Northrop Grumman (New York stock market :NOC) is one of the world’s leading defense contractors with a strong portfolio of products and services in the aerospace and defense industry. The company is well positioned to take advantage of secular trends in the defense industry and has several significant growth opportunities, such as ground-based strategic deterrence, space weaponization, and the development and manufacture of the B-21 bomber.
Northrop is focused on producing materiel for classified programs and has exposure to several major military development programs that are still in their early stages. The defense budget is a political process, which makes it difficult to predict, so Northrop Grumman’s focus on a steady flow of contracts wins a tangible growth profile. Defense contractors like Northrop Grumman benefit from regulated margins, mature markets, customer-paid research and development, and long-term revenue visibility, allowing the company to generate substantial cash for shareholders.
Northrop Grumman has three significant growth opportunities in the aerospace and defense industry: ground-based strategic deterrence, space weaponization, and development and manufacturing of the B-21 bomber. These programs are expected to bring substantial growth to the company and consolidate its leadership position in the industry.
Northrop Grumman has a strong presence in the space segment, which is its fastest growing segment. The company is a leader in rocket engines, a market that is expected to see significant growth as new entrants need rockets to launch small satellites into low orbit. Northrop’s expertise in the defense sector is evidenced by its involvement in the Ground Based Strategic Deterrent program.
Northrop Grumman’s involvement in the United States Air Force ground-based strategic deterrence program contributes significantly to the company’s success. This next generation of land-based nuclear missiles is currently in the engineering and development phase and was awarded in September 2020. The program is valued at approximately $13 billion through 2029 and highlights Northrop Grumman’s expertise in the defense sector.
Big Power, Budget and Northrop Competition
Rising great power competition refers to the growing geopolitical competition between the world’s major powers, particularly the United States, China, and Russia. This competition is driven by a range of factors, including economic, military and technological power, geopolitical influence and cultural differences.
In recent years, the United States has faced a growing threat environment, characterized by the growing capabilities of competitors and adversaries, the proliferation of advanced technologies and a series of new security challenges, such as cyberattacks and irregular warfare. As a result, the United States has had to adapt its military strategy and posture to deal with these emerging threats, leading to calls for increased defense spending.
The US defense budget has historically been one of the largest in the world, with spending estimated at $738 billion in 2021. It is expected to continue growing in response to the growing threat environment, some say experts. projecting an increase that will exceed $1 trillion by 2027. The increase in defense spending will aim to modernize the US military, build its capabilities, and improve its readiness to respond to emerging threats. This may involve investments in new technologies, such as artificial intelligence, hypersonic weapons and cybersecurity, as well as in personnel, training and infrastructure.
In addition to these investments, the United States could also seek to strengthen its alliances and partnerships, both in Europe and in Asia, in order to deter potential adversaries and ensure that it remains a dominant military power. For example, the United States has recently increased its military presence in Europe and the Indo-Pacific region in response to growing concerns about Russian and Chinese aggression. The United States also has pushed more arms sales to allies, which would benefit US defense companies.
From the perspective of Northrop Grumman, a leading defense contractor, rising great-power competition and a growing threat environment are likely to present significant business opportunities. Northrop’s portfolio is strongly aligned with key Department of Defense (DoD) spending areas, including space, hypersonics and new bombers. As the United States increases its defense spending, Northrop Grumman should benefit from growing demand for its products and services in these key areas. This increased demand could lead to increased revenue and profits for the company, and potentially lead to new contracts and partnerships with the US government and other defense customers.
Financial and evaluation
All figures provided, unless otherwise stated, are consensus figures from FactSet.
With a forward price to earnings ratio of 21x, Northrop Grumman is currently trading at a premium to Lockheed Martin (LMT) at 18x. We believe this premium is justified by NOC’s better growth prospects. The company is expected to grow 4.7% in 2023 and accelerate to 7.2% in 2024, driven by the growing combination of the faster-growing space segment and growing support for military spending.
In our view, LMT’s revenue growth is less impressive, with a stable outlook for 2023 and modest growth of 3-4% per year thereafter. Despite this, the growth prospects for both companies highlight the growth potential of the aerospace and defense industry and Northrop Grumman’s strong position within the sector. We believe NOC’s premium valuation reflects its growth potential and industry-leading position.
Northrop Grumman is expected to see improved margins over the medium term as the company transitions to more profitable production contracts from development-stage programs and benefits from increased sales from growing defense spending at the stranger. Space systems segment margins are expected to improve as ground-based strategic deterrence matures and approaches double-digit operating margins in Northrop’s other segments. These modest forecasts should translate into significant free cash flow growth for the company and its shareholders over the next five years and beyond.
Northrop Grumman is expected to keep its capital expenditures relatively high as a percentage of sales over the next two years to account for the capability of ground-based strategic deterrence. However, the company is not expected to add capacity indefinitely, and the ratio should normalize to 3% of sales.
Northrop Grumman is a relatively stable stock with consistent earnings and long-cycle contracts, but investing in the stock still carries several risks. Some of these risks include:
Valuation risk: If the company fails to meet growth expectations, its valuation premium relative to other defense companies could decline, leaving it vulnerable to significant downside potential as multiples will adjust to align with their peers.
Defense budget risk: The defense budget may not meet expectations, which would negatively impact Northrop Grumman given its large size and broad portfolio in growth areas. The US budget could be strained by an economic downturn or internal division, or the country could choose to turn inward if the population refuses to bear the cost of maintaining a global empire. Either way, export opportunities for Northrop Grumman and the US defense budget are likely to shrink.
Geopolitical Risk: A temporary de-escalation of geopolitical tensions between Russia, Ukraine, the United States and China could lead to reduced defense spending and negatively impact Northrop Grumman’s stock price.
Risk of cost overruns: The risk of cost overruns could result in higher capital expenditures, higher operating expenses, lower free cash flow and lower margins. This can happen if the company takes on more complex or expensive projects than expected, or if it experiences delays or disruptions in its operations.
In my view, Northrop Grumman is a high quality company with growth potential due to its portfolio and secular trends in the aerospace and defense industry. The company is trading at a reasonable valuation, with a forward price-to-earnings ratio of 21x, relative to its peers. While investing in Northrop Grumman stock comes with certain downside management risks, such as potential defense budget cuts, geopolitical tensions and cost overruns, the company’s position as a as an industry leader and its focus on regular contracts provides a tangible benefit. growth profile.