Opportunity NOCs: Why Northrop and the Defense Business in General is Attractive
Defense companies have better prospects than the market implies
Economic Moats are strong in this area driven by niche technology, long-term government contracts, and security clearances
These companies generally have competent management with reasonable incentive schemes
Northrop Grumman is our preferred choice due to its high exposure to prioritized programs including the nuclear triad
Special thanks to my equity research interns for their contributions to this project: Fergus Washington-Smith, Yan Souza, and Nirmal Patel.
Executive summary
I recently purchased shares of Northrop Grumman (NOC) for clients in our Core Equity and Concentrated Equity portfolios. The stock trades at $372.47 as of 06/25/2021. Based on a valuation approach that projects and then discounts future cash flows, I believe the stock is worth somewhere between $445 and $581.
Since the fall of the Berlin Wall in 1989, the United States has been the undisputed global hegemon. This position is being challenged by an increasingly powerful China with a potential flashpoint over Taiwan. China views reunification as destiny while the US has protected the island since 1950. If you believe data is the new oil, then Taiwan is an unrecognized, yet essential ally due to their global leadership in semiconductor manufacturing. For this reason, I believe military spending is likely to grow at least as fast as the overall economy and be concentrated specifically on capabilities to retain balance and protect interests in Asia.
Economic Moats in the defense industry are wide due to long-term government contracts, the necessity of security clearances, and specialized technology that is difficult to replicate. Northrop Grumman is the prime contractor on the new B-21 long-range bomber and ICBM (long-range missiles) programs that I believe are essential to future US military budgets. They also have exposure to other key areas such as space, cyber, jet fighters, and various weapon and mission systems. I also believe that Northrop is well managed with a reputation for making savvy capital allocation decisions.
To be clear, I am not predicting a war. However, I believe the geopolitical backdrop is more favorable to an expanding military than a shrinking one. In my opinion, the current prices in defense industry shares do not reflect that likelihood.
NOC is historically cheap relative to the S&P 500
Figure 2 NOC is historically cheap relative to the S&P 500. Chart shows relative valuation to the S&P 500 based on a multiple of forward earnings per share. Data and analytics provided by FactSet
Macro
Does the United States government make defense spending decisions based on the state of the budget or based on the perceived threat? Conventional wisdom says that defense companies do better during Republican administrations and when budgets are flush with cash. But is this actually true? Military spending appears to be marginally stronger during republican administrations. According to our research, since 1960 Republican Presidents on average spend 6.9% of GDP on defense vs 6.6% for Democrats. Also, the last budget surplus in 2001 conveniently precedes a ramp up in military spending. Did the United States decide to increase military spending in 2002 because it had a new Republican president and money to spend? Or did something else happen?
Correlation is not causation. Since the fall of the Berlin Wall in 1989, the United States has been the undisputed global hegemon which led to military spending as a percentage of GDP to decline from 5.87% (macrotrends.net) to 3.12% in 2001. The United States spends money on defense primarily in response to changes in perceived threat levels. 9/11 jolted the American public and Congress responded (despite an economic recession which led to a less favorable budget) by increasing military spending as a share of the economy. Relative spending levels peaked in 2010 at 4.92% of GDP when the threat of 9/11 had someone faded and budgets came into focus following the financial crisis. Spending fell to 3.87% of GDP by 2020 despite the economic recession suppressing GDP (Statista).
Large US Budget Deficits have Created an Overly Pessimistic Forecast on Military Spending
Figure 3 The US Budget Picture is bleak leading investors to conclude that military budgets will be cut in response.
Now, most commentators seem to be logically concluding that the US is likely to suppress military spending in response to massive government deficits (shown in the chart above). They are wrong for two reasons. 1.) The US position as global hegemon is being challenged by an increasingly powerful China. China is spending aggressively on key areas such as conventional military (especially in the South China Sea), space, and AI. Military planners now believe China may try to invade Taiwan sometime in the next decade. If you do not understand why that is so important, know that Taiwan is home to the most advanced semiconductor manufacturing facilities that drive not only economic activity but also military advantage. Please find an example in world history where a dominant power willingly ceded ground to an upstart. It simply does not happen. 2.) The budget is less of an issue because Congress does not seem to recognize any limits to spending and the federal reserve cheers them on. Even if that were to change, I would argue that the level of threat is growing fast enough that military spending is growing in importance relative to other priorities. Military spending as a % of GDP is close to its historical lows in the United States. With China increasingly challenging the US-led world order, it is hard to envision a future where defense spending does not rise.
