Is Northrop Grumman’s New Space Division Eclipsing Earnings?

Defense giant — and now space giantNorthrop Grumman (NYSE: NOC) reported earnings on Wednesday last week, and by most yardsticks you’d have to say the quarter was pretty successful.

Both sales and earnings for Northrop’s fiscal Q2 2018 exceeded expectations. The company reported 10% year-over-year sales growth to $7.1 billion, where Wall Street had expected only $7 billion. Profits soared 24% to $3.93 per share, a dime ahead of estimates. Topping it all off, Northrop Grumman raised estimates for the rest of this year, and said it now expects to end 2018 with per-share profits of between $16.60 and $16.85 per share.

Granted , at the midpoint, that’s slightly below the $16.80 that Wall Street analysts said they were looking for. But it’s still in the ballpark, and Northrop confirmed it expects sales to come in at a cool $30 billion, which is right where Wall Street had placed its own bullseye. All things considered, it was a successful earnings report.

So naturally investors sold off Northrop Grumman stock by 7%, and kept on selling it through Thursday.

Profits from Northrop’s newest space division are still awaiting liftoff. Image source: Getty Images.

What’s up with that?

Yeah, that was kind of a strange reaction to some pretty good news out of one of the nation’s premier defense companies. So let’s see if we can figure out which nit investors might have been picking when deciding to sell the stock, shall we?

My best guess is that margins were to blame. Northrop Grumman earned operating profit margins of 13.5% in fiscal Q2 2017. This year, that margin took a 190-basis point beating, falling to 11.6%. That’s not an entirely surprising result. Northrop Grumman’s profit margins have been at historic highs recently, and were probably due for a rollback at some point after all. Plus, management had previously warned investors to expect no more than “high 11%” profit margins this year.

But even so, telling investors to expect a margin decline doesn’t mean that investors didn’t hope for better news. The confirmation that profit margins are indeed eroding probably explains at least part of investors’ reaction to the report.

On the other hand, another of Northrop’s promises that seemed to be getting fulfilled in Q2 was more positive. Last quarter, Northrop told investors it expected its free cash flow number to improve significantly off of the $1.7 billion generated last year, to anywhere from $2.3 billion to $2.6 billion in 2018. As it turned out, Q2 saw Northrop’s FCF number more than double off of Q2 2017 to $676 million. This strong result gave management enough confidence to raise the floor on its projection for this year’s FCF to $2.4 billion.

As far as growing cash profits goes, Northrop Grumman is ahead of schedule.

Introducing Northrop Grumman Innovation Systems

Speaking of schedules, Northrop Grumman finalized its purchase of Orbital ATK, now dubbed “Innovation Systems,” in June, and observed in its earnings release that it’s already on track to deliver a promised “$150 million of annual cost synergies by 2020.”

Rightsizing the workforce is expected to yield $50 million in savings as early as next year, in exchange for a $25 million investment in spending this year. But management originally said it expected it would have to spend $75 million to achieve its full targeted synergies.

That implies that moving from $50 million in savings next year to $150 million in savings by 2020 should require a further $50 million in investments in 2019 — essentially zeroing out the cost savings that will be purchased by this year’s spending. Long story short, investors won’t necessarily be able to see if Northrop has succeeded in reaping all the synergies it promised for 2020 until 2020.

Until then, Innovation Systems could prove a drag on margins. S&P Global Market Intelligence clocked Orbital ATK at 11.2% operating profit margins in the year preceding its acquisition. Since it’s joined Northrop, though, the company-formerly known-as-Orbital ATK has produced only 9.8% profit margins, below average for core Northrop and below what Orbital ATK had been producing independently as well.

The sooner those synergies that Northrop Grumman has been promising from this acquisition arrive the better.

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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.

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