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Northrop Grumman Wins a $1.4 Billion Arms Deal

By Rich Smith - Oct 2, 2019 at 8:53AM

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It took a while, but Congressional approval finally came through.

Almost exactly one year after the U.S. Defense Security Cooperation Agency notified Congress of the sale, it's finally becoming a reality.

Roughly one year ago, I told you about the huge win Northrop Grumman (NOC 1.44%) was going to book if the U.S. Congress approved the sale of nine E-2D Advanced Hawkeye (AHE) Airborne Early Warning and Control (AEW&C) aircraft to Japan for some $3.14 billion -- including both the cost of the airplanes themselves and also the cost of their support and upkeep. One year later, on September 26, 2019, the U.S. Pentagon finally awarded the contract, formalizing the sale, to Northrop: For $1.36 billion, i.e., about 43% of the total deal value, the company will sell Japan nine of its most advanced airborne early warning aircraft.

E-2D Advanced Hawkeye aircraft in flight

Image source: Northrop Grumman.

At the 10.5% operating profit margin Northrop Grumman is currently earning on products sold through its aerospace systems division, this should work out to a cool $140 million or more in operating profit on the sale itself. The defense company should then earn even more profit as it continues to support Japan's air fleet over ensuing years.

Unfortunately for Northrop Grumman investors, the rest of what I told you last year also looks to be coming to pass.

What investors need to know

Last year, I laid out the economics of Northrop Grumman's various defense divisions, from the then-tiny "innovation systems" unit that is Northrop Grumman's most serious foray into space, to the larger "mission systems" division that generates the bulk of Northrop's profits, to the flagship aerospace systems division -- Northrop's largest business unit -- that is building the Hawkeyes for Japan.

As of last year, mission systems was clearly the most valuable of these units, generating the company's richest operating profit margin of 13%. Aerospace, despite raking in the most revenue, earned a profit margin of only 10.8% -- respectable to be sure, but not as rich as mission systems -- with innovation systems trailing with a 10.5% operating profit margin.

Fast-forward to today, and data from S&P Global Market Intelligence show that the first half of 2019 saw revenue rising at about 4% year over year for both aerospace and mission systems. The revenue generated from mission systems sales, though, is growing steadily more profitable (13.2% over the last six months), while aerospace revenue is still generating just 10.8% margins.

Innovation systems, now bulked up with the addition of Orbital ATK's space business, earned Northrop a very respectable $336 million in operating profit in the year's first half -- a 11.4% margin on sales of $3 billion.

That's good news -- but here's the more important news: The $1.36 billion bump in revenue Northrop Grumman will receive from the Hawkeye sale to Japan will make aerospace systems more important than ever as Northrop's main revenue driver. Still, by all indications, growing revenue isn't doing anything to expand profit margin at this division. Thus, the bigger the aerospace unit becomes, the lower we can expect Northrop Grumman's overall operating profit margin to drift.

For the company as a whole, since 2017, operating margin at Northrop has already fallen from an incredible 17.1% to just 13.1% today. The more airplane sales contracts Northrop Grumman signs, the clearer I expect this trend in profit margin to become.

Rich Smith 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.

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