When the U.S. government said in September that it was rethinking the way in which Defense Department contractors get paid, stocks across the defense industry swooned in response. Although those price declines didn't push every defense stock into the bargain range, Northrop Grumman (NYSE:NOC) is now more than 25% below its early 2018 highs, and looking increasingly attractive. If you're considering investing in this sector, here's why Northrop Grumman stock should be on your short list.

The bad news

Although this is a bit of an oversimplification, when a company wins a defense contract, it's on the hook to pay for the costs of the program until it's completed, at which point it gets paid in full by the government. However, since much of the work that companies like Northrop Grumman do spans years and can cost billions of dollars, the government actually does dole out cash along the way -- incentive performance- and progress-based payments. The Department of Defense is considering reducing the size of these payments.   

A military drone silhouetted by a setting sun

Image source: Getty Images

This would leave contractors responsible for more of their ongoing costs  -- even though they would eventually get fully paid. Essentially, it would tie up more of their cash flow and capital, which would reduce the amount of cash available for dividends and stock buybacks, and potentially lead to higher leverage and increased interest expenses.

Nothing has been decided just yet; the industry and the government are discussing matters in hopes of finding what both sides view as a workable middle ground. However, investors haven't looked kindly on the prospect of change on this front. Adding to their concerns is the fact that Democrats have retaken control of the House of Representatives, which could lead to more restraint in military spending in the coming years. The president has also been talking about the need for widespread budget cuts.   

This is all clearly bad news for defense contractors in general, but don't get too emotional here when it comes to Northrop Grumman. For starters, military spending will always be a necessity -- the United States has to be prepared to protect itself. Secondly, Northrop Grumman is actually doing really well today.

For example, its revenues through the first nine months of 2018 were up nearly 13% year over year, though that was partly because of an acquisition. Earnings over that span advanced 40%. But, equally important, the company increased its full-year earnings guidance based partly on an improved operating margin outlook and lower-than-anticipated interest expenses. The company has a $52.6 billion backlog of work lined up that should support it for years to come. And the backlog grew by $400 million between the second and third quarters, showing that Northrop is winning new work.   

NOC Chart

NOC data by YCharts

To be fair, there are some other issues to think about here. For example, the company's strong top-line gains were partly driven by its $9.2 billion acquisition of Orbital ATK in June. That expanded Northrop's space operation, but fool.com's Rich Smith is worried that it could cut into the company's margins over time. And with margins already historically high, that could crimp long-term earnings growth. It remains to be seen how big an impact this will have (noting the forecast for improved margins in the third quarter), but Smith's late June concerns about downside risk proved correct -- the stock has fallen around 20% since his article was published -- notably worse than the 12% drop experienced by the broader industry, as measured by the iShares US Aerospace & Defense ETF.

Pricing in the risks?

Following that steep drop, however, the stock's valuation is starting to look more appealing. And while lower margins at the Orbital ATK unit are a legitimate concern, an expanded space business will allow Northrop to win more government contracts than it could before. That's likely to be worth the potential risk of a little margin compression over the long haul.

NOC PE Ratio (TTM) Chart

NOC PE Ratio (TTM) data by YCharts

The company's current price-to-earnings ratio is 16.6, below its five year average of 19 and, perhaps more important, lower than the industry average of 18.6. The price-to-cash flow ratio is around 14.9 today, notably lower than its five-year average of roughly 16, or the 16.2 average of its peers. The price-to-sales ratio is similarly low, though the valuation differences on that metric aren't as wide.

In other words, after its stock price took a steeper fall than the overall industry, Northrop appears to be at worst fairly valued and, more likely, relatively cheap.   

Worth a close look today

If you are looking to add a military contractor to your portfolio, Northrop Grumman should pique your interest. Its valuation is low compared both to its own recent average and to the valuations of its peers. Meanwhile, its performance remains strong, its backlog continues to expand, and the possibility of tighter margins ahead due to the Orbital ATK acquisition appears priced into its stock. That purchase, meanwhile, notably expanded the company's reach in the space sector, which should be a net positive over the long term.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.