US Military Spending is Largely Driven by Geopolitics and the Change in Perception of Threat, and Less so by the Party Affiliation of the President.
Figure 4 source: www.macrotrends.net, Blue bars indicate Democratic president while Red bars signal a Republican president
Military spending is also likely to change in its nature. Since 09/11, the US has been engaged in asymmetric warfare fighting terrorist groups and less powerful nations in the Middle East. China has more sophisticated missile systems, anti-aircraft defenses, nuclear warheads, space capability, and a sizable (and growing) navy. I believe the US will place more emphasis on programs designed to confront this challenge such as stealthy long-range bombers, cyber & space capabilities, ICBMs (sometimes referred to as Ground-Based Strategic Deterrent), autonomous drones, missile defense capabilities, and better submarines.
Investment Options – Why NOC?
There are several big domestic players in the defense business:
Boeing Company
Northrop Grumman Corporation
Raytheon Technologies Corporation
Lockheed Martin Corporation
L3Harris Technologies Inc
General Dynamics Corporation
Huntington Ingalls Industries, Inc.
Boeing, Raytheon, and General Dynamics all have significant exposure to commercial aerospace which can be a great business, but not what I am looking for now. Lockheed is the largest of the rest and is extremely successful, but I have concerns about the potential for the F-35 order book to be deprioritized over time due to cost overruns. L3Harris has a nice military communications business but seems to be too focused on cost-cutting for my taste and the valuation does not appear as attractive as alternatives. Huntington Ingalls is a spin-off from Northrop and might have the biggest moat in the group as the only viable option for aircraft carriers. However, I believe aircraft carriers may be a bit lower priority given the advancement in Chinese missile technology and the increasing focus on the South China sea as a potential war theater. That said, as part of my research I stressed-tested most of these companies for adverse scenarios in a DCF model and my concerns seem to be more than priced into the stocks. From what I can tell, this just looks like a good pond to fish in.
Ultimately, I settled on Northrop Grumman. Should we get to a scenario where the United States is less enthusiastic to spend on the military than I expect, I want to own companies with programs less likely to be cut. I view the nuclear triad (submarines, long-range bombers, and ICBMs) as about as essential as it gets. Conventional warfare is important, but I believe priority #1 is deterrence and that means nuclear. We have all seen the statistics that the US has enough warheads to blow up the earth several times over, but few reports explain why that is deemed necessary. The triad is important because of redundancy. Should an adversary believe it can neutralize the nuclear fleet, they could confidently carry out an attack. However, the triad provides the United States sufficient redundancy that if part of the nuclear arsenal becomes vulnerable, it remains a very risky proposition to attempt to carry out a nuclear attack for fear of retaliation and escalation. Northrop Grumman (NOC) is the primary contractor on the B-21 (next generation bomber), next-generation ICBMs as well as a smaller supplier to the next generation of nuclear submarines. Northrop has a cyber business and is also a major player in space operations which is increasingly important due to the critical nature of satellites and other space infrastructure. In 2018, Northrop completed the $9.2B acquisition of Orbital ATK bolstering their space business and helping NOC win the ICBM contract. While the F-35 program has faced criticism over costs, many analysts believe that the B-21 program may see orders expand over time (See B-21 Bomber link below).
I believe the critical nature of Northrop’s programs reduces the risk that the business will suffer negative consequences if defense budgets were pressured.
Economic Moat – Can they Protect Profits?
Defense companies have wide moats for several reasons.
The first is that the industry structure has supported specialization and consolidation. The US Government awards a contract to the winning bid for a certain project. Let’s use the F-35 as an example. Lockheed Martin is the prime contractor on that and in the process develops specialized technology that will help them win successive contracts that benefit from the same technology. Lockheed also served as the prime contractor to the F-22 Raptor which was the predecessor to the F-35. Northrop won the contract for the new bomber program, dubbed the B-21 Raider. They also made its predecessor, the B-2A Spirit. The incumbent does not always retain superiority (Boeing used to have the advantage in both categories with the F-15 fighter and the B-52 bomber) but the incumbents generally seem to have an advantage. Part of this reason is that programs last decades so specialized engineering talent should concentrate to the winning suppliers. The prime contractor does tend to subcontract out parts of the program to other defense companies, for example the F-35 fuselage currently makes up 7% of Northrop’s revenue. Once the technology is developed, contracts go from cost-plus to fixed price which carry a higher margin profile. The company churns out said widgets until something better is developed, usually decades later and often by the same company. These business dynamics allow multiple defense contractors to consistently earn high returns on invested capital for long periods of time.
