Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Shares of Northrop Grumman (NOC 0.00%) are up 43% over the past 12 months, notching bigger gains than any of the other big five U.S. defense contractors (with the possible exception of Boeing, which has doubled -- but which also isn't really a pure-play defense contractor). Northrop shares are on the move again this morning, rising nearly 1% -- and for that, you can thank the analysts at Jefferies & Co.
Here's what you need to know.
Upgrading Northrop Grumman
Jefferies upgraded Northrop Grumman stock to buy this morning, according to a write-up on StreetInsider.com (requires subscription). What's more, the analyst has predicted that Northrop stock currently priced around $345 could rise as high as $400 a share over the next 12 months -- delivering a 16% profit to shareholders (plus a tidy 1.3% dividend yield).
Jefferies has revised its "model assumption" to account for Northrop's pending acquisition of Orbital ATK (OA). The analyst predicts that marrying Orbital ATK's defense munitions and space launch business to Northrop Grumman's specialties in terrestrial aerospace and sensors could result in a business earning as much as $20 a share by 2020.
The analyst further predicts that Northrop Grumman can grow revenue "at the high end vs. peers through 2020 and beyond," while further arguing that the "risk" of margins shrinkage in Northrop's flagship aerospace systems business will be "removed" as R&D spending peaks in 2018.
Dollars and percents
Does Jefferies' recommendation make sense? And what does it mean in dollars and percents? Let's tackle the top-line prediction first. Over the next five years, most analysts who follow Northrop predict that the company will grow its sales by 33%, from $25.8 billion last year to $34.4 billion in 2022, according to data from S&P Global Market Intelligence.
By way of comparison, analysts see Lockheed Martin growing its sales 23% over the next five years, 29% five-year revenue growth at Boeing, 34% for General Dynamics, and Raytheon growing fastest of all -- 43%. If Raytheon is the peer that Jefferies is referencing then, it follows that the analyst is predicting even faster sales growth for Northrop than the 33% growth rate that's already the consensus on Wall Street.
Valuing Northrop Grumman stock
That being said, let's keep things in perspective here. If everyone else is right, 33% sales growth for Northrop, spread over the next five years, works out to a compound growth rate of 5.9% per year. On the other hand, 43% total growth over that time period would work out to a growth rate of 7.4% -- a faster clip to be sure, but only by about 1.5 percentage points.
Conclusion: Assume that Jefferies is right, and Northrop Grumman grows its sales as fast as Jefferies says it will. Even so, to justify paying a multiple of 20 times Northrop's $20 in projected earnings three years from now, Northrop will need to expand its profit margins significantly, in order to ensure its profits grow much faster than its sales.
Let's end with a few words on Orbital ATK. As you may have heard, on Monday the European Commission approved Northrop Grumman's planned acquisition of Orbital ATK. The companies still need to get the U.S. Federal Trade Commission to sign off before the merger can proceed, but securing the EC's approval is certainly a step in the right direction for Northrop.
Despite Jefferies' optimism, however, this merger may not work out as well for Northrop as investors hope. Currently, Orbital ATK is hip deep in a government-funded project to develop a new "Next Generation Launcher" (NGL) to lift large payloads into orbit for the Air Force. Problem is, NGL isn't expected to be ready for operation before 2021. And by then, it may have to compete with not one, but two new heavy launch rockets -- the Space Launch System from Boeing and Lockheed (which hasn't flown yet), and the Falcon Heavy from SpaceX (which has) -- plus Boeing's and Lockheed's existing fleet of Atlas and Delta launch vehicles besides.
At the risk of trying to predict the future without aid of a crystal ball, I'd say there's better than average chance that the NGL project will be canceled before it ever gets off the ground, taking Orbital's -- and by then, Northrop's -- investment along with it.