Northrop Grumman Corporation — 2018 Q2 Form 10-Q
Business context and reporting period
Quarterly report for the three and six months ended June 30, 2018. Northrop Grumman is a global security and aerospace company serving primarily the U.S. government, including the Department of Defense and intelligence community, with additional international, government and commercial customers.
On June 6, 2018, the company completed its $7.7 billion cash acquisition of Orbital ATK, renamed Northrop Grumman Innovation Systems, and established a fourth reportable sector. Only post-acquisition results are included in reported 2018 results.
Key financial metrics
| Metric | Three months ended June 30, 2018 | Three months ended June 30, 2017 | Six months ended June 30, 2018 | Six months ended June 30, 2017 |
|---|---|---|---|---|
| Total sales | $7.119 billion | $6.473 billion | $13.854 billion | $12.883 billion |
| Operating income | $823 million | $873 million | $1.677 billion | $1.735 billion |
| Operating margin | 11.6% | 13.5% | 12.1% | 13.5% |
| Net earnings | $689 million | $555 million | $1.428 billion | $1.205 billion |
| Diluted EPS | $3.93 | $3.16 | $8.14 | $6.85 |
| Effective tax rate | 18.8% | 31.7% | 17.0% | 24.7% |
Six-month net cash provided by operating activities was $638 million, compared with $68 million in the prior-year period. Capital expenditures were $504 million, producing free cash flow of $134 million versus negative $365 million in 2017.
Cash and cash equivalents were $1.539 billion at June 30, 2018, down from $11.225 billion at December 31, 2017, primarily reflecting the Orbital ATK acquisition, debt repayments and other financing activity. Long-term debt was $14.387 billion, excluding the current portion of $744 million; commercial paper outstanding was $249 million. The company also had $1.6 billion of undrawn committed credit capacity and was in compliance with its debt covenants.
Backlog was $52.2 billion, including $8.7 billion from Innovation Systems. Management expected approximately 50% of June 30 backlog to convert to revenue within 12 months and approximately 75% within 24 months.
Material changes versus the prior comparable period
- Sales increased 10% in the quarter and 8% year to date, driven primarily by $400 million of post-acquisition Innovation Systems sales and higher Aerospace Systems volume.
- Operating income declined 6% in the quarter and 3% year to date. Margin compression reflected higher unallocated corporate costs, acquisition-related costs, lower segment margins and a reduced FAS/CAS pension adjustment.
- Net earnings and diluted EPS increased 24% in the quarter and 19% year to date, benefiting from lower tax rates, higher non-service pension income and higher interest income. These benefits more than offset higher interest expense and acquisition-related corporate costs.
- Technology Services sales declined 10% in the quarter and 7% year to date, while operating income declined 24% and 15%, respectively, due to completed or winding-down programs and unfavorable contract adjustments.
- Mission Systems sales increased modestly, but operating income declined 8% in the quarter and 3% year to date due to lower margins, including a forward loss provision on an Advanced Capabilities program.
- Aerospace Systems sales increased 11% in both the quarter and year to date. Second-quarter results included $69 million of favorable cumulative contract estimate-at-completion adjustments on multiple restricted programs.
- Product sales rose 18% in the quarter and 13% year to date, while service sales declined 5% and 2%, respectively.
Acquisition, outlook, risks and unusual items
- The Orbital ATK purchase price allocation was preliminary and included $6.3 billion of goodwill and $1.3 billion of acquired intangible assets. Management expected to substantially finalize the allocation by year-end 2018; material adjustments remained possible.
- Innovation Systems contributed $400 million of sales, $39 million of operating income and $30 million of net earnings in the reported period. Acquisition-related costs were $23 million in the quarter and $29 million year to date.
- The filing does not provide a clear updated full-year earnings, revenue or cash-flow guidance figure. Management stated that available cash, operating cash flow and financing sources were expected to fund operations for at least the next 12 months.
- The company faces substantial dependence on U.S. government funding and appropriations, contract performance and cost estimates, fixed-price contract exposure, supplier and subcontractor performance, cybersecurity threats, international and geopolitical risks, and integration risks related to Orbital ATK.
- Material contingencies include the FSS litigation, government investigations involving time-charging practices, legacy Orbital ATK shareholder litigation and SEC investigations, and environmental remediation obligations. Bethpage environmental matters could generate additional costs that the company could not reasonably estimate.
- Environmental remediation costs were estimated at $453 million to $836 million of reasonably possible future costs, with $463 million accrued at June 30, 2018; related recoverable deferred costs were $236 million.
- On July 19, 2018, the company fully redeemed $700 million of assumed Orbital ATK senior notes. The filing also notes possible changes to unrecognized tax benefits and ongoing IRS examinations.
- The company increased its quarterly dividend 9% to $1.20 per share in May 2018. Approximately $2.3 billion remained available under the share repurchase authorization at quarter-end.
Most important facts for investors to verify
- Whether Orbital ATK integration delivers the anticipated revenue synergies, cost savings and operating margins, and whether the preliminary goodwill and intangible-asset valuations require material revisions.
- Whether reported earnings growth is sustainable after considering the lower operating margin, favorable EAC adjustments, pension-related income and tax-rate benefits.
- The pace of cash conversion from the significantly higher $52.2 billion backlog and the reduction in cash following the acquisition.
- Future debt repayment, interest expense and liquidity requirements, including commercial paper usage and the post-quarter repayment of Orbital ATK notes.
- Resolution and potential financial impact of the FSS matters, government investigations, SEC matters, tax examinations and Bethpage environmental obligations.
- Trends in Mission Systems and Technology Services margins, fixed-price contract exposure, forward loss provisions and future contract estimate-at-completion adjustments.