Northrop Grumman’s 8.4% return over the past six months has outpaced the S&P 500 by 6.7%, and its stock price has climbed to $507 per share. This performance may have investors wondering how to approach the situation.
Is there a buying opportunity in Northrop Grumman, or does it present a risk to your portfolio? See what our analysts have to say in our full research report, it’s free.
Why Do We Think Northrop Grumman Will Underperform?
We’re glad investors have benefited from the price increase, but we're cautious about Northrop Grumman. Here are three reasons why you should be careful with NOC and a stock we'd rather own.
1. Slow Organic Growth Suggests Waning Demand In Core Business
We can better understand Defense Contractors companies by analyzing their organic revenue. This metric gives visibility into Northrop Grumman’s core business because it excludes one-time events such as mergers, acquisitions, and divestitures along with foreign currency fluctuations - non-fundamental factors that can manipulate the income statement.
Over the last two years, Northrop Grumman’s organic revenue averaged 4.4% year-on-year growth. This performance was underwhelming and suggests it may need to improve its products, pricing, or go-to-market strategy, which can add an extra layer of complexity to its operations. 
2. Free Cash Flow Margin Dropping
Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.
As you can see below, Northrop Grumman’s margin dropped by 6 percentage points over the last five years. This along with its unexciting margin put the company in a tough spot, and shareholders are likely hoping it can reverse course. If the trend continues, it could signal it’s in the middle of a big investment cycle. Northrop Grumman’s free cash flow margin for the trailing 12 months was 4.4%.
3. New Investments Fail to Bear Fruit as ROIC Declines
ROIC, or return on invested capital, is a metric showing how much operating profit a company generates relative to the money it has raised (debt and equity).
We like to invest in businesses with high returns, but the trend in a company’s ROIC is what often surprises the market and moves the stock price. Unfortunately, Northrop Grumman’s ROIC has decreased significantly over the last few years. We like what management has done in the past, but its declining returns are perhaps a symptom of fewer profitable growth opportunities.
Final Judgment
Northrop Grumman falls short of our quality standards. With its shares beating the market recently, the stock trades at 17.6× forward P/E (or $507 per share). This valuation tells us a lot of optimism is priced in - you can find better investment opportunities elsewhere. Let us point you toward one of our top software and edge computing picks.
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