Lockheed Martin vs. Northrop Grumman: Which Defense Contractor Has the Best Prospects?

Source: Northrop Grumman.

For years, the defense industry has been under pressure, as government budget cuts have focused on reducing the amount spent on the military, and led to smaller windfalls for defense contractors. Yet, even through difficult conditions, Lockheed Martin (LMT 0.74%) and Northrop Grumman (NOC 1.58%) have sought to grab as much of the remaining available business as they can. More recently, as geopolitical tensions have risen during 2013 and 2014, both Northrop Grumman and Lockheed Martin have seen their shares take off, as investors bet on the renewed need for a strong U.S. military presence around the world.

With all the challenges facing the defense industry generally, it's easy to understand why investors might have difficulty deciding which of the best-known defense contractors offers the most opportunities for profit. To help answer that question, one thing that seasoned investors often do is to look at the return on equity that companies produce from their investments in their own businesses. By using what's known as a DuPont analysis, a method that investors have used for nearly a century now, you can get a better sense of how Lockheed Martin and Northrop Grumman have produced earnings for shareholders, and which has the better chance of continuing to do so in the future.

Source: Lockheed Martin.

Understanding return on equity: The DuPont analysis
Return on equity provides a basic look at how profitable a company is by comparing the earnings of a company with the shareholder equity on the company's balance sheet. In general, the higher the ROE, the better the company is doing at taking its available financial resources and using them to capitalize on profitable opportunities.

By itself, though, return on equity only gives a partial look at a company. The DuPont analysis goes further, breaking down the ROE calculation to look more closely at the multiple drivers that determine return on equity.

Specifically, the analysis looks at a company's net profit margin, asset turnover ratio, and equity multiplier ratio to get three different views of corporate performance. It also measures the impact of debt financing and tax efficiency on profits. Let's look at how Lockheed Martin and Northrop Grumman compare on those factors.

Net profit margins: Northrop edges out Lockheed
Net profit margins compare earnings to revenue for a particular company. The results reflect the pricing power available in the industry, and how effective companies are at competing with their peers and handling the fixed costs of operating their businesses.

Source: S&P Capital IQ, author calculations.

Profit margins in the defense industry are relatively thin, and while both Lockheed Martin and Northrop Grumman have done a good job of keeping their financing costs in check, both pay a sizable amount of taxes. Overall, Northrop Grumman has done a slightly better job of producing more earnings from its sales, and that nets it the advantage on the profit-margin side.

Asset turnover ratio: Lockheed fights back
Looking solely at profit margins ignores how much a company had to invest in building up an asset base in the first place to put itself into position to generate those profits. The asset turnover ratio compares revenue to assets in order to determine how capital-intensive a business is, and how good a job a company does in creating sales from that asset base.

Source: S&P Capital IQ, author calculations.

Lockheed Martin does a much better job than Northrop Grumman of maximizing its sales from its assets. Even though Lockheed has less than one-and-a-half times the assets of Northrop, it generates almost twice the revenue, leading to a much higher asset turnover ratio.

Equity multiplier ratio: Lockheed pushes into the lead
Leverage is the last part of the DuPont analysis, with the comparison of assets to shareholder equity. The more debt a company takes on, the greater the equity multiplier ratio will be. That can contribute to a high return on equity. Yet, when leverage pushes ROE artificially high, there's greater risk for investors of a reversal in future years.

Source: S&P Capital IQ, author calculations.

Lockheed Martin has more assets than Northrop, but its shareholder equity is so low that it produces a massive equity multiplier ratio. Unearned revenue, long-term debt, and pension liabilities all play a role in boosting Lockheed's leverage levels; but similar factors have been in place for a long time, so it doesn't appear to be a one-time phenomenon for the company.

The final answer: Lockheed finishes on top
Multiply all of those figures together, and you can see that Lockheed Martin ends up with a huge ROE advantage over Northrop Grumman.

Source: S&P Capital IQ, author calculations.

Looking at these figures, it's tempting to conclude that Lockheed Martin is the obvious choice. Investors have tended to agree, giving Lockheed an earnings multiple of nearly 18 compared to the roughly 13 times earnings at which Northrop shares trade.

Nevertheless, with so much leverage on its balance sheet, Lockheed's advantage looks far less attractive. With Northrop Grumman's higher profit margins balancing out Lockheed Martin's higher asset turnover ratios, value investors might well prefer to stick with the cheaper stock on a valuation basis.