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...
Northrop Grumman (NOC -0.02%) had a tough time of things last week.
The aerospace giant (with an emphasis now on space) announced Q2 earnings last Wednesday. With sales up 10% year over year and profit up an even more impressive 24% (to $3.93 per share), Northrop beat expectations soundly. Now, you'd probably presume investors were pleased with these results -- but they weren't.
Instead of bidding up Northrop in response to the earnings beat (and guidance raise -- did I mention they raised this year's earnings guidance to as much as $16.85 per share?), investors sold off its stock. Egged on by cuts to price targets announced at Goldman Sachs and Credit Suisse, Northrop Grumman shares fell by nearly 7% Wednesday, and continued sliding on Thursday.
The pessimism has moderated since, but as of today, the stock still hasn't returned to its pre-earnings levels -- and it's there that Buckingham Research sees an opportunity.
Northrop Grumman builds stealthy bombers -- but is it a stealth bargain in defense? Image source: Getty Images.
Upgrading Northrop Grumman
This morning, Buckingham announced that it is taking advantage of Northrop's price collapse last week to recommend buying the stock today. Calling Northrop's new and improved share price "an investment opportunity," Buckingham raised its price target to $371 and upgraded Northrop Grumman stock to buy.
Why? In addition to the improved price, Buckingham says in a note covered on TheFly.com, the analyst doesn't believe that investors are giving Northrop enough credit for potential increases in defense spending, or for the company's recent wins in the defense sphere -- such as Northrop's monster B-21 stealth bomber contract win (valued at close to $80 billion over a term of years), or its role in developing a new "Unmanned Undersea Vehicle Family of Systems" for the Navy, just announced last night in a contract initially valued at nearly $800 million.
Questioning the analyst
And to an extent, I agree with Buckingham on this. Northrop's earnings report last week was very impressive -- in every respect aside from a modest decline in profit margins, which to be fair I had already expected was coming. And it has scored some impressive contract wins.
Where I differ with Buckingham in its enthusiasm over Northrop, though, isn't with the company's accomplishments or the contracts it's been winning -- it's with Buckingham's apparent failure to acknowledge the even more significant pitfalls in this investment.
Take the James Webb Space Telescope for example, which has been getting a lot of ink in the mainstream press lately. More than 10 years overdue and approaching $10 billion over budget, NASA's planned successor to the Hubble Space Telescope (which Northrop is building) was recently delayed again and now isn't expected to launch before 2021. Northrop CFO Ken Bedingfield called this a "negative adjustment" and outgoing CEO Wes Bush said, "[I]t's tough," but it could get even tougher.
The longer it takes to get JWST in orbit, and the more the prices balloon, the greater the chance that this program will get canceled outright -- and the more of a hit Northrop Grumman will take to its reputation for completing space projects on time and on budget. That could impact the company's ability to win more space projects in the future, and damage the value of its $7.8 billion investment in acquiring Orbital ATK.
Where's the alpha in OmegA?
Speaking of Orbital, in acquiring its new space subsidiary, Northrop inherited Orbital ATK's ongoing project to build an "OmegA" class heavy lift rocket for use by the U.S. Air Force, which is bringing tens of millions of development dollars to Northrop, and promises hundreds of millions -- perhaps billions -- of revenue dollars if it ever goes into production.
There's just one problem: I don't think OmegA will ever see the light of day.
As I've previously noted, space market research firm StratSpace Intelligence says the marketplace for heavy lift rockets today is already "in excess" and "over capacity," with about twice as many heavy lift rockets in production than the world can find a use for. Contradicting Orbital's (now Northrop's) efforts to add a new rocket to the mix, StratSpace predicts that "several major vehicles in this class [must] cease flying" to bring the market back into balance -- which doesn't bode well for Northrop's chances of developing this rocket to completion.
Worsening matters, the 2019 National Defense Authorization Act currently working its way through Congress contains a provision that states Congress' clear preference for buying reusable rockets for government-sponsored space missions -- and so far as we know, OmegA is not reusable. Congress even goes so far as to demand that the Air Force justify each and every instance in which it buys a rocket that is not reusable going forward. By the time OmegA has been fully developed, there may not be a market for it at all.
You can call me a pessimist if you will, but I simply think that Buckingham Research's optimism about Northrop Grumman stock is misplaced. There's more downside than upside here -- and perhaps more downside than Buckingham even realizes.
