Northrop Grumman targets mission-critical defense strategy

Worries over US defense budget cuts has created a buying opportunity for long-term investors.

By TheStockAdvisors Oct 27, 2011 10:21AM
By Benjamin Shepherd, Personal Finance

Northrop Grumman (NOC) trades at 1.3 times the company’s book value and 0.5 times sales -- a bargain for a company expected to grow  revenues at an average annual rate of 9% over the next few years.

The stock has pulled back by 15 percent this year because of a recently passed deficit-trimming measure that would cut $350 billion from planned national defense spending over the next 10 years.

The US government accounts for more than 90 percent of Northrop Grumman’s annual revenue, but the firm’s focus on key electronics and systems should shield its defense contracts from the axe.

Although the company built its reputation on heavy weapons, the firm has streamlined its business to focus on high-growth product categories.

The defense contractor recently divested some of its less-profitable shipbuilding operations, though the firm will continue to produce systems and components for the B-2 stealth bomber, the F-35 joint-strike fighter and a host of unmanned aerial drones.

Management expects the electronic systems and information systems divisions to contribute about half the company’s annual revenue.

These business units produce radars, as well as communication, navigation, control and surveillance systems.

Northrop Grumman also provides training, maintenance and logistical support services to the military under long-term contracts.

Investors initially questioned Northrop Grumman’s new strategy. But the prescient decision to focus on the systems and components that are essential to the military’s mission-critical hardware should insulate the firm from the bulk of the defense spending cuts.

Management has also focused on maximizing profit margins, which should provide some downside cushion in the event of budget cuts.

The firm’s second-quarter gross margin came in at more than 18 percent, while operating margin jumped to 9.7 percent from about 6 percent only a few years ago. Northrop Grumman now boasts the best operating margins and free cash flow in the defense industry.

Northrop Grumman’s order book stands at roughly $42 billion, more than half of which has already been funded.

This backlog should also help cushion the blow of the federal government’s budget cuts and protect the company’s ample quarterly dividend. Yielding 3.6 percent, shares of NOC rate a buy up to 61.

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