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Morningstar | Non-Operational Items Pushing Northrop's 2019 EPS Down but Deeper Issues May Be Afoot, Trimming FVE

Normally, we'd chalk up Northrop's weak 2019 EPS guide to its typical conservatism, but it represents the fourth U.S. defense contractor to issue a 2019 earnings outlook below consensus. Northrop set its 2019 EPS midpoint at $18.75, which compares with consensus of $19.61. Although non-operational headwinds are impacting earnings, 2019 organic revenue growth that will lag peers and flat to slightly down margins are disconcerting. We plan to decrease our $320 fair value estimate by 5%-7% on the back of lower 2019 and 2020 growth coupled with slightly lower margins in our model.

Management is guiding to roughly 10% growth in 2019, implying $34 billion in sales. The full-year inclusion of the IS business (formerly Orbital-ATK) is driving about half of this growth, and we peg 2019 organic growth at about 5%. The F-35 continues to be a revenue driver, but its growth rate is decelerating. The $3 billion F-35 revenue figure management cited implies year-over-year growth in 2018 of around 30% per our estimates. Management anticipates F-35 to grow at a mid- to high-single-digit rate in 2019 and then only mid-single-digit growth during 2020. The other flagship program, the B21 bomber, will see flat revenue in 2019 versus 2018, but since the program is margin dilutive this should boost AS' margins slightly. Northrop's low- to mid-11% segment operating margin guide for 2019 means segment level margins will stagnate and could potentially fall. We were at 11.5% segment margins in 2019 going into the call, but we're planning to move this projection down slightly.

Net cash provided by operations rose $1.2 billion to $3.8 billion, but increasing capital expenditures ate up about $320 million of the cashflow growth. Northrop doesn't guide on cashflow, but going into earnings we were looking for $4.2 billion in 2019 operating cashflow. In 2020 management anticipates a working capital release, particularly in the new IS business, that should provide a year-over-year tailwind.

The company's 2019 EPS target of $18.75 came in below our forecast, and management noted the following headwinds for EPS this coming year: a less robust FAS/CAS tailwind ($2), a successful 2018 contractual cost claim that won’t repeat ($1), Orbital-ATK acquisition related costs (70 cents), and a higher tax rate (70 cents). Northrop’s operating businesses should add about $1.80 to EPS in 2019 relative to 2018.

Northrop also provided some guidance on capital expenditures. Management expects the absolute level capital expenditures to level off this year and then drop, hitting 2.5% of sales in 2021. We were forecasting this level of capital expenditures as a percentage of sales in 2022, so we're pulling forward our ramp down in capital spending, which should slightly offset our less favorable growth and margin outlook. Pensions were the other cash item that management spent time on during the call. Here Northrop anticipates required contributions of $90 million in 2019, $220 million in 2020, and $410 million in 2021. Northrop's executive team stressed that CAS less required pension funding should remain positive through 2021 and beyond.

Turning to the outlook for each business, Northrop sees AS revenue landing just above $13.5 billion in 2019 coupled with operating margins of at least 10.5%. Going forward we think operating margins will hover around 10.5% for AS, as a higher mix of development programs keeps a lid on profitability. IS margins will land in the mid-10% range per management guidance. Management anticipates mid-single-digit growth at the MS business, leading to revenue of $12 billion-$12.5 billion in 2019. The JRDC program with MDA and a classified ISR program have been weighing on growth in the MS business (knocking about $450 million of revenue off the 2018 top line) but these headwinds should subside in 2019. Northrop places its outlook for operating margins at MS at around 13% in 2019, which is flat versus 2018. In the TS business, 2019 sales are expected to land in the low $4 billion range with mid- to high-9% operating margins.

At the new IS business, which is essentially the Orbital-ATK acquisition, Northrop is forecasting sales at a little over $5.5 billion with growth being driven by a domestic sales increase of around 10% year over year. The IS guide implies flat revenue year over year and basically no margin expansion. Regarding the former, we're not that worried since we put the stagnant top line down to lumpiness in international sales, but the flat margin evolution is slightly more concerning. Northrop puts the lackluster margin evolution down to mix among other factors. We'll be watching IS operating profits closely to see if post acquisition cost synergies begin to come through.