Northrop Grumman Is a Space Company Now, and That's Good News for Investors

Seven years ago, Northrop Grumman (NYSE: NOC) embarked upon a bold experiment. Buying space company Orbital ATK, Northrop would transform itself from an aerospace company (with an emphasis on the "aero" part but only a tangential relationship to space) into a more balanced aerospace stock with equal parts aeronautics and space systems.

Initially, the experiment didn't go well. Orbital ATK had invested heavily in an OmegA rocket ship that Northrop hoped would give it a leg up winning Pentagon rocket-launch contracts, but within a couple years of buying Orbital, the U.S. Space Force declined to buy any rocket launches on OmegA, and the program was terminated.

Judging from last week's earnings report, however, Northrop has recovered from this initial stumble. Increasingly, it's also contributing to Northrop's profitability.

Northrop's Q3 sales and earnings

Let's start with the big picture. Reporting Q3 earnings last week, Northrop said that total sales grew 2% year over year to $10 billion, but earnings per share grew 13% to $7. None of the company's four main business divisions grew very much; mission systems was the fastest grower at 7%, and space revenues actually declined 3%. At the same time, though, space enjoyed a big increase in profitability, with operating profits rising 14% year over year (more than any other division).

Operating profit margins for Northrop's space business reached 12%, making it now Northrop's second most profitable business (after mission systems, which earned 13.8%). Combined, these two businesses now generate more than half of Northrop's total revenues, and produce its biggest profit margins besides. Aeronautics profit margins were 10.4%, and defense systems only 9.4%.

Northrop noted that it brought in $11.7 billion in new orders during the quarter, significantly outpacing quarterly revenue, and resulting in a book-to-bill ratio of 1.2. This implies that sales should rise in future quarters. What's more, Northrop noted that much of the new work is coming from mission systems and space, the company's two most profitable divisions, as well as from aerospace, the third most profitable.

Valuing Northrop Grumman stock

So while revenue growth was slow overall in Q3, Northrop's strong order intake implies that growth will pick up in future quarters. Growth specifically in the company's two most profitable businesses further implies stronger profits on that greater revenue. Bearing all this in mind, Northrop raised its guidance for the rest of 2024.

But did it raise guidance enough to justify buying Northrop Grumman stock?

Management anticipates that sales will exceed $41 billion this year across the company, implying a price-to-sales ratio of about 1.8 on the stock, and an enterprise value-to-sales ratio of about 2.2. Both of these numbers are above the long-term historical average for Northrop stock, however, implying the stock is richly priced.

On the plus side, Northrop raised guidance for operating profits to be more than $4.5 billion, and raised guidance for adjusted profits, too. Management now anticipates per-share earnings will be at least $25.65. It's hard to say how close that will be to the actual earnings as calculated according to generally accepted accounting principles (GAAP). But assuming the GAAP number is similar, this implies about a 20 times P/E ratio on the stock -- a bit expensive for 13% profit growth, but not unreasonably so.

Finally, Northrop also confirmed that it will grow free cash flow by more than 20% this year, to about $2.5 billion. That sounds good, until you realize that at a $73.9 billion market capitalization, it means Northrop Grumman stock currently costs nearly 30 times this year's free cash flow -- which seems quite a lot to pay for a defense stock, and more than the P/E would imply.

All things considered, I'd say Northrop shares look pretty pricey right now. None of the financial metrics I'm looking out really scream "cheap!" to me. That being said, I still hope to see the company grow its high-margin space business. With strong sales prospects as the company participates in the U.S. Space Force's multibillion-dollar PWSA missile defense system, and a promising partnership with Firefly Space to develop a pair of new space rockets, space will play an important role in Northrop's future.

I only wish the stock was a bit more of a bargain, so that I could buy into that 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.