"There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated."
-- Warren Buffett, 1999 Berkshire Hathaway Chairman's Letter to Shareholders
It's not every day that one of the United States' premiere defense contractors announces a $4 billion share repurchase program. Yet, astonishingly, that is what we have all been witness to in the recent corporate actions of Northrop Grumman (NOC -0.72%). This is a major move by management, one that reflects the firm view that its company's own shares are the best possible use of corporate funds. However, this is a lot of money we're talking about, being spent six years into a secular bull market that has seen Northrop's shares reach new heights. The success or failure of this initiative will have far-reaching effects for years to come. Is this truly the best move to make with shareholders' capital, or is Northrop's board getting a little carried away?
Shots fired
In a continuation of what has been a corporate policy for over a decade, Northrop's board went public on Sept. 16, 2015, with the news that they had approved yet another multibillion-dollar share repurchase authorization. This follows a slew of aggressive repurchases in recent years.
Northrop has done its shareholders a great service by buying back just under $12 billion of its shares over the last five years, particularly in fiscal year 2011, when a massive $2.3 billion was repurchased at prices far below where they stand today.
When you can't grow, buy back shares
Northrop's operating history over the last four years has been respectable, but it should be noted that growth has been lacking. It is, perhaps, for this reason that the company elected to buy back shares with its sizable cash flows -- there are few new markets for it to compete in that can "move the needle," especially in the face of an increasingly budget-conscious United States government.
Northrop Grumman Annual Results
| Metric | 2011 | 2012 | 2013 | 2014 |
|---|---|---|---|---|
| Revenue | $26.4 billion | 25.2 billion | $24.7 billion | $24.0 billion |
| Net income | $2.12 billion | $1.98 billion | $1.95 billion | $2.07 billion |
| Free cash flow | $1.62 billion | $2.3 billion | $2.12 billion | $2.03 billion |
| Return on equity | 17.6% | 19.9% | 19.4% | 23.2% |
| Average shares outstanding | 276.8 million | 248.6 million | 229.6 million | 208.8 million |
Data source: S&P Capital IQ.
What would Warren do?
Everyone's favorite billionaire investor, Warren Buffett, is notable for having very strong opinions regarding share buybacks. They can be a spectacular move -- provided they are made at advantageous prices. The trick, of course, is accurately estimating the true value of an enterprise -- no easy task and arguably in the eye of the beholder. Difficulties aside, this is the task faced by investors and corporate boards. So, the question becomes: Where are we in terms of valuation for Northrop Grumman today -- in particular, relative to its peers General Dynamics and Lockheed Martin?
| Company | Price/Earnings NTM | Enterprise Value/EBITDA NTM | Enterprise Value/Total Revenue NTM |
|---|---|---|---|
| Northrop Grumman | 16.79 | 10.05 | 1.51 |
| General Dynamics | 15.39 | 9.39 | 1.37 |
| Lockheed Martin | 17.62 | 10.23 | 1.55 |
Data source: S&P Capital IQ.
It's now clear why Northrop hasn't considered buying one of its competitors over repurchasing shares, acquisitions being one of the four possible uses of corporate funds. All three of the companies in question trade for more or less the same valuation. This is not an exhaustive study of future cash flows based on product cycles at Northrop; the purpose is to get a feel for whether or not Northrop's board is wandering off the reservation with its recently announced share buyback program. Northrop's market value, held up to the light of an S&P 500 that currently trades at a P/E ratio of 19.34, seems to point us in the direction of its latest buyback program being good but not great. In the face of an at least 15% income tax rate on any dividends the company might pay instead, the move will likely amount to a wash for Northrop Grumman shareholders.
Foolish takeaway
American corporations have been notoriously aggressive with share buybacks in recent years, and history will need to be the judge of the merits of this financial engineering. As for Northrop Grumman's recently announced $4 billion buyback program, it is safe to say that management isn't harming shareholders, but they aren't hitting a home run with the move, either.
