from the flat 12% number it was anticipating earlier this year.
Better still, a bit later in the call, Northrop's CFO confirmed that he does not see a risk of "a precipitous drop in the margin rates, assuming we continue to perform."
Thing 4: Free cash flow
At the midpoint of the year, capital spending was $471 million and we now expect our 2016 capital spending will range between $800 million and $1 billion. We continue to expect free cash flow of $1.5 billion to $1.8 billion. -- Bush
Likewise, Northrop Grumman is holding steady to its projections for free cash flow this year. That's both good and bad news, though. According to S&P Global Market Intelligence data, last year, Northrop produced only $1.7 billion in free cash flow from its business, a 17% drop from 2014 levels -- which was down 4% from 2013 FCF, which was down 8% from 2012! If Northrop can break this trend in 2016 and report free cash flow close to the top of its projected range, then all will be well and good.
If not, 2016 could mark the company's fourth straight year of declining cash profitability.
Thing 5: Space -- the final frontier
Space is an area that I really think we're on the beginning next steps of a change in the way of looking at the space portfolio for the nation. [...] As we go forward, I think just about all of the space missions that are going to need to be recapitalized [...] So, I think there will be quite a few very good opportunities for both our company and the companies with whom we partner in addressing these new needs in space. -- Bush
It's always nice to end these kinds of reports on an optimistic note, and I think Northrop Grumman's CEO's comments on the emerging opportunities in space do just that.
Mind you, Bush didn't go into any deep specifics on the space projects that his company is angling to work on, the profit margins they might generate, or the free cash flow that might result -- and really, given how fast the picture is changing in space, that's not surprising. Just knowing that Northrop has its eye on the space ball, though, is reassuring.
And we'll be watching how they perform up there, as well.
