EUR 850.00 For Business Accounts Only

Morningstar | Northrop faces near-term margin headwinds, but will continue to deliver solid growth and cash flow.

Under the leadership of CEO Wes Bush, we think Northrop Grumman's management has executed admirably, lifting operating margins from the midsingle digits in 2004 to 12.6% in 2017. Moreover, U.S. defense budgetary pressures have lessened, and we forecast U.S. defense spending to rise over the next several years under the Trump administration. Northrop operates four segments: aerospace systems, mission systems, technology services, and a new innovation systems segment that consists of the Orbital ATK acquisition. Aerospace includes manned (F-35, F/A-18, B-21, B-2) and unmanned aircraft (Global Hawk, Fire Scout) and space systems. Mission systems consists of radars, sensors, and systems for surveillance and targeting, including significant content on the F-35. Technology services provides cybersecurity, and IT solutions to government clients, as well as logistics and maintenance. The company has also expanded its footprint in satellites, launchers, and missile defense via its $9.2 billion acquisition of Orbital ATK, which closed in the second quarter of 2018. Orbital ATK will operate as a stand-alone Northrop unit called innovation systems. The B-21 bomber win (worth $80 billion) positions the firm on a lucrative contract. In addition, we think aerospace systems will return to growth rates above our defense budget forecast, owing primarily to the F-35 ramp. As evidenced by the recent withdrawal from T-X trainer, Northrop will increasingly focus on high-end platforms and does not see itself as a lower-cost manufacturer or a company willing to compete on price. Northrop was also recently selected as a finalist for the GBSD program to replace U.S. land-based nuclear missiles. An outright win on this program could boost our forecast.Despite accelerated growth, Northrop will face margin headwinds due to a mix shift toward cost-plus programs, which are lower-margin. Concomitantly, because of the Orbital ATK deal, share buybacks will not continue at the elevated levels of recent years, but we expect Northrop to remain profitable and generate cash while earning returns above its cost of capital thanks to its wide moat.