Another source of economic moats originates from security clearances. More than 30% of Northrop’s revenue currently comes from programs that are classified which is largely driven by the Aeronautics and Space business lines (see Northrop business summary slides link below). Some of the remaining revenue comes from programs like the B-21 Raider (currently 5% of revenue but a large source of future growth) that is so protected that it will not be made available for export to US allies. Given this level of importance, the US Government tightly controls who can and cannot work on these projects. Along with specialized technology and large sums of capital needed, security clearances pose a large barrier to entry for any potential new competitors.
Over the past 5 years, Northrop has averaged a 13.6% ROIC (Source: Financial data and analytics provider FactSet). This is not an astronomical number but it is attractive and I would argue much more predictable than most businesses.
Below is a short summary of Northrop’s capabilities and where they get their revenue (source: Northrop Grumman Overview)
Governance - Can we Trust Management?
Most defense companies seem to have well-aligned incentives and reasonable management teams. Most of these companies have no concerning related-party transactions. They also generally employ some sort of ROIC-type metric as part of their long-term executive incentives.
I am particularly impressed with Northrop’s ability to use capital allocation to align their business with US Military priorities and enhance their ability to win new important contracts. They sold their IT services division but notably kept the cyber operation. Northrop spun off Huntington Ingalls years in advance of this year’s military budget request which hinted at de-prioritizing surface ships such as aircraft carriers in favor of deterrence (read as nuclear triad). The acquisition of Orbital ATK was so savvy that Lockheed complained about it being anticompetitive as it put Northrop over the edge to win the new ICBM program which will be a source of cash flow for decades. This series of capital allocation moves began under former CEO Wes Bush (2010-2018) and appear to be continuing under Kathy Warden (2018-present).
Valuation – Is there a Margin of Safety?
For this exercise, I am using a DCF (Discounted Cash Flow) analysis starting with FCFF (Free Cash Flow to the Firm).
Industry level top-line assumptions
To calculate a baseline expectation for top-line growth, I used NATO countries as a proxy for NOC’s addressable market. I compiled the NATO country defense from Statista (link below). The weighted average spend for those nations in 2020 was 1.76% of GDP (ex-US) while the USA was at 3.87%. I assume that by 2040, the USA will creep up to 4% of GDP while NATO (ex-US) reaches its 2% target. I also assume that nominal GDP grows at a 4% CAGR (Compound Annual Growth Rate) over that period. In total, NATO’s military spend should grow at a 4.27% CAGR. I then assume growth consistent with nominal GDP beyond 2040. This baseline expectation provides a neutral revenue growth number. My analysis is not granular enough to predict line by line and I believe that is possibly too difficult over a very long period. So instead, I am focusing on the company’s business line and how important I perceive it to be in future military budgets. If I think the category is going to take share of the budget over time, I project growth north of 4.27% and vice versa.
Other Assumptions and Considerations
I believe in being conservative in assumptions that are not a part of my core thesis.
WACC (Weighted-Average Cost of Capital) – According to FactSet, NOC has a WACC of 4.89%. However, that is reliant on a 10-year Treasury at 1.57%. I am not comfortable with the idea that rates will stay that low forever, so I’m using a WACC of 7%. In other words, I am assuming a 10-year Treasury at 3.68% which is historically low but much higher than today’s figure.
Tax Rates – I expect the US corporate tax rate may increase at some point, so I don’t want to build my valuation off of today’s figure. I assume a tax rate of 30%, which is typical of where the company typically sat prior to the recent US corporate tax cuts.
CAPEX and D&A – I am assuming these are consistent with the past 10 years as a % of revenue. This should prove conservative because the company is finishing a heavy CAPEX cycle in part from the B-21 program.
Pension – I assume an additional $300M each year to the pension
Segment Operating Margins – I am using historically conservative operating margins on an operating segment basis because the revenue growth assumptions are segment by segment. From 2011 to 2020 that figure ranged from12.51% to 13.87%. My analysis assumes it stays at 11.32% or lower. Currently those margins are being pressured a bit because of the high level of cost-type contracts associated with development work. As programs move from development to production (and fixed price), the mix shift should improve NOC’s margin profile. However, I wanted to be conservative here in case political pressure makes future margin profiles less attractive.
