Sunday, November 8, 2009

Bravo Northrop

Northrop Grumman (NOC - $52.37) is on a roll.

The Northrop-built USS New York was commissioned on Saturday. The ship's bow "contains 7.5 tons of steel recovered from the World Trade Center and the ship is named in honor of the victims and heroes of the 9/11 terrorist attack."

If that were not enough, the company just announced the sale of its advisory services business (TASC) for $1.65 billion. One can imagine that government consulting is a growth industry and Northrop is selling while the market is hot.

What do you do when your stock is ridiculously undervalued? Northrop knows. In the process, they are putting on a clinic for wayward capital allocators.

NOC is using its cash to fund stock buybacks/dividends and engaging in transactions that will force the market to reevaluate. They have repurchased $650 million worth of stock year-to-date and the $1.1 billion in proceeds from TASC are earmarked for share buybacks too.

Northrop knows that you sell ancillary businesses in negotiated transactions (TASC was pursued by a number of private equity groups) and repurchase your shares when the investing public is ignorant of unrealized intrinsic value. Most companies choose the opposite approach, selling shares cheap and pursuing acquisitions at negotiated rates.

Our friends at Interdigital (IDCC) seem determined to horde cash and do just that! I sure hope they are paying attention to Northrop?!!?

Northrop has 321 million shares outstanding for a $16.8 billion market capitalization. This despite clear statements that structural free cash flow is between $1.9 billion and $2.4 billion annually.

Is Northrop really only worth 7 to 9 times free cash flow?

The company's underlying fundamentals may be obscured for those who don't look below the surface. There was a large goodwill write-off last year. Who needs those pesky cash flow statements anyway? This year, Northrop is filling a hole in its pension plan. For the first nine months of 2009, the company $800 million in discretionary contributions to its pension plans.

To be clear, none of this detracts from the long-term earnings and free cash flow potential of Northrop.

I'm frankly glad these issues are being put to rest.

Northrop could easily become an acquisition target. By cleaning up its balance sheet, selling off non-core businesses, and clearly illustrating its massive cash flow generation, they may actually be working towards that goal.

Northrop may actually be putting its shareholders first! Perish the thought. Still few investors seem to notice.

One exception: Bruce Berkowitz. Northrop is a top holding in the Fairholme Fund.

As a standalone firm, Northrop is worth at least $65 a share. In a takeover, Northrop will garner $80 or more. For obvious reasons, it is my favorite company in the aerospace/defense industry with strategic assets and enticing exposures to unmanned aerial vehicles and more.

Investors will come around sooner or later, but managers worldwide should start taking notes now.

CEO Ronald Sugar is leaving behind quite a legacy.

Disclosure: The author owns shares of Northrop and Interdigital.

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