Northrop Grumman

The US Navy selected Boeing over Northrop Grumman to develop its 6th generation carrier-based attack aircraft, to eventually replace F-18 models in the 2030s. The decision endorses Boeing's capacity to deliver next-generation fighters following the Air Force's selection of Boeing to build the F-47.

Why it matters: We thought Northrop had the upper hand in the competition, so the US Navy could diversify its supplier base, but Boeing managed to allay the military's concerns about its capacity to successfully run two fighter programs at the same time. Boeing's storied St. Louis facility, where it produces F-15 and F-18 aircraft (with Northrop supplying F-18 fuselages), will proceed to develop and presumably supply the F/A-XX and F-47 stealth fighters. Northrop, which hasn't built fighter aircraft from scratch since the 1990s, will, along with Lockheed Martin, continue its involvement in the F-35 program for decades to come and will likely develop yet-to-be announced unmanned companion aircraft for 6th generation air wings.

The bottom line: We trimmed our forecast for aerospace revenue at wide-moat Northrop and added these to Boeing's defense line. Our $630 per-share fair value estimate for Northrop Grumman is unchanged, with $10 per share of time value offset by the F/A-XX hit. Our fair value estimate for wide-moat Boeing increased to $254 per share from $246. At recent prices, shares of both firms (coincidentally) trade around 24% below our fair value estimates. Defense sector shares have traded downward since peaking as a group in mid-August, after Iran made conciliatory remarks about opening the Strait of Hormuz.

Coming up: Northrop has the option to appeal the Navy's decision, but we doubt the outcome will change if it does. We think it likely that Northrop ends up utilizing its specialized engineering and manufacturing capacity to participate in the F/A-XX program, for example, by building fuselages as it does today on F-35 and F-18.

Our fair value estimate is $630 per share, representing 21 times our 2026 earnings forecast and 16 times enterprise value/2026 estimated EBITDA. We forecast top-line growth averaging 5.1% in the next five years, mostly due to Northrop's existing commitments on early-stage programs such as the Sentinel strategic missile and the B-21 bomber.

We anticipate slightly improving margins over the medium term as the firm moves into more-profitable production contracts from development-stage programs and may achieve operating leverage on increased sales from overseas defense spending growth. We expect slightly improving margins in defense systems as the Sentinel matures, approaching the double-digit operating margins of Northrop's other segments. Altogether, even these fairly mundane forecasts result in significant growth of free cash flow to the firm (and, based on the company's appropriate distributions and sage investment policy, to shareholders) over the coming five years and beyond. The company has increased its dividends per share by 11% annualized over the past 10 years, and we foresee similar payouts in the future.

The company has maintained a relatively high capital expenditure as a percentage of sales over the last two years as it added capacity for the Sentinel. We don’t think Northrop will need to add capacity in perpetuity, though, and expect this ratio to normalize at 3% of sales, or 110 basis points below the trailing five-year average.

We think a below-average 7.1% weighted average cost of capital is justified for this steady business. Government funding ensures that Northrop's sales aren't dependent on GDP, and the company maintains a sound balance sheet.

We assign Northrop Grumman a wide Morningstar Economic Moat Rating due to its intangible assets and customer switching costs.

We observe that wide moats are prevalent in the defense industry. We believe significant intangible assets imparted by extreme product complexity thwart new entrants and switching costs that a risk-averse customer faces emerge from the mission-critical nature of the products, often decades-long product lifecycles, and prohibitive time and cost to switch suppliers. These dynamics prevail across Northrop Grumman’s business lines. The firm routinely earns returns on invested capital in the midteens, nearly double our 7.1% estimate of its cost of capital, and we forecast it to continue to do so for decades.

We believe incumbent firms are most eligible to service the military’s need to purchase arms (broadly defined). Arms production requires specialized expertise and usually lacks commercial viability outside of defense (aside from commercial aerospace), so new entrants would likely need to develop know-how from the ground up. We observe only a few capable incumbents in each major category of defense systems development. The SIPRI arms industry ranking further evinces limited competition: Lockheed Martin, Boeing, BAE Systems, RTX, Northrop Grumman, Airbus, and General Dynamics have remained the top six or seven global arms producers for the past 15 years.

