Northrop Grumman (NOC -0.27%) has been a strong performer over the last 10 years, easily outpacing both the S&P 500 and the defense-focused SPADE Index.
But the stock's performance has begun to wane in 2020, with the shares losing to the broader market by nearly 20 percentage points on investor fears that government spending could decline in the years to come.
Sentiment is turning on defense stocks, but Northrop Grumman has a portfolio to be envied and an optimistic growth forecast. Here's why the stock can power higher in the years to come.
A formidable arsenal
The bull case for Northrop Grumman boils down to the company's significant exposure to the programs that are most important to Pentagon leaders.
Northrop Grumman is the prime contractor on two-thirds of the nuclear triad refresh, a $500 billion effort by the Pentagon to update Cold War-era nuclear weapons and deterrents. That's the military's top priority, and will soak up a huge portion of government procurement spending over the next decade.
The company is leading the effort to design and build the B-21 bomber, which the Congressional Budget Office estimates could cost the Pentagon $49 billion by 2028. It also is developing a new Ground Based Strategic Deterrent (GBSD) intercontinental ballistic missile, winning a $13.3 billion down payment in September.
Northrop won the GBSD deal in part thanks to its $9.2 billion acquisition of Orbital ATK, a deal that also made it a leader in space technologies. Space is the fastest-growing segment of the company right now, growing sales 17% in the quarter and 13% year to date.
The GBSD program is fueling that growth, but there is a lot more to the business than just the nukes. In the quarter, the space segment captured an important strategic communications satellite contract, hit milestones in a booster program for NASA, and launched a "mission extension vehicle" designed to dock with an aging satellite and extend that satellite's useful life.
Northrop is also a major player in drones, and has significant exposure to Lockheed Martin's F-35 program thanks to its role as a key subcontractor.
Better days ahead
In the recently completed third quarter, Northrop Grumman delivered something that its rivals largely failed to match: Expectations for growth.
The company ended the quarter with a record $81.3 billion backlog. Its book-to-bill ratio in the quarter, a measure of how much new business was brought in compared to how much was billed out, was a remarkably strong 2.23 times, but that included the massive ballistic missile award. Absent that award the book-to-bill was a more modest 0.76 times, fueled by nearly $2 billion in classified awards and close to $1 billion in aerospace contracts.
Northrop officials on the post-earnings call forecast 4% revenue growth in 2021, which was a lot more optimistic than rival Lockheed Martin's commentary on the coming year. CEO Kathy Warden said, "We certainly see the opportunity to continue to grow the backlog next year," which would be remarkable considering GBSD billing is likely to reduce backlog by more than $1 billion in 2021. Warden continued:
We have a number of opportunities that we're pursuing across all sectors. I'll point to a few Next Gen Jammer in mission systems, as well as the 3DELRR replacement called SpeedDealer, also in mission systems. We have NGI, the Next Generation Interceptor, which would be in space. So these are just a few examples of large potential awards, new starts that we could look to, to bolster our book-to-bill next year. But certainly, we expect that book-to-bill won't be as robust as this year, just given the singular effect of the GBSD award and the strong backlog that we have across our sectors.
The company generated free cash flow of $1.072 billion in the quarter, a number that exceeded net income. Warden on the call said that Northrop Grumman expects to generate enough cash in the years to come to continue investing in research and development and paying down debt while also planning on "resuming share repurchases and maintaining a competitive dividend."
Northrop boosted its dividend last May, and I would expect another dividend hike in the months to come.
Is Northrop Grumman a buy?
The real question is whether investors should buy into any defense prime right now. After years of Pentagon budget growth, we were due a flattening no matter who won the U.S. presidential election, and unexpected government spending due to the pandemic has only added to the pressure on government allocators.
It could be a difficult few years for the industry in terms of new contract awards, but among defense contractors, Northrop Grumman looks like a winner. Its portfolio is loaded with items that are likely to survive cost-cutting efforts, and its optimism about 2021 growth is notable. Throw in a relatively healthy 1.8% dividend yield that has upside potential, and there is a lot to like about the stock even in a tight budget environment.
For long-term investors able to see past what could be a choppy period for defense stocks, Northrop Grumman is a solid addition to the portfolio.