Defense Cuts Won’t Shake Northrop

Northrop Grumman (NYSE:NOC) is one of the largest integrated defense companies, with divisions that cover the entire security spectrum. It’s in the midst of precautionary cost-cutting because there are indications that the pullbacks from Iraq and Afghanistan — as well as the ending of the space shuttle program — will trim the aerospace and defense budgets and affect the entire industry.

The situation may be similar to 1985 through 1997 when big cuts in defense spending caused industry consolidation. During that time, the larger players — like Northrop — got larger and focused on restructuring and investing in new technologies. Likewise, the recent industry consolidation is likely to be beneficial to Northrop shareholders as the company concentrates on higher margin businesses and sells off less profitable divisions.

Northrop�s management has been preparing for this by increasing the quarterly dividend from 30 cents a share five years ago to the current quarterly rate of 50 cents, resulting in a yield of 3.52%. That’s only a 29% payout ratio and likely a sustainable rate, no matter what happens with defense spending. Northrop is proactively cutting costs by eliminating 500 jobs in its aerospace division by the end of the year. The company is offering a voluntary buyout program to about 23,000 employees, followed by involuntary layoffs — the old carrot-and-stick approach.

Northrop�s stock has sold off notably since the market got wind of the coming restructuring, but that has only increased the dividend yield. Because it’s highly likely for Northrop to become a major consolidator in the industry, and with the low payout, the dividend could offer plenty of cushion for shareholders to ride out the uncertainty.

Northrop has an entrenched position in the defense sector, where servicing existing systems and equipment promises to bring it plenty of return business so that the restructuring goes according to plan and the dividend remains intact. Northrop currently yields nearly double the rate of the 10-year Treasury note, with a steady revenue stream. The government may cut the defense budget, but it knows that its needs defense contractors to be in good financial shape, so any cuts should be measured and distributed among all big industry players.