I'd really like to like Northrop Grumman stock after its strong Q2, but the stock simply costs too much to buy.
One week after reporting earnings, General Dynamics (GD 0.76%), which saw its stock initially slump despite reporting strong sales and earnings growth, is just about back to where it started with its shares trading a few dollars below $300. That same one week after reporting earnings, though, Northrop Grumman (NOC -0.26%), which also reported strong sales growth, is seeing its stock up 10% and approaching $500 a share.
What's the difference between these two defense stocks? Three words: book-to-bill. Let me explain.
Northrop Grumman's second-quarter win
In almost every other respect, Northrop's performance mimicked General Dynamics' in the second quarter. Sales at the former grew a respectable 7% to $10.2 billion, and earnings per share rushed ahead 19% to $6.36. Free cash flow soared 80% year over year, to a strong $1.1 billion.
Unlike General Dynamics, which saw mixed revenue trends (some units growing in size, others shrinking), Northrop's four big divisions all grew revenue last quarter. Sales grew slowest in its newest (but already biggest) business, space, up 2% to $3.6 billion.
The company's second-biggest business, aeronautics -- which is building the Air Force's new stealth bomber among other things -- grew much faster at 14%. Defense and mission systems, the two smallest units, posted revenue growth of 7% and 5%, respectively.
Operating profit margins increased at space and defense, while falling a bit at aeronautics and mission systems. But with revenue growing across the board, that didn't matter much. Northrop's profits overall surged strongly.
What the future holds for Northrop Grumman
All that bodes well because the single biggest differentiator between General Dynamics' second-quarter earnings and Northrop's was the fact that General Dynamics took in fewer orders in the quarter than it recorded as revenue. In other words, it isn't currently booking enough new contracts to replace the old ones it has fulfilled -- its book-to-bill ratio. That metric was an anemic 0.8 in the quarter, implying that future sales growth will probably slow at the Northrop rival.
In contrast, Northrop posted a strong 1.5 book-to-bill ratio in the second quarter. For every $1 worth of backlogged work that was converted into revenue, the company signed $1.50 worth of new contracts. And this implies that as fast as sales grew in the second quarter, they will grow even faster in the future.
Recognizing this, management raised its sales guidance for the rest of this year, forecasting revenue of roughly $41.2 billion in 2024. It also hiked its operating earnings forecast to more than $4.3 billion and said adjusted earnings per share could exceed $25 this year. (Northrop left its free-cash-flow outlook unchanged at about $2.5 billion, however.)
Is Northrop Grumman stock a buy?
What this means for investors depends on how long Northrop's growth spurt will last. On the one hand, $25 a share in net profit this year would be a big improvement over 2023's earnings of just $13.53. Still, with the stock trading near $500, this implies a current-year price-to-earnings (P/E) ratio of about 20 -- not terribly expensive, but also not compellingly cheap.
A strong book of future business implies that earnings will continue growing in the near term. But at last report, analysts polled by S&P Global Market Intelligence are still forecasting 10% or less in annual earnings growth for Northrop over the next few years, which suggests little confidence that the second quarter's strong book-to-bill ratio has legs.
I'm also not particularly enthusiastic about the stock's price/earnings-to-growth (PEG) ratio. A 20 P/E with about 10% growth implies a PEG of about 2.0 (or twice what one would ordinarily consider an attractive number).
Add in the fact that free cash flow at Northrop is only $2.5 billion, and my final worry is that -- as good as Northrop's earnings might look this year -- they're not being backed up by enough cash production to feel real. With a market capitalization of $72 billion, and about $15 billion more debt than cash on its balance sheet, this stock's ratio of enterprise value to free cash flow is already pushing 35, which seems very expensive to me if 10% growth is the best Northrop can muster over the next few years.
Ultimately, despite the strong performance in the second quarter, I'm not inclined to buy Northrop Grumman at current prices.
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.
