Northrop Grumman built the X-47B UCAS drone aircraft, the world's first full-size, aircraft carrier-capable, mid-air-refuelable military airplane. Image source: Northrop Grumman.

It's earnings season on Wall Street, and this week the focus turns to defense contractors. Over the next few days, at least a half-dozen of America's biggest defense firms will report their first-quarter 2016 numbers. Among the first to report will be Northrop Grumman (NYSE:NOC), one of the country's foremost manufacturers of military drone aircraft.

Northrop reports tomorrow. Here's what we know today.

What analysts say

  • Buy, sell, or waffle?: According to S&P Global Market Intelligence, 20 analysts follow Northrop Grumman stock, and their opinions are evenly split: Ten rate it "buy." Ten rate it "neutral."
  • Revenue: On average, analysts expect to see revenues roughly flat year over year at $5.9 billion.
  • Earnings: Profits should rise 3% to $2.49 per share.

What management says
Northrop Grumman turned in a neat feat last quarter (and all of last year, for that matter). Total profits produced by the company declined -- but earnings per share went up. Management made this happen by continuing to invest in itself, racking up debt and using the money to buy back its own shares. Less profit spread across fewer shares resulted in more profit per share remaining.

However, that strategy, which worked so well for Northrop last year, could begin running out of gas this year. To see why, take a look at profit margins.

What management does
While the numbers have been a bit up and down, overall and over the long term, Northrop Grumman's profit margins on the revenue it collects have been declining. In the most recent quarter, for example, gross margins were off 70 basis points year over year (and down even more sequentially). Operating and net margins were both down 40 basis points year over year.


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Data source: S&P Global Market Intelligence.

What to watch tomorrow
Northrop Grumman is predicting full-year operating profit margins of "~12%" in 2016, so roughly equal to what it produced last year. Revenue, according to management, will come in at or below $23.5 billion, which means sales growth prospects are minimal (Northrop also did $23.5 billion in business last year).

With revenues flat to down, therefore, and profit margins hopefully flat -- but trending down -- Northrop Grumman has guided investors to expect no more than $10.20 per share in profits this year, and perhaps as little as $9.90. Both these numbers, you'll note, are below the $10.39 that the company earned last year.

That gives us two numbers to watch tomorrow: First, the share count. Are buybacks indeed slowing down, such that earnings-per-share growth from stock concentration alone must stall? And Q1 profits -- are they growing as analysts project, or are they falling, as Northrop's full-year guidance would imply?

A third worry is free cash flow. Last year, Northrop Grumman produced $2.2 billion in operating cash flow, spent $471 million on capital improvements, and thus generated free cash flow of $1.7 billion -- about 15% below its reported $2 billion in "net earnings." This year, management is expecting to ramp up capital spending to at least $700 million and perhaps as much as $1 billion as it gets its LRSB bomber program under way. Absent a big increase in cash flow, though, that implies a big drop in free cash flow, perhaps as low as $1.5 billion.

With money starting to get tight, it would be no surprise if Northrop needs to put an end to its stock buyback program. From here on out, Northrop's only means of growing profits may be by actually becoming more profitable.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.