Northrop Base Case
My base case scenario assumes that Northrop gains share in the industry due to what I perceive to be an enviable position in prioritized programs as discussed above. My segment level growth assumptions lead to consolidated revenue growth around 5% through 2040 and 4% thereafter. Fair value is $581.43 leading to margin of safety of 36%
Northrop Key Programs Slump Case
This scenario lowers the growth rate in the space and aerospace segments to 3.75% from 6.75%. This is where the ICBM and B-21 Bomber revenue is reported. If the B-21 flight tests run into problems and/or the ICBM program runs into political hurdles, the growth rates of those segments would come under pressure. Consolidated revenue growth through 2040 would thus fall below 4%. In this scenario, I also reduced the terminal growth rate to 2%. I believe this to be a relatively bearish scenario, but still the fair value is $337.29 which is less than 10% the price of $372.47 as of 06/25/2021.
Northrop Bear Case
This scenario lowers the growth rate which would test the idea that perhaps the pundits are right and military spending will shrink as a % of GDP. In this scenario, I have revenue growth in the mid 2% range through 2040 (and 2% thereafter) and the stock valued at $281.95. I suppose it is possible to imagine a kumbaya-type worldpeace scenario that is more draconian (for NOC) but I am trying to be a realist.
Expected Value Weighted by Probability
I like to test my valuation using these scenarios by thinking about my probability of being correct relative to other modeled scenarios. If I have a 50% chance of being correct vs a 25% chance on the other two modeled scenarios, I still have a valuation of $445.53 and a margin of safety at 16%. This is not much, but I’m comfortable with this considering the layers of conservative assumptions used in the process. I also like to try and estimate what the current market price may be implying to test my conviction. Based on this analysis, the market price implies I have a roughly 25% chance of being correct. This exercise gives me confidence that my views are not priced into the current market price and that there is sufficient upside in the stock given my view of the company’s prospects.
Risk
While I attempt to capture risk within my valuation framework, the greatest risk is often in the unknown. I foresee the greatest risks to this investment to be potential troubles in some of their major programs like ICBM or B-21 and a potentially weak military budget environment. However, it is possible there are holes in my thesis I have not yet found that could materially depress the intrinsic value of the company. Do your own homework prior to investing.
Further Reading/Sources
Charioteer Investing on NOC - https://charioteerinvesting.com/northrop-grumman-noc-three-for-me/
Contrarian Edge article on defense stocks - https://contrarianedge.com/us-and-china-in-the-foothills-of-cold-war/
Macrotrends.net - https://www.macrotrends.net/countries/USA/united-states/military-spending-defense-budget
Statista - https://www.statista.com/statistics/584088/defense-expenditures-of-nato-countries/
FRED (budget data) - https://fred.stlouisfed.org/series/FYFSGDA188S
Perspective on US Budgets https://www.thebalance.com/us-deficit-by-year-3306306
FY2022 White House Discretionary Budget Request https://www.whitehouse.gov/wp-content/uploads/2021/04/FY2022-Discretionary-Request.pdf
Taiwan as Flashpoint - https://www.economist.com/briefing/2021/05/01/chinas-growing-military-confidence-puts-taiwan-at-risk
B21 Bombers - https://www.thedrive.com/the-war-zone/40803/plan-to-buy-145-b-21-raider-bombers-gets-endorsement-from-biden-air-force-nominee
ICBM - https://spacenews.com/northrop-grumman-clears-first-design-review-of-next-generation-icbm/
Northrop Schedule14A - https://investor.northropgrumman.com/node/37926/html
Northrop 10K - https://investor.northropgrumman.com/node/37626/html
Northrop Business Summary Slides - https://investor.northropgrumman.com/static-files/a70ef0fd-6777-4ec2-95bc-e5493387a76d
In Summary
At Aurora, we are constantly looking for “the right pitch” in our sweet spot where we believe the probabilities are in our favor. This blog represents our thinking at the time of publication. By the time you read this, our opinion may have changed. If you are a DIY investor, use this only as a starting point for your research and be sure to do your own due diligence. For questions regarding our individual stock strategies, please reach out to us!
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.
