Northrop Grumman Crushed It on Earnings -- Then Sold Off

By Rich Smith Markets Fool.com

Against all odds, Northrop Grumman (NYSE: NOC) pulled a rabbit out of the hat -- in fact, three rabbits.

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Heading into earnings day on Thursday, I noted that Northrop Grumman had already come a long way toward meeting Wall Street's targets for fiscal 2016, having already made three-quarters of the revenue it was supposed to collect and 81% of the profits it was supposed to earn. Nevertheless, the company was issuing cautious guidance of its own for the year, which seemed to imply there was a risk Northrop would fail to deliver.

But it didn't fail. It succeeded in spades.

One of Northrop's biggest successes this year was winning the batwing-shaped B-21 Raider stealth bomber contract. Image source: Northrop Grumman.

The news

Announcing fiscal 2016 earnings on Thursday, Northrop reported:

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  • Sales growth of 4% for the year, topping $24.5 billion in revenue, and beating Street estimates
  • Earnings per share growth of 17% -- $12.19 per diluted share
  • Free cash flow of $1.9 billion

Measured by all three of these yardsticks, Northrop Grumman exceeded expectations on Thursday. It even managed to generate nearly twice as much cash profit in Q4 of the year as it had generated in Qs 1 through 3 -- combined.

So why aren't investors satisfied?

The reaction to the news

Despite all the good news Northrop Grumman reported concerning its performance in 2016, investors seem to have focused instead on the guidance that Northrop issued for what to expect in 2017. And here, Northrop's promises to rack up $25 billion in sales, to earn between $11.30 and $11.60 on those sales, and to generate positive free cash flow of between $1.8 billion and $2 billion appear to have fallen short of the mark.

While analysts quoted on Yahoo! Finance agree that Northrop should grow by 2% and generate sales of $25 billion this year, they have been telling investors to expect Northrop to translate those sales into $12.23 per share in profit -- holding earnings roughly stable. Instead, Northrop is telling investors to expect an earnings decline. Even assuming the company can scale to the top of its new guidance range, $11.60 in profits this year will still "miss estimates" by more than 5%, and also result in a 5% year-over-year decline.

If you're looking for a reason investors sold off Northrop Grumman stock by 1.7% Thursday in reaction to what was by all accounts a superb earnings report -- well, I suspect you've just found it.

What comes next?

Investors in publicly traded companies generally frown upon the prospect of investing in companies in decline. The problem is, declines may be the best Northrop Grumman can offer at this point. Examining the data points in the company's earnings release, we find profit margins in the aerospace division declining by 70 basis points year over year (to 11.4%), technology services margins inching down 10 bp to 10.6%, and mission systems margins merely flat at 13.2%.

Even 2% revenue growth won't be enough to keep profits growing when margins are declining at this rate. Meanwhile, one of the big drivers of Northrop's earnings growth over the past three years -- its stock buybacks -- has ground to a halt. With long-term debt now up to $7.1 billion, pension liabilities at $6.8 billion, and cash reserves at just $2.5 billion, Northrop simply doesn't have the cash available to keep buying back stock.

So what's the long-story-short version here? Northrop Grumman is a fine company with a fine business. But at 18.6 times earnings, its stock is priced for strong earnings growth that the company's declining margins and anemic sales growth simply cannot provide. I see a long road ahead for Northrop now -- and it's sloping down.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.