Welcome to Week 3 of Defense Stocks 101. I present to you my third analysis of a large-cap defense stock I originally mentioned when looking at the prospects for the entire defense industry. Two weeks ago, I gave the well-diversified and very cheap Alliant Techsystems (NYSE: ATK) a solid thumbs-up. Last week, L-3 Communications (NYSE: LLL) proved slightly more exposed to potential budget cuts as it derives most of its business from the U.S. military, prompting me to suggest caution. Now, Northrop Grumman (NYSE: NOC) looks like the flavor of the week. As with the other defense stalwarts, I'll examine Northrop's long-term business prospects, financial performance, management quality, and valuation to see whether this company deserves some investor attention.

What Northrop Grumman does
Northrop Grumman has five operating divisions: aerospace systems, electronic systems, information systems, shipbuilding, and technical services. The aerospace systems segment includes aircraft and spacecraft, as well as high-energy laser systems and microelectronics. Electronic systems manufactures various types of defense electronics, including early warning, navigation, and communications systems. Information systems offers products and services focused on areas such as reconnaissance, intelligence processing, cybersecurity, and IT. Quite obviously, the shipbuilding segment makes ships, such as the U.S. Navy's nuclear-powered aircraft carriers, along with providing ancillary support products and services. Finally, the technical services division provides logistics, infrastructure, and sustainment support services, as well as training and simulation.

For fiscal 2010, each segment contributed to Northrop Grumman's operating results as follows:

Segment Name

Segment Revenue Amount (in $M)

% of Total Revenue

Pre-Tax Operating Margin

Aerospace systems 10,910.00 31.39% 11.51%
Electronic systems 7,613.00 21.90% 13.44%
Information systems 8,395.00 24.15% 9.01%
Shipbuilding 6,719.00 19.33% 4.84%
Technical services 3,230.00 9.29% 6.38%

Source: Capital IQ, a division of Standard & Poor's. Percentages do not add to 100% because it excludes corporate-related revenue and profit figures.

While the numbers don't blow me away, it deserves mentioning that Northrop's current business strategy seems outstandingly aligned with the likely future direction of defense spending. Northrop has a substantial presence in both the unmanned aircraft and cybersecurity product lines, two areas the Defense Department expressly views as critical for the future of modern warfare. Also worth mentioning, the company's board of directors approved plans to spin off its barely profitable shipbuilding division to its shareholders at the end of this month. This should help both companies increase performance and increase their focus on their core competencies.

Financial performance
In examining the last decade, Northrop's performance certainly seems underwhelming, especially having already seen two superior performances from competitors in my previous articles. In the past 10 years, the company generated an average return on equity of 6.98%, although the figure hit a 10-year high in 2010 at 15.5%. Despite that uptick, Northrop still trails its industry peers by a substantial amount.

Things look equally bleak on the margin front. During the previous decade, Northrop generated average gross and net margins of 17.25% and 3.34%, respectively. Equally unappealing, those figures never exceeded 20% for gross margins and 6% for net margins. It also bears noting that all this lackluster financial performance occurred during a decade in which defense spending more than doubled. Seeing these kinds of numbers take place during a period of industrywide boom makes me doubt Northrop's ability to increase shareholder value faster than the market in the future. This stands as a major blemish in Northrop's evaluation.

Management evaluation
I also like to know that the management team running the companies I invest in has shareholders' interests at heart. This certainly seems the case with Northrop Grumman. Both executives and directors own meaningful numbers of shares in the company. While this won't guarantee future performance, I sleep better at night knowing management and I have mutually aligned interests. In this case, the present management gets a pass in this respect.

Valuation
Intelligent investors never pay too much for even the best businesses. Right now, Northrop Grumman sells at a multiple of 9.77 times earnings. Over the past decade, the company sold at an average P/E ratio of 15.74, which means the shares currently trade at a 38% discount to their decadelong average. Compare this to rival defense contractors United Technologies (NYSE: UTX), with a current P/E of 16.77, Lockheed Martin (NYSE: LMT) at 11.10, Boeing's (NYSE: BA) 15.63, or the 10.97 figure for General Dynamics (NYSE: GD), and you'll get a good sense of Northrop's relative cheapness.

Typical of some defense stocks these days, this sounds quite cheap, especially considering the overall market currently trades at roughly 16.5 times earnings. While this discount seems substantial, remember Northrop Grumman looks like an average business at best and some of these other companies appear to enjoy better future prospects. The game of investing is all about getting more than you pay for, which makes investing in Northrop seem like a less than compelling option at this point in time.

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Andrew Tonner owns none of the stocks mentioned in this article. The Fool has written puts on L-3 Communications and owns shares of General Dynamics, L-3 Communications, Lockheed Martin, Northrop Grumman, and Raytheon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.