Perhaps the biggest news in the stock market in the last week comes from the defense industry. U.S. defense contractor Northrop Grumman Corporation (NYSE:NOC) has agreed to acquire global aerospace and defense tech firm Orbital ATK Inc (NYSE:OA) for $9.2 billion.
It’s a huge, all-cash deal which unites two long-time rivals at a time when international political tensions are on the rise. The deal also comes ahead of planned upgrades for U.S. ballistic systems.
OA stock is surging on the news. Its up more than 20% and is trading close to the $134.50 takeover price.
NOC stock is also up on the news — a much more pedestrian 1.5%.
So what are the actionable investment ideas out of this acquisition?
The easy one is buy NOC stock. Here’s why.
Northrop Grumman Builds Up At The Right Time
North Korea continues to launch missiles and threaten the safety of the United States and its allies. While the North Korea problem has been around for a while, it has recently escalated. Defensive and preventative action is more likely each day.
Meanwhile, the number of terrorist attacks in developed countries is on the rise. This has been particularly true in Europe this year where there have been more terrorist attacks in 2017 through August than there were in all of 2015 or 2016.
There is also a really ugly civil war going on in Yemen. According to the Washington Post:
Saudi Arabia has a pending deal to acquire $500 million in precision-guided munitions from the U.S., part of a proposed $110 billion arms package to Riyadh, which is enmeshed in a civil war in Yemen. A Saudi-led coalition, which is supported by the United States, has been carrying out airstrikes in Yemen since March 2015.
In the big picture, despite the aforementioned spikes in violence, we are currently living in one of the most peaceful times in human history. The global death rate from war is near a multi-century low.
But the global death rate looks awfully cyclical. Periods of low death rates are followed by periods of high death rates. Periods of high death rates are followed by periods of low death rates.
That isn’t to say that we are due for a big war which which will cause a spike in the death rate. It is to say, though, that higher fear levels related to political conflict are justified. This is especially true when we have triggers like North Korea.
These heightened fears will flow into heightened levels of defense and military spending. That is why the U.S. military is finally modernizing its atomic weapons. Last summer, the Air Force asked for proposals to replace its outdated ICBM system.
Bottom Line on NOC Stock
The big winner out of all of this? Northrup Grumman. The Orbital ATK acquisition makes NOC the undisputed leader in this space.
Consequently, I think NOC stock is a buy here.
Financially, NOC is now looking at sales of near $30 billion this year, versus just over $25 billion prior to the acquisition. The deal is expected to be accretive to earnings and free cash flow in the first full year after the transaction closes. Cost-saving synergies are estimated to be around $150 million per year. Management thinks they can hit that cost-saving target by 2020.
Meanwhile, the growth profiles of both ATK and NOC are very similar on a standalone basis. Both companies are expected to grow sales in the 3% to 6% range over the next several years. Earnings are expected to grow in the high single digit range at NOC and at the low double-digit range at OA.
Overall, then, this new NOC is a higher revenue and higher margin company growing at a similar rate as it was before. That means bigger bottom-line results into perpetuity.
Because of this, I think NOC stock is the best play in the defense industry right now.
As of this writing, Luke Lango was long NOC.