Northrop Grumman: Priming For Offense When It’s Not Needed
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Summary:
- Geopolitical tensions may temporarily benefit defense stocks, but technological ties and political strategies under Trump’s leadership could deflate risk and limit long-term growth for Northrop Grumman.
- While revenue growth is forecasted, Northrop Grumman’s EBITDA margin constraints and current overvaluation suggest limited return potential, making it a Hold with just a 3.5% annual total return.
- Global conflicts pose both revenue and contraction potentials for defense contractors; however, the Middle East alone lacks the scale to boost defense stocks if tensions ease between world powers.
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It may seem appealing to buy defense stocks at the moment, given the heightened geopolitical risk profile in the Middle East, Ukraine, and surrounding Taiwan. However, if the U.S. continues down the path of technology-backed, Musk-led, and Republican-governed Western relations, the current geopolitical risk climate is likely to deflate. While certain segments of the military-industrial complex may be girding for war, a large and powerful cohort of various industries and politicians are working against these interests. Despite strong recent price returns, my forward-looking analysis of Northrop Grumman (NYSE:NOC) tells me that the investment is currently a Hold.
Macroeconomic Analysis: War and Peace Are Both Bad for Defense Contractors
Since February 2022, when the Russia-Ukraine war broke out, we’ve seen 30,000 civilian casualties reported. Moreover, an estimated 14.6 million people require humanitarian assistance. The Pentagon estimates over 600,000 Russian casualties, including killed or wounded personnel. In October 2024, a U.S. official estimated that more than 57,500 Ukrainian soldiers had been killed and 250,000 wounded. The truth is, the death toll is almost impossible to verify. Indeed, Putin told reporters in June that Ukrainian losses are five times higher than Russia’s, with Kyiv losing at least 50,000 service personnel a month. Following Trump’s election victory, he has reportedly communicated with both Putin and Zelenskyy, urging Putin not to escalate the conflict and discussing peace resolutions with Zelenskyy.
Moreover, while tensions around Taiwan remain high (even with an impending Trump presidency), we are less likely to see outright hostility from Trump, who is more known for a transactional approach to international relations. Chinese President Xi Jinping has extended his congratulations to U.S. President-elect Trump following his recent election victory. Xi emphasized the importance of China and the U.S. finding the “right way to get along” in the new era. This sets a positive tone for the 47th U.S. president’s term, with a sentiment of cooperation and economic competitiveness likely to take precedence over military confrontation during the next four years.
That said, the conflict in the Middle East shows less potential for peaceful resolution. Trump has emphasized the need for Israel to end the war in the region quickly, though Trump is also renowned for a ‘maximum pressure’ approach to terrorism. This has raised concerns among Gulf states about potential escalations in regional tensions, especially as Netanyahu is committed to a staunch, effective and lasting retaliation against Hamas, even though the terrorist organization has offered a ceasefire plan with hostages released, which Israel has rejected because of associated security concerns.
This hot geopolitical climate has been good for Northrop Grumman’s business. In June 2024, Northrop Grumman finalized a co-production agreement to manufacture medium-caliber ammunition in Ukraine, becoming the first U.S. defense company to establish such a partnership with Ukrainian borders during the ongoing conflict. In addition, the world’s largest aerospace and defense companies, including Northrop Grumman, are projected to nearly double their combined cash flow of $26 billion in 2021 to $52 billion by 2026 as a result of the surge in government orders amid heightened geopolitical tensions.
However, girding for war may be good for defense contractors, but war often is not. An analysis by the CFA Institute found that during major conflicts, such as World War I and World War II, the defense sector did not consistently outperform the broader market. Logistical challenges, supply chain disruptions, increased competition, and other hazards are bad for most businesses. In that respect, defense contractors need to make sure that they avoid actions that could inadvertently undermine their interests. Moreover, it would be wise for those elected to Western leadership positions to respect the multipolarity and diversity of governance structures in the world right now. With a Trump presidency and potential future candidates following in the footsteps of the current MAGA movement, we could see much less political international jousting from political candidates who are easily directed by the interests of the military-industrial complex. In any case, the long-term growth thesis of Northrop Grumman looks weak, both in an escalatory and deescalatory geopolitical environment. This is the foundation of my Hold rating for its stock.
Of course, as famously established by Ray Dalio, the greatest threat to global peace has been considered to be the economic decline of one empire (the U.S. currently) and the rise of another (China currently). However, it’s not so clear that the U.S. is certainly going to decline, nor that China will inevitably take the position as the predominant global superpower. Instead, it appears more likely that we are growing into an economy where the balance of power will be largely equilibrated. The United States currently has a general government debt equating to about 121% of the nation’s GDP. On the other hand, China has a general government debt that is estimated to be approximately 90% of its GDP. This is why Musk’s support for Trump and Trump’s willingness to allow Musk to mitigate the U.S. Federal budget is so crucial. Indeed, this may be the fundamental component to engendering international economic order without war. As the backing of the current Republican Party is so strong, and Musk has mentioned he will support future political candidates, this activist investment within the U.S. government shouldn’t be underestimated. Indeed, based on my analysis, the result is likely to be bad for business for defense contractors.
