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Northrop Grumman Narrows Focus Amid Defense Market Uncertainty

By Lou Whiteman - Nov 4, 2017 at 1:17PM

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When a contractor starts turning down opportunities to bid on massive new programs, defense investors need to be paying attention.

Defense contractors typically fight tooth-and-nail for every potential contract, knowing that large, needle-moving program wins are hard to come by. That's why Northrop Grumman's (NOC -0.57%) decisions in recent months to back out of bidding for multiple awards that it was once considered among the favorites to win raised a lot of eyebrows in the industry. The company's reasoning for the moves should give investors throughout the industry pause.

B-2 bomber

A Northrop Grumman B-2 Spirit bomber in flight. Image source: Northrop Grumman.

The details

Northrop in mid-October said it would not bid for the U.S. Navy's $2.16 billion MQ-25 Stingray tanker drone competition, and in September walked away from a competition to design and build a new U.S. Air Force training plane. Both were programs where Northrop seemed well-suited to compete. The company was deeply involved in a demonstrator program that laid the foundation for the MQ-25 program, and the Air Force has flown Northrop trainers since the early 1960s.

Northrop earlier in the year also pulled out of a competition to design a new Long Range Standoff Weapon. The company has something of a history of making such decisions, famously rattling the Pentagon and its partners earlier in the decade when it unexpectedly pulled out of the KC-X tanker competition.

While the moves were unexpected -- companies are typically loath to irritate Pentagon procurement officials eager for competitive bakeoffs for new technologies -- each one can at least partially be explained by program specifics. Industry analysts attributed the MQ-25 decision to the Pentagon's apparent focus on keeping costs low over a robust set of features, a move that likely put Boeing at an advantage. Similarly, when discussing the T-X trainer decision, Northrop officials said they were not interested in bidding in competitions where the "lowest-cost, technically acceptable" solution was seen as a favorite.

The big squeeze

The decision not to bid, unsurprisingly, was one of the first topics CEO Wes Bush was questioned about during the company's third-quarter conference call. Bush chose his words carefully, but painted a picture of a defense climate where bids are coming in so low that at times there isn't much profit from the war business.

"When we're looking at one of these opportunities, let me be really clear, our objective is not just to win..." Bush said. "If you can't really execute on it and deliver on it for your customer and your shareholders, then you've done the wrong thing."

It's possible the company is simply finding it hard to make money in areas where its rivals can be profitable, though Northrop Grumman's operating margins are running similar to those of its competitors. Northrop's actions and comments could also suggest that companies are stretching to win new business. A wave of post-Cold War consolidation has created an industry headlined by five massive companies -- Northrop, Boeing, Lockheed Martin, General Dynamics, and Raytheon -- who along with a tier of midsize contractors are chasing a limited amount of business.

Four of those five either missed on revenue guidance or saw revenue fall year over year in the third quarter, and it is possible that management teams could feel pressure to make sure they win big deals and keep growing.

Such pricing pressure could help explain why Northrop was so attracted to Orbital ATK. In September, Northrop agreed to buy Orbital for $9.2 billion in cash and assumed debt to bolster its space offerings. Orbital has unique skills and capabilities that are expected to be in demand as defense continues to shift toward advanced technology.

Staffing issues

Another issue that could be impacting Northrop's bid decisions, and which could affect the entire industry, is a shortage of talent. Contractors have complained for years that the government is too slow in providing the top-secret clearances many of their workers need. A series of high-profile security breaches by contractor employees (think: Edward Snowden) probably hasn't helped push the Pentagon to go faster.

Bush said that the clearance cycle is still an issue in the industry, and admitted it is a factor in the company's decision whether or not to pursue new work. He said that Northrop has a "really strong pipeline of talent" coming in, but added, "it's just something that we're having to manage very, very closely, pay a lot of attention to."

Hold your fire

Defense stocks have enjoyed an impressive run, with shares of Northrop up 115.9% since October 2014 and up 27.43% year to date. Investors are betting that increased defense spending fueled by the Trump White House and simmering issues in North Korea, the Middle East, and elsewhere will lead to higher profits at defense contractors, but Northrop's experience should at least temper that enthusiasm.

Credit Northrop management for conservatism, but alas there is a lot of credit already priced into the stock. The company's 2.05 price-to-sales ratio and 22.64 price-to-trailing-earnings ratio are among the highest in an inflated industry, and well above 10-year averages. Now is not the time to be buying into the industry or the stock.

Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool recommends Orbital ATK. The Motley Fool has a disclosure policy.

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