On the surface, Northrop Grumman (NYSE:NOC) delivered blowout third-quarter results, with earnings beating consensus estimates by about $0.70 per share. But a deeper look shows that not all was as rosy as the headline numbers would imply.

Revenue for the quarter came in a bit shy of expectations, and much of the earnings-per-share beat is attributable to tax and pension adjustments, not from operations. Northrop's initial 2020 guidance for mid-single-digit sales growth was a bit of a disappointment. The company also revealed that regulators are probing whether it is living up to the terms imposed on it when it was allowed to buy Orbital ATK in 2018, a fresh complication to Northrop's effort to win a $60 billion contract to replace the Air Force's intercontinental ballistic missiles.

NOC Chart

Defense stock. Data by YCharts.

The sky isn't falling at Northrop Grumman, but there is enough noise in the quarter to think that the company, the top-performing major defense stock over the past year, is due for a pullback.

An unremarkable quarter

Last week, Northrop Grumman posted third-quarter earnings of $5.49 per share, easily topping expectations, but that beat was fueled by a benefit of about $0.37 per share from a lower-than-expected tax rate and an $0.18 benefit related to pension accounting. Organic sales grew by 5% in the quarter but total revenue of $8.48 billion missed expectations by about $80 million. 

A rendering of the forthcoming B21 bomber in flight.

Northrop Grumman's B21 bomber is one of the company's flagship programs. Image source: Northrop Grumman.

The company's aerospace systems segment was the laggard, reporting operating income down 14% year over year to $324 million. Northrop attributed the decline to project completion timing issues, coupled with issues with its B-2 modernization program and in commercial space. Overall companywide operating margin dropped 330 basis points year over year to 11.2%.

Northrop Grumman provided an initial forecast for "mid-single-digit" sales growth in 2020, which lags the guidance provided elsewhere in the defense sector. At least part of the issue is low-margin work at the Lake City Army Ammunition Plant in Missouri that Northrop acquired as part of its deal for Orbital ATK.

There was also a lot to like about Northrop's long-term outlook. The company's backlog grew to $65 billion at the end of the quarter, aided by a new $1.4 billion order for surveillance aircraft and more than $600 million in new classified space work, resulting in a book-to-bill ratio of 1.2 at quarter's end.

The FTC is asking questions

Northrop Grumman spent $9.2 billion on Orbital ATK with competitors like the government's Ground Based Strategic Deterrent (GBSD) in mind. Orbital is one of only two U.S. makers of solid rocket motors, and its expertise is a key part of Northrop's effort to replace the aging Minuteman incumbent ballistic missile.

To win Federal Trade Commission (FTC) clearance to close the deal, Northrop Grumman agreed to make Orbital's rocket motors available "on a non-discriminatory basis," but Boeing (NYSE:BA), Northrop's principal rival for the GBSD and maker of the Minuteman, surprised the Pentagon this summer when it decided not to compete. Boeing implied at the time that it felt the deck was stacked against it due to Northrop's ownership of Orbital and called for "government intervention" in September to even the playing field.

Flames shooting out of the bottom of a solid rocket motor during a ground test.

A solid rocket motor during a "static fire," or ground test. Image source: Northrop Grumman.

Boeing's message has apparently been heard. Northrop disclosed in its 10-Q quarterly filing that it has received "a civil investigative demand from the FTC requesting certain information relating to a potential issue of the company's compliance with the order in connection with a pending strategic missile competition."

Northrop said it believes it has complied with the order, but the FTC inquiry creates new risk. There is almost no way the government would require Northrop to unwind the Orbital deal, but it is possible the FTC could force conditions that would allow Boeing to reenter the GBSD competition or push the two companies to work together on a combined bid.

Northrop Chairman and CEO Kathy J. Warden during a post-earnings call with investors said the GBSD team is proceeding as scheduled and that the Air Force so far has not pushed the company to pair with Boeing to create a so-called "national team."

We do not currently expect any change to the Air Force acquisition strategy as a result of this inquiry. They plan to award next August, so there is some time. Our proposal is due in December, and so obviously we will continue to monitor that, but right now, we do not see any impact. And in terms of the question about any pressure, we are not receiving any pressure to engage in a national team, because I would point out that we do have a, what we're calling nationwide team that includes many large and small companies across the country, who are bringing strong capability that will support our GBSD bid.

No time to jump in

There's nothing in the quarterly report to suggest Northrop Grumman is going to fall off a cliff, but in a quarter that was by and large business as usual for most of the defense majors, Northrop's stood out as the one that raised the most questions about future performance.

Given the forecast for sluggish growth, the potential complications to the massive GBSD competition, and the long, slow timetable on other important programs like Northrop's B-21 bomber, it seems unlikely Northrop Grumman shares will continue to outperform their peers in the quarters to come. For new money going into the defense sector right now, there are better buys than Northrop Grumman.