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Sell Block: Defending Northrop Grumman

Thursday, 21 May 2009 | 8:42 PM ET

Northrop Grumman has proved itself Obama-resistant, jumping 35% since March 6 despite a less-than-hawkish White House. For that reason, Cramer on Thursday released the stock from his Sell Block.

Sell Block
Cramer's call to sell Northrop Grumman was a mistake and he isn't afraid to admit it.

What’s the significance of March 6? That’s when Cramer passed on the stock during that day’s Lightning Round segment. And he did so because he feared Obama would cause problems for defense companies on the whole. But that wasn’t the case, at least not for Northrop Grumman . Just yesterday the company upped its quarterly dividend by 3 cents a share.

Sell Block
Cramer's call to sell Northrop Grumman was a mistake and he isn't afraid to admit it.

Cramer underestimated the reach these defense firms have. Their factories create jobs in virtually every congressional district, so Congress is very reluctant to cut spending in this area. And this doesn’t even take into account how politically damaging it can be to be seen as week on defense. That’s why the 2009 defense budget increased 4% despite certain programs being cut.

Northrop Grumman has managed to avoid those cuts, while at the same time putting itself into the middle of some of the best defense projects out there. The company’s exposure to the most at-risk part of the budget, which pays for Iraq and Afghanistan, is just 1% of revenues. Meanwhile, the $300 billion F-35 Joint Strike fighter program, for which Northrop makes 25% of the components, is entering production. So, too, are the company’s contracts for unmanned aerial vehicles, which account for a $2.6 billion backlog. Then there are the eight Virginia class submarines the government has ordered, for $5.6 billion, that Northrop will split with General Dynamics. About 65% of the company’s backlog should convert to revenue in 2009, “an avalanche of cash,” as Cramer called it.

Still, there’s plenty of room for improvement here. Northrop claims the lowest margins among its peers – just 8.6%. Poor performance on a number of contracts, largely in shipbuilding, has cost the company money. Management is stepping up, though, with an aggressive profitability plan that should widen the shipbuilding operating margins to 10% from 3%. Northrop is also passing on risky IT outsourcing contracts in favor of better, more profitable business.

The stock is trading at just 8.6 times earnings, an undeserved discount to other defense contractors considering how strong Northrop is. And the sector as a whole is already cheap. Beyond that, though, the dividend increased to $1.72 annually boosts the yield to 3.5%. If next year’s expected $1.78 payout comes through, then that yield will jump to 3.7%. Lockheed Martin and Raytheon aren’t paying dividends like that, Cramer said. The dividend should be safe, too, as expected earnings are three times higher than the payout.

See why Cramer’s releasing Northrop Grumman from the Sell Block? He’s bullish on NOC, but even more so at $43. The dividend yield will reach 4% at that point.

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