Valuation Analysis: The Company Is Overvalued Even in the Current Beneficial Environment
Turning to the financials, even if the company delivers the growth indicated by the consensus estimates, the investment is still not appealing right now. The company’s five-year average annual revenue growth rate is just 5.09%. Given my macroeconomic analysis above, I will be using 4.5% as its annual revenue growth rate for the next five years. With a total revenue of $41.3 billion in December 2024, this then increases to $51.47 billion in December 2029, based on my growth estimate.
The company has a five-year average EBITDA margin of 16.4%, but it is currently lower, at 10.9%. Management has noted in recent earnings calls that shifts toward lower-margin programs and challenges executing certain projects have adversely affected overall margins. That said, it’s reasonable to assess that the business will experience some relief from this in the medium term, so my estimate for its EBITDA margin for December 2029 is 14%. Therefore, I estimate that the company will have an EBITDA of $7.21 billion.
The company’s 10-year median EV-to-EBITDA ratio is 11.6, but it is currently 19.44, partially due to its low EBITDA margin at the moment. Its five-year average forward EV-to-EBITDA ratio is 14.6, and given slightly slower revenue growth moving forward than historically, an EV-to-EBITDA ratio closer to its 10-year median seems valid to me. Therefore, I will be using a terminal multiple of 14. Therefore, my December 2029 enterprise value estimate for Northrop Grumman is $100.94 billion. As its current enterprise value is $91.84 billion, this indicates a five-year CAGR of just 1.91%. The company also provides a forward dividend yield of just 1.55%, making the annual total return likely just 3.5%, based on my analysis.
Northrop Grumman’s weighted average cost of capital is 4.11%, with an equity weight of 82.24% and a debt weight of 17.76%, with equity costing 4.327% and debt at 3.5716% after tax. When discounting my forecast of the company’s 2029 enterprise value of $100.94 billion back over five years at a discount rate of 4.11%, equal to its weighted average cost of capital, the indicated present-day intrinsic value is $82.53 billion. This reveals a -10.14% margin of safety.
Contrarian Analysis: Global Tensions Could Still Escalate, With Long-Term Risks in the Middle East
With the potential withdrawal of U.S. support for Ukraine, new evidence suggests that Ukraine may be able to quickly develop nuclear weapons. A study for the Ukrainian Ministry of Defense indicates that Ukraine could construct a device similar to the ‘Fat Man’ bomb using plutonium from its nuclear reactors. The report also outlines the legal basis for Ukraine to withdraw from the Nuclear Non-Proliferation Treaty due to Russia’s violations. This development could intensify tensions with Russia and may inadvertently prompt a more aggressive Russian military response if Russia believes the U.S. will not intervene.
Conditions in the global order remain delicate, so it is not unlikely that tensions will continue to escalate and defense revenues may increase in the near term. Nonetheless, I am hopeful for a peaceful resolution in Ukraine, which would require diplomatic cooperation among Trump, Zelenskyy, and Putin. Any non-compliance from one party, either covertly or overtly, could worsen conditions. While Ukrainian nuclear weapons could pose a threat to global order, they could also serve as a deterrent to Russia. Based on my analysis, Ukraine is likely to remain an independent country (excluding the territories currently held by Russia) following a potential peace deal under a Trump presidency.
Building on this Foreign Policy article, I believe part of the reason for the West’s insistence on NATO expansion to include Ukraine was that the country does not have nuclear weapons right now. The U.S. pushed for Ukraine to give up its nuclear weapons in the mid-1990s. It’s a fair analysis to accept that either Ukraine must be welcomed into NATO or Ukraine will develop nuclear weapons, withdrawing from the Nuclear-Proliferation Treaty due to conditions of the Russia-Ukraine war. Either one of these outcomes creates a reason for concern, but ironically, it is the former, Ukraine’s addition to NATO, which would arguably be the greatest threat to Russian-American relations in the medium term, given that this crosses a line firmly outside Putin’s tolerance.
When looking at Taiwan, I do find an invasion from China unlikely. While the U.S. is weaponizing TSMC (TSM) by not allowing the company to export advanced semiconductor chips to China, China is developing its own powerful domestic semiconductor manufacturing ecosystem. Moreover, an invasion of Taiwan by China would essentially render TSMC inoperable, and a global depression would ensue. This would be counterproductive to China’s economic success, as well as destructive to the West (it would also most likely be the defining catalyst beginning World War III, in my opinion). From my research, I also feel quite certain that Xi Jinping does not have these hostile intentions to the West. While he may be heavily invested in his country’s defense and protecting his position in the new multipolar order, this can be navigated peacefully with the correct leadership in the White House, which I believe Trump will be. That said, if such an invasion does happen, I expect defense companies to get a short-term revenue boost but face long-term contraction due to the associated macroeconomic disruptions, as I outlined in my macroeconomic analysis above.
The one area where defense contractors could continue to perform well in the medium term to long term is in the Middle East, as the threat from terrorism is difficult to solve with economic factors and diplomacy. Yet, this region of conflict does not have the scale needed to attract heavy investment into defense companies, reaffirming my Hold rating.
Conclusion: Hold
A Trump presidency should be good for international relations, and based on my analysis, we are likely to see a heavier investment from the technology industry into political candidates moving forward to keep up the momentum of the recent Republican win. I expect that over the long term, such war-averse candidates in U.S. politics will be bad for the defense business, and given that Northrop Grumman is overvalued even on a five-year basis, it is certainly worth no more than a Hold rating at this time.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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