Northrop Grumman makes a wide range of military vehicles, intelligence-gathering and communication systems, radars, sensors, and munitions. Product development ranges from years to decades, and if the military is dissatisfied with a product, it is much faster and easier to work with the existing contractor to fix it than to fund an alternative. We view the products with the longest procurement cycles like bombers and strategic missiles as the moatiest because they provide extraordinarily long-term revenue and profit visibility. We view short-cycle products such as defense IT contracting less favorably. Further, the military’s ability to succeed while protecting soldiers’ and civilians’ lives is contingent on these products working as intended, which we think protects proven suppliers from competition.

We believe that all four of Northrop’s business segments possess wide moats. Aeronautics has exposure to several highly prioritized long-cycle programs, particularly as the prime contractor on the new B-21 bomber and as the sole provider of fuselages for Lockheed’s F-35, both of which we anticipate will provide Northrop with decades of development, production, and maintainment revenue, as these aircraft are likely to remain in service through the 2060s. We are positive about the company’s leadership in military autonomous aircraft, which are more complex than commercial unmanned aerial vehicles. This is due to complex integration with military targeting systems and the need to carry heavy loads at high altitudes for long periods.

The missile subsegment of the defense systems business has long-term contracts to create the United States' new intercontinental ballistic missile, the Sentinel, which should remain in service until 2075. This missile business also has one of the moatiest parts of the acquired Orbital ATK: Solid rocket engines are a critical component for medium- and long-range missiles, and there are only two producers in the US. The only competitor in this area, Aerojet Rocketdyne, was acquired by L3Harris in 2023.

Though munitions are on the shorter end of the contracting lifespan, the products Northrop offers in its mission systems unit include upgrade kits and other integrations with long-lived platforms. Moreover, the maintenance portion of this segment represents the strong interplay between the technical complexity and switching costs sources of moat: The original manufacturer of a given system—Northrop's Global Hawk surveillance drones, for example—specifies the parts replacement and service intervals for maintenance of that system. This can only be performed by an approved provider, often several times over the service life of the program.

We think the space systems segment still has a wide moat. This segment produces complex satellites, sensors, and subsystems for launching satellites. Although cheap, reusable launch rockets have scrambled some of the math that drove demand for large, long-lived, "exquisite" satellites in high geostationary orbit, we think the technical complexity of military-grade satellites remains a stiff barrier to entry for all but a few incumbents. Further, because it is quite difficult to replace custom products that are in orbit, we think the military faces substantial switching costs and would want to see proven reliability before awarding a long-cycle product to an untested contractor. A case in point of the complexity and mission-critical nature of this segment's products (albeit in a civilian application) is the James Webb Space Telescope, which Northrop built for NASA. We would reconsider this segment’s moat rating if we saw new entrants making competitive bids on material military satellite contracts, which would surprise us.

Risk to Northrop Grumman’s economic moat exists in the possibility, however remote, of a significant lapse or error in its government contracting or production processes causing its exclusion from delivering key defense systems. More broadly, if a malfunction, breach, or vulnerability of one of the company’s systems jeopardized military readiness, security, or capability or caused casualties, it would represent a key product governance failure on the part of the company and could be seen as a breach of the moat if it led to exclusion from a major program family or suspension from federal contracting. Other than B-21 and Sentinel, which come close, no single program represents more than 10% of our forecast returns, so we see it as diversified enough and remote enough not to model it into our forecast.

Northrop Grumman has won the Sentinel and B-21 bomber programs, both of which should drive material top-line growth over the next few decades.

Northrop's space segment is the dominant provider of rocket motors because of its 2018 acquisition of Orbital ATK.

Defense contractors' business cycle is not correlated to GDP.

Northrop Grumman depends on US military funding for its sales, which is an inherently political and thus uncertain process.

There is a risk that SpaceX will threaten defense incumbents' oligopoly in space contracts, such as space transportation programs and satellite communications.

Northrop has a relatively high proportion of classified work, which limits our visibility into the business.