By now you've heard the news. Pentagon powerhouse Northrop Grumman (NYSE:NOC), one of the nation's foremost makers of military aircraft, reported its fiscal third-quarter earnings last week -- and it was a blowout. Net profits up 16.7%. Guidance raised -- again! -- with management now predicting $24 billion in full-year sales, and profits of as much as $11.75 per share.
Needless to say, investors were pleased, and Northrop Grumman stock exited the week 4% above its pre-earnings price. But what comes next for Northrop?
For its fiscal third quarter 2016, Northrop Grumman reported:
- Sales growth of just 3% -- $6.2 billion in total.
- Profits growth out of all proportion to that sales growth -- $3.35 per diluted share, or 22% better than last year.
- And free cash flow (cash from operations minus capital expenditures) almost precisely equal to reported net income: $601 million.
How'd they do it?
So how did Northrop Grumman turn what can only be described as an anemic sales quarter into such a strong earnings performance? Two ways. Firstly, Northrop Grumman improved the rate at which it converts revenue dollars to profit dollars -- its operating profit margin. Operating margins that averaged 13.3% one year ago grew 10 basis points to 13.4% in fiscal Q3 2016.
More important than the margin expansion, though -- and in fact, I'd argue this is the single most important number in Northrop Grumman's entire earnings report -- was the reduction of its share count. One year ago, Northrop Grumman's weighted average count of shares outstanding stood at 187.9 million. Last quarter, that share count fell 4.4% to just 179.6 million. This declining share count reduced the number of shares among which net profit must be divided to determine profits per share.
And simply put, fewer shares equals more profits per share.
A long-term trend
We've been talking about Northrop Grumman's shrinking share count for more than three years now, ever since the date the company announced its aggressive plan to spend heavily on share buybacks, and cut its share count by 25%. While the pace of those buybacks has slowed a bit of late, there's good reason for that: Northrop Grumman has accomplished its mission.
According to data S&P Global Market Intelligence, two-and-a-half years ago, midway through 2013, the company's share count stood at well over 239 million. Today, that number has shrunk by nearly 60 million shares -- 25% of the company's shares outstanding, gone. Poof!
What comes next
The effect of this dramatic reduction in share count is evident in the company's supercharged earnings number -- seen this quarter, and in many, many similar quarters over the past few years. The question today is what kind of earnings growth investors should expect to see at Northrop Grumman now that the share buyback program has largely run its course?
So far, this program has succeeded in dramatically reducing Northrop's shares outstanding, but at a cost. Over the course of three years, Northrop's cash reserves have shrunk by two-thirds, from $3.1 billion to just $1.1 billion, while its long-term debt has swelled from $3.9 billion to $6.4 billion ($12.4 billion with pension liabilities figured in). Further buybacks -- were they even anticipated -- would be difficult to accomplish given the strained state of the company's balance sheet. Going forward, Northrop is going to have to grow its earnings the old-fashioned way: by growing sales and improving its profit margin.
Given the slow state of sales growth we saw last quarter, and the middling improvement in profit margins, that could prove difficult. Granted, management raised sales and earnings guidance for the rest of this year -- but there's only one quarter remaining in this year. As for 2017, that's still up in the air. But with analysts projecting no more than 8.5% long-term earnings growth for the company over the next five years, and Northrop Grumman stock currently selling for nearly 19 times earnings, I cannot say that I am optimistic.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 333 out of more than 75,000 rated members.
The Motley Fool has no position in any of the stocks mentioned. 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.