Northrop Grumman (NYSE:NOC), a leading defense contractor, is poised for substantial growth in the coming years thanks to its involvement in two major programs, the Ground Based Strategic Deterrent, and B-21 bomber. NOC’s space segment, which dominates in rocket motor production following its acquisition of Orbital ATK in 2019, is also a key contributor to its success. However, due to political factors, NOC’s reliance on funding from the US military makes its future uncertain. In this article, I will delve into the four segments of NOC that have strong competitive advantages and will provide a valuation of NOC. Despite NOC’s promising future, I believe that the current share price is fair.
NOC is a company that specializes in providing defense-related products and services. They are involved in large military development projects, and their aerospace division produces both autonomous and piloted aircraft, including the F-35 program, Global Hawk drones, and the B-21 bomber. Their defense systems branch focuses on artillery and missile ammunition, guidance systems, missile defense systems, and aircraft maintenance and upgrades. Their mission systems team creates and integrates various platforms’ radar, navigation, and communication systems. Finally, their space systems division produces satellites, sensors, space structures, long-range missiles, and rocket motors.
NOC’s rocket motors segment is dominant despite not being the most profitable. This is due to the increasing demand for rocket motors, with Amazon’s Kuiper and the US Air Force’s Ground Based Strategic Deterrent program being key programs for NOC. The space systems segment possesses a wide moat. This is due to its long-term contracts to manufacture the United States’ Ground Based Strategic Deterrent and the acquisition of Orbital ATK in 2019, which has a highly worthy area of expertise in solid rocket engines. The technical complexity of military-grade satellites is a significant barrier to entry for most competitors, despite growing interest from commercial companies like SpaceX and Amazon (AMZN).
Additionally, replacing custom products already in orbit is extremely difficult, resulting in substantial switching costs for the military. The mission-critical nature of the military’s reliance on satellites for intelligence gathering and secure communication means significant switching costs are associated with these products. The complexity and mission-critical nature of products like the James Webb Space Telescope, which NOC built for NASA, exemplify this.
Defense contractors earn significant profits due to regulated margins, long-term revenue visibility, and customer-paid R&D. The United States has consistently increased its military budget in recent years, with expenditures rising from $648 billion in 2017 to $817 billion in 2023. This trend can be attributed to various factors, including geopolitical tensions, the militarization of space, and ongoing development efforts related to the B-21 bomber. However, I don’t expect much growth in this industry as defense budgets depend on a country’s wealth and perception of danger.
The defense industry has tens of thousands of contractors, including small businesses, with prime contractors sourcing from smaller subcontractors, suppliers, and each other. Large defense contractors have significant intangible assets, such as product complexity, long product cycles, contract structures, and switching costs. These assets act as a barrier to entry, making it hard for new companies to compete.
Product complexity is the main intangible asset, requiring specialized expertise that lacks commercial viability outside of the defense industry. Developing a military program is a long and expensive process with significant sunk costs, including developing a workforce with the required experience and security clearances and developing a prototype to pitch for a contract. The defense industry’s contract structure is the second key intangible asset that enables incumbent firms to generate excess returns, making it hard for new entrants to compete.
Switching costs for military customers are high due to mission criticality, extended product cycles, a lack of alternatives, and the significant investment required to switch suppliers. The defense systems segment has a wide moat due to technical complexity and high cost of failure, making it difficult for competitors to enter the market.
In the manned aircraft subsegment, NOC is the sole supplier of Lockheed’s F-35 fuselage, which is a highly prioritized, long-term program. The development of stealth aircraft is a complex process, and the already-awarded production contracts act as significant barriers to entry for potential competitors. Additionally, switching costs in this segment are generally high due to prolonged product development and procurement cycles, potential catastrophic losses from product failure, and the challenge of creating a viable alternative.
This segment also has a wide moat due to the technical complexity of the products, preventing new entrants from developing competing products. Additionally, I believe switching costs arise from the high cost of failure and the tight integration of these products into long-cycle platforms. This segment’s products mainly comprise high-end sensors on military vehicles for surveillance, targeting, and navigation purposes. While technical know-how protects these products, I believe switching costs are a more powerful moat source because these sensors need to work flawlessly for the military to achieve its objectives. Although these products can be updated relatively quickly, their integration into long-cycle products like fighter jets, ships, and other vehicles would require the customer to invest a significant amount of time beyond that needed to develop a competing product to switch to another provider.
Demand for F-35 and B-21 bombers to remain strong
The demand for advanced military aircraft such as the F-35 and B-21 bombers remains high. NOC’s plant in California is currently in various stages of producing five B-21 Raider bombers for the US Air Force. Also, the latest defense budget proposal would have the Department of Defense appropriating $3.25 billion for the B-21 in FY23. That’s compared to FY22, when the Air Force received $2.87 billion – a $320 million increase.
I used a DCF valuation method and considered a cost of capital of 7.6% along with an unlevered beta of 1.23 for the Aerospace & Defense industry to arrive at a share value of $456. My forecast predicts a 4% revenue growth in the medium term, primarily from existing programs, with a slowdown in growth thereafter. I also anticipate a minor improvement in margin due to the maturity of the Ground Based Strategic Deterrent program. These are my key assumptions:
Compared to the guidance provided by NOC, my assumptions are towards the lower end of that range.
At $456 per share, the shares would still be trading at a significant discount to Lockheed Martin (LMT) at 10.7x compared to LMT’s 15.5x multiple.
However, I believe that this discount is justified due to LMT’s higher return on invested capital than NOC. Although there are brief moments when NOC’s EBITDA margin is higher than LMT’s, NOC’s return hardly surpasses that of LMT’s. This is because LMT appears to be better at allocating capital and generating more revenues from it.
The defense budgeting and the sales process are susceptible to political wrangling, which can delay approval of the budget, affecting NOC’s ability to plan and execute existing contracts. Although defense spending has recently increased, defense budgets remain vulnerable to these risks. Execution risk arises from the aftereffects of COVID-19 on the supply chain and labor market. Due to production issues and supply chain disruptions, NOC may face challenges in meeting deadlines or contractual obligations, which could affect costs and customer relationships. While fixed-price contracts are generally reserved for mature programs, NOC bears the financial risk of cost overruns, making poorly executed development programs a financial risk for NOC.
Defense contractors have an advantage in that their business cycle is not tied to GDP, which provides stability. The defense industry does carry some risks, but factors such as high product complexity, long product cycles, and switching costs create significant barriers to entry, giving NOC a wide moat in its business segments. However, uncertainties related to political factors and NOC’s dependence on funding from the US military raise concerns about its future. Overall, I believe that the shares are priced fairly.