Please ensure Javascript is enabled for purposes of website accessibility

Northrop Grumman Beats on Earnings, Investors Cheer -- But Should They Fear?

By Rich Smith – Jan 29, 2016 at 6:05PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

How does a company turn a revenue miss and declining earnings into growing profits per share? With buybacks. And debt.

Source: U.S. Pentagon.

Northrop Grumman (NOC 2.88%) reported its fiscal Q4 and full-year 2015 earnings on Thursday -- and knocked the cover off the ball. Expected to earn just $2.01 per share, Northrop instead reported $2.49 in per-share profit for the final quarter of the year -- and 7% growth for the year as a whole, $10.39 per diluted share.

Granted, Northrop Grumman missed analyst estimates for its revenues, reporting just $23.5 billion in total annual sales. But with shares up 3.7% in the two days following release of the financial report, investors appear to be forgiving that misstep. So, who is right?

The good
As I noted, Northrop Grumman "beat earnings" and grew its profits for the year, which was no small feat given the way defense spending in general has been chopped here in the U.S. From a high of $691 billion in 2010, overall military spending has fallen nearly 20% in five years, to just $560 billion last year. But it's how Northrop achieved this feat that is the real story.

Yes, $10.39 per share was better than the $9.75 per share that Northrop earned in 2014. But overall net income at the company actually declined by 4%, to $2 billion. The reason that earnings per share grew while earnings, period, fell, is that Northrop Grumman's continued repurchasing of its common stock has concentrated what profits the company makes among fewer and fewer shares outstanding. To make an apples-to-apples comparison between "then" and "now," you need to understand that last year, Northrop was divvying up its net income among more than 212 million outstanding shares. This year, earnings were divided among just 192 million shares.

That makes a difference.

The bad
Generally speaking, stock concentration is a good thing. As demonstrated by Northrop Grumman's report, it permits a company to grow earnings for shareholders in good times and bad, and even when overall profits are falling.

The downside, though, is that stock buybacks can be a drain on cash. Over the past year, Northrop Grumman's net cash reserves have declined by more than $2 billion as the company spent with abandon to buy down its shares outstanding. Cash levels that were at $3.9 billion at the end of 2014 have sunk to $2.3 billion today. Long-term debt -- $5.9 billion at year-end 204 -- has now grown to $6.4 billion.

The ugly (truth about valuation)
Northrop Grumman generated just $1.7 billion in free cash flow last year, down 15% from 2014's $2 billion in positive FCF. True, much of the decline owed to Northrop making a big contribution to its pension fund. But pension contributions are necessary expenses, and a use of cash, and they must still be factored into our valuations.

Valued on free cash flow, Northrop Grumman shares cost 20 times FCF. That's a pretty rich valuation for a stock that analysts think will only grow profits at less than 8% annually over the next five years, and for one that only grew profits 7% last year -- and even then, only grew them through share buybacks. It's much too much to pay if free cash flow continues to sink, rather than grow.

Now, factor in the fact that Northrop Grumman currently carries about $4.1 billion more long-term debt on its books, than it has cash and equivalents to pay it with. Valuing the enterprise just on its market cap plus net debt, I calculated an enterprise value-to-free cash flow ratio of more than 22 for Northrop Grumman stock.

That's simply too much to pay. And investors should stay away.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 249 out of more than 75,000 rated members. 

The Motley Fool has no position in any of the stocks mentioned. 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.

Stocks Mentioned

Northrop Grumman Stock Quote
Northrop Grumman
$545.60 (2.88%) $15.30

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.