Northrop Grumman Corporation Earnings Spook Investors -- but It's the Price That Should Worry You

By Markets Fool.com

For the second day running, shares of defense contractor Northrop Grumman are down -- 3% as of this writing. And if you guessed this had something to do with Northrop's earnings release... you're right.

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But what exactly is the connection between earnings coming up and Northrop's stock price going down? That's what we're here to find out. Let's begin with the highlights. In Q1 2015, Northrop Grumman reportedsales up 2% at $6 billion even -- a reversal of last quarter's decline. Each and every dollar of sales recorded was promptly replaced by new orders flowing in the door -- $6.1 billion worth -- resulting in a book-to-bill ratio of 1.02.

That was the good news, and so far, nothing scary. Now let's move on to the bad news:

  • Cash burn accelerated from last year's Q1, with free cash flow coming in at negative $771 million.
  • Operating profit margin fell 130 basis points to 12.3%.
  • Net profit plunged 16%.
  • And on the bottom line, earnings per share (diluted) dropped 8%, a result of the company's continued share buybacks leaving fewer shares among which to divvy up the profit.

That's considerably less encouraging, and the likely reason investors have been selling the stock. But is it a good reason?

Taking care of the staff
After all, as Northrop made clear in its earnings release, a big reason that profits and free cash flow suffered this past quarter was that management made a lump-sum, $500 million pre-tax discretionary contribution to its employees' pension fund in Q1. Additionally, management pointed out that last year's Q1 earnings benefited from a $0.23-per-share tax benefit, which made Q1 2015's earnings look weaker in comparison.

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Regardless of these various line items pushing and pulling earnings up and down in the short term, Northrop CEO Wes Bush insists that the company is "off to a strong start in 2015." The strong book-to-bill ratio, in the face of growing revenue, tends to support this assertion. What's more, despite numbers that might lead one to expect Northrop would trim expectations for the full-year's results (Q1 looking so weak), Northrop instead increased its guidance for the full year. Specifically, management told investors to expect:

  • Full-year sales of $23.4 billion to $23.8 billion (level with previous guidance)
  • Operating profit margins in the mid-12% range (i.e., better than it reported in Q1)
  • Free cash flow of $1.7 billion to $2 billion (unchanged despite the faster Q1 cash burn)
  • And on the bottom line: profits per diluted share of $9.40 to $9.60, which is anywhere from one to two dimes higher than what Northrop had previously promised.

None of which exactly paints the picture of a sinking ship. So should you take advantage of Northrop Grumman's mini-sell-off this week, and buy the stock?

To the contrary
This, of course, depends on the valuation -- which always matters. So let's give Northrop Grumman every benefit of every doubt, and assume the company hits the top end of each of its estimates.

If by year-end, Northrop Grumman produces $23.8 billion in sales, $2 billion in free cash flow, and $9.60 per share in profit, then at current prices the stock is trading for 1.3 times sales, 15.2 times FCF, and 16.1 times GAAP profit. Those last two numbers look a mite pricey for a stock that, according to S&P Capital IQ, is not expected to grow its earnings at even 8% annually over the next five years (much less grow in the double digits). At the same time, Northrop's best-case price-to-sales ratio of 1.3 sits significantly above the one-times P/S ratio that I ordinarily recommend as a starting point when seeking out bargains in the defense sector.

Long story short: It wasn't a great quarter for Northrop Grumman. It wasn't a disaster, either, and management seems confident that the next three quarters will look a whole heckuvalot better than this last Q1 did.

But the stock still costs too much.

The article Northrop Grumman Corporation Earnings Spook Investors -- but It's the Price That Should Worry You originally appeared on Fool.com.

Rich Smithdoes not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 332 out of more than 75,000 rated members.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. 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.