No Good Deed Goes Unpunished at Northrop Grumman, as Cost Improvements Cut Profits in Half

Northrop Grumman (NYSE: NOC) stock is in a funk. With the company reporting earnings on Tuesday, the stock promptly tanked 12.6%. Rebounding briefly on Wednesday, Northrop then proceeded to resume sliding a day later before bouncing again on Friday.

Northrop Grumman Q1 earnings

It's not hard to guess why. Year over year, Northrop Grumman suffered a significant slide in sales as two of its business segments -- its two biggest business segments, aeronautics and space -- saw sales weaken by 8% and 18%, respectively, in the first quarter. Modest gains in the company's other two, smaller businesses of defense and mission systems weren't enough to keep sales stable.

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Total sales across the company fell 7%.

Operating profit at the defense company declined as well. Indeed, it was cut roughly in half, down 46% at $573 million for the quarter. Operating profit margins shrank 450 basis points to just 6.1%. Earnings per share tumbled 47% to just $3.32 per share, and free cash flow ran negative to the tune of $1.8 billion.

What went wrong at Northrop

So it was pretty much miserable news all around. Most pundits focused on a single aspect of the news, the 18% fall-off in sales at the company's space business. Northrop blamed the decline on the "wind-down of work on the restricted space and Next Generation Interceptor (NGI) programs, which reduced sales by $228 million, as well as decreases for Commercial Resupply Services (CRS) missions, Space Development Agency (SDA) satellite programs and other restricted space programs."

That's a pretty big list of programs responsible for the decline, though. It might have taken less time for Northrop to list space programs that were not responsible!

On the plus side, at least profit margins on the sales Northrop did make in space inched higher, rising 50 basis points to 11%. Also, it's worth pointing out that despite all its troubles, Northrop still managed to earn $283 million in operating profit from its space work. That's not as much as it earned a year ago, but it's still a decent number.

To my mind, therefore, Northrop's bigger issue in Q1 wasn't its space business at all, but rather its aeronautics division -- the business segment responsible for building Northrop Grumman's new B-21 stealth bomber.

Image source: Northrop Grumman.

B-21: No bingo, no bueno!

Northrop has been doing tremendous work on the B-21 project, which has been praised by defense market analysts and the U.S. Air Force alike for its "smooth progress" and for "coming in under budget" -- a rarity in defense contracting. Indeed, by some estimates the B-21's looking likely to cost taxpayers as much as 28% less than it was originally forecast to cost.

That's great news for taxpayers. It's unfortunately turning out to be less-great news for Northrop Grumman shareholders, however, at least in the short term. Explaining why its profits got cut roughly in half last quarter, management said, "The loss [for Northrop's aeronautics unit, not for the whole company] largely relates to higher manufacturing costs ... from a process change made by the company to enable an accelerated production ramp, as well as increases in the projected cost and quantity of general procurement materials."

In other words, parts and materials needed to build the B-21 cost more in the quarter, and Northrop didn't pass those on to the government. To the contrary, Northrop made efforts to drive costs down further, and accelerate production -- and ate those costs, too!

Is Northrop Grumman stock a buy?

So basically, Northrop Grumman took one for the team last quarter. Should its stock be punished for that? Not necessarily.

Look, I've made no secret of the fact that I'm not thrilled with the valuation on Northrop Grumman stock. Like many other defense stocks, I think Northrop stock costs too much. Although its valuation has shrunk over the course of this year's slow-burn sell-off, Northrop Grumman stock still sells for nearly 1.7 times trailing sales, more than 18 times earnings, and a staggering 37 times free cash flow, according to data from S&P Global Market Intelligence.

Northrop's also guiding for low-single-digit sales growth this year (just 2% or 3%), and for less profit than Wall Street wants to see (perhaps as little as $25 per share).

Still, Northrop's space business remains profitable. Its defense business is working hard to ramp production on the B-21, and performing in a manner that's likely to endear it to cost-cutters in the Trump administration. If there's any fairness in the world, that should translate into additional contract wins for Northrop as it proves itself to be the rare defense contractor that knows how to deliver cutting-edge products on time and on (or even under) budget.

If you liked Northrop Grumman stock before this week's sell-off, and weren't scared off by the pricey valuation then, I don't necessarily think you should sell it now that it's nearly 12% cheaper, just because it's making investments to do its job even better and more efficiently in the future.

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