Northrop Grumman: Innovating with Orbital

04/16/2019 5:00 am EST

Focus: INDUSTRIALS

Stephen Leeb

Founder and Research Chairman, Leeb Group

Northrop Grumman (NOC), a holding in our model growth portfolio, has completed more than two quarters since its June 2018 acquisition of Orbital ATK, which was renamed Northrop Grumman Innovation Systems (IS) once it began operating as a subsidiary of the mother company, explains Stephen Leeb, editor of The Complete Investor.

Orbital has added about 15% to Northrop’s revenue base. So far there have been no hiccups, with Orbital being nearly fully integrated into the whole.

Margins have remained at pre-acquisition levels. That’s a bit disappointing but not unexpected in that the company’s business lines, while largely dedicated to defense, do not directly overlap with those of other Northrop divisions.

Specifically, IS is dedicated to small space systems and satellites (for both defense and commercial) while prior to IS, Northrop concentrated on much larger space systems.

Other areas promise rising margins over the longer term because the Defense Department has specified them as necessary, including missile products, ammunition, electronics, aerospace and propulsion structures, and launch vehicles.

By and large these areas are new and fully complementary to Northrop’s existing operations. The company continues to target $150 million in cost savings by 2020, which means we should begin to see margins rise with the next quarterly report.

The one area where we have seen a synergistic contribution is in international sales, where IS has a much stronger presence than Northrop. In the most recent quarter, though revenue contributions were not broken down by division, international sales were the largest ever for Northrop.

With the Northrop brand supporting IS, international sales should continue to grow faster than when IS was a stand-alone entity.

Compared to other defense companies, international sales for Northrop had been lagging as a percentage of total sales. Street recognition of its increased international presence could lead to an increase in Northrop’s P/E.

Also positive is that free cash flow (FCF) in the fourth quarter reached record levels, with the gains more than commensurate with the added revenues brought in by IS.

Prior to the Orbital acquisition we were projecting profits of about $23 a share in 2021. Now assuming cost synergies live up to their estimates and the signs of revenue synergies continue, 2021 profits could approach $25 a share.

We also expect FCF to grow faster than earnings and potentially reach $3.7 billion by 2021, resulting in an FCF yield of nearly 8% based on the current price.

Overall the acquisition is on target for increasing earnings and FCF growth as well as broadening the company’s scope both geographically and in areas of competence. A higher P/E paired with accelerating earnings should result in strong gains in the years ahead.

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