Northrop Grumman Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Wall Street analysts love a good space story, and that's good news for shareholders of Northrop Grumman (NYSE: NOC) as it moves ever closer to its acquisition of satellite launch provider Orbital ATK (NYSE: OA).

This morning, for the second time in less than a month, Northrop Grumman stock won an upgrade on Wall Street. But just like the last time, while I agree that mankind's move into space is a good thing, I fear the analysts are wrong to recommend one of the several companies that are working to get us there.

Here's what you need to know.

Second verse, same as the first

It's been nearly a month since Northrop Grumman's last upgrade, which took place on Feb. 14 -- two days after the European Commission approved Northrop's acquisition of smaller rival defense firm Orbital ATK in a $7.8 billion transaction ($9.2 billion with assumed debt).

Back then, investment banker Jefferies & Co. centered its buy thesis for Northrop on a belief that acquiring the launch provider would give Northrop Grumman a strong position in the burgeoning market for space launch and satellite systems, and enable industry-high growth rates and as much as $20 per share in earnings by 2020. Today, it's Citigroup, not Jefferies, that's making the argument that Northrop Grumman stock is a buy -- but its arguments are much the same.

Growth by acquisition

Like Jefferies, Citigroup paired its upgrade to buy today with a higher price target. Jefferies had pegged Northrop Grumman stock at $400 in value; Citigroup now says $405.

Why does Citigroup likes Northrop so much? After all, over the past five years, S&P Global Market Intelligence data show that Northrop Grumman grew its revenue at only an anemic 0.5% annualized rate. But in Citigroup's view, buying Orbital ATK and adding that company's revenue stream to Northrop's own should permit it to post "modest margin expansion."

Back when it announced its acquisition of Orbital in September, Northrop told investors that it expects to squeeze out $150 million in "estimated annual pre-tax cost savings" by merging with Orbital ATK. Citigroup, however, argues that this estimate is conservative -- that there's "cushion in [Northrup Grumman]'s synergy outlook," and that the company could earn more than the $150 million in cost savings that it's already promised, according to a write-up in (requires subscription) this morning.

Does that make sense?

I see a few flaws in Citigroup's logic, however, that bear watching by any investors considering a purchase of Northrop Grumman stock.

On the one hand, it's true that Orbital ATK has been showing better revenue growth than Northrop Grumman has lately. In fact, from 2013 to 2017, Orbital ATK's sales grew nearly 50%. Problem is, most of that growth came from the combination of revenue streams from Orbital's two predecessor companies, Orbital Sciences and Alliant Techsystems, in 2014. Since that merger, the now-combined company has shown much more modest revenue gains of about 4.5% annualized over the past two years. In contrast, Northrop -- which as I mentioned above has grown its sales only 0.5% per year on average over the last five years, actually posted a growth rate of 4.7% over the last two years.

Not to belabor the point, but it turns out that lately, Northrop has been growing faster than Orbital ATK -- the company that Citigroup says will accelerate Northrop's growth rate.

Citigroup's margin argument also requires some examination. According to S&P Global data, Northrop Grumman earned an operating profit margin of 12.8% on its revenue last year. But once again, Orbital ATK's operating margin -- while respectable at 11.1% -- was actually inferior to what Northrop Grumman was producing on its own.

In both regards, therefore -- sales growth and profit margins -- it looks to me like Northrop Grumman could potentially find itself worse off with Orbital than it was without it.

Final point

On top of all that, I need to re-emphasize the point I made back in February. According to Citigroup, by buying Orbital ATK, Northrop will turn itself into an "attractive 'space play,'" deriving 20% of its annual sales from space-related sales and services.

Orbital ATK is currently deeply involved in a project to build a new "Next Generation Launcher" (NGL) to lift large payloads into orbit for the Air Force. Problem is, the Air Force already has multiple options for such heavy lift launches -- United Launch Alliance's Delta IV and SpaceX's new Falcon Heavy being the most obvious. At the same time, the market for large satellite launches appears to be stagnant today (if not actually shrinking), meaning that by the time NGL is ready to launch in 2021, there may not be a market for it.

If that's how things play out, Orbital ATK and Northrop Grumman may find they've invested tens of millions of dollars in a product that no one actually needs, or wants -- in which case, Northrop may end up not being much of an "attractive 'space play'" at all.

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