Business Context and Reporting Period
Northrop Grumman Corporation is a global security and defense contractor serving primarily the U.S. Government, including the Department of Defense and intelligence community. This unaudited Form 10-Q covers the three and nine months ended September 30, 2017, compared with the corresponding 2016 periods.
The company operated through Aerospace Systems, Mission Systems and Technology Services. Results are substantially driven by long-term government contracts accounted for primarily under percentage-of-completion methods.
Financial Performance and Position
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Sales | $6.527 billion | $6.155 billion | $19.169 billion | $18.111 billion |
| Operating income | $845 million | $826 million | $2.532 billion | $2.362 billion |
| Operating margin | 12.9% | 13.4% | 13.2% | 13.0% |
| Net earnings | $645 million | $602 million | $1.837 billion | $1.675 billion |
| Diluted EPS | $3.68 | $3.35 | $10.46 | $9.23 |
| Operating cash flow | Not separately provided | Not separately provided | $1.006 billion | $1.282 billion |
| Free cash flow | Not separately provided | Not separately provided | $356 million | $674 million |
- Product sales increased 11% in both the quarter and year to date, while service sales declined 1% in both periods.
- At September 30, 2017, cash and cash equivalents were $1.878 billion, versus $2.541 billion at December 31, 2016.
- Total assets were $26.513 billion and shareholders’ equity was $6.493 billion at September 30, 2017.
- Carrying value of long-term debt was approximately $7.1 billion at September 30, 2017, including $863 million classified as current. The estimated fair value was $7.8 billion.
- The company had no borrowings under its $1.6 billion five-year unsecured credit facility and was in compliance with its debt covenants. A U.K. facility had approximately $149 million outstanding.
- Capital expenditures were $650 million for the first nine months, compared with $608 million in 2016.
- Dividends paid were $515 million for the first nine months. The quarterly dividend was increased 11% to $1.00 per share in May 2017. The company repurchased $393 million of common stock year to date, with $2.3 billion remaining under its authorization.
Segment Results
| Segment | Q3 2017 Sales | Q3 Sales Change | 9M 2017 Sales | 9M Sales Change |
|---|---|---|---|---|
| Aerospace Systems | $3.082 billion | +11% | $8.950 billion | +12% |
| Mission Systems | $2.837 billion | +5% | $8.357 billion | +3% |
| Technology Services | $1.183 billion | -1% | $3.552 billion | -2% |
Segment operating income increased 4% in the quarter and 3% year to date. Segment operating margin declined to 11.6% from 11.9% in the quarter and to 11.7% from 11.9% year to date. Aerospace Systems growth reflected higher Manned Aircraft, Space and restricted program activity; Technology Services sales declined as several programs were completed.
Material Changes Versus the Prior Comparable Period
- Quarterly sales rose 6%, operating income rose 2%, net earnings rose 7% and diluted EPS rose 10%. Year-to-date sales rose 6%, operating income rose 7%, net earnings rose 10% and diluted EPS rose 13%.
- Year-to-date operating cash flow fell $276 million and free cash flow fell $318 million, primarily because increased accounts receivable and inventoried costs consumed working capital.
- The quarterly operating margin decreased because of higher unallocated corporate expenses and lower segment margins. Year-to-date margin improved modestly, largely because of a higher net FAS/CAS pension adjustment.
- Unallocated corporate expenses increased by $90 million in the quarter, partly due to $27 million of Orbital ATK transaction costs and prior-year tax and overhead benefits that did not recur.
- Net earnings benefited from a lower effective tax rate of 17.8% in the quarter and 22.3% year to date, compared with 21.7% and 23.0%, respectively. Benefits included research credits and additional manufacturing deductions.
- Aggregate favorable net estimate-at-completion adjustments contributed $102 million of operating income in the quarter and $315 million year to date, compared with $121 million and $387 million in the prior-year periods. These included a $56 million favorable adjustment on a restricted Aerospace Systems program.
- Total backlog declined modestly during the first nine months; the filing does not provide a clear dollar backlog value in the supplied text.
Guidance, Outlook, Risks and Unusual Items
- Management expected an ongoing annual effective tax rate of approximately 30%, absent discrete tax items or changes in tax legislation.
- Management stated that cash, operating cash flow and available financing were expected to fund operations for at least the next 12 months.
- On September 17, 2017, Northrop Grumman agreed to acquire Orbital ATK for approximately $7.8 billion in cash plus assumption of approximately $1.4 billion of net debt, or $134.50 per Orbital ATK share. Closing was expected in the first half of 2018, subject to shareholder, regulatory and other conditions.
- In October 2017, after the quarter end, the company issued $8.25 billion of unsecured senior notes with maturities from 2020 through 2047 to fund the acquisition and related costs. Certain notes require special mandatory redemption at 101% of principal if the acquisition is not completed by the applicable deadline.
- The acquisition carries integration, regulatory approval, financing, customer acceptance and internal-control risks. The filing notes that Orbital ATK had previously restated financial statements and identified material weaknesses in internal control over financial reporting.
- U.S. Government budget uncertainty, continuing-resolution funding, potential government shutdowns, delayed appropriations and the company’s dependence on government contracts could affect new awards, performance and collections.
- Environmental remediation obligations had a reasonably possible future cost range of $409 million to $796 million, with $416 million accrued and $210 million of deferred costs expected to be recoverable through government contract overhead charges.
- The company disclosed significant unresolved FSS contract litigation with the U.S. Postal Service, including company claims and government counterclaims, but stated that the outcome could not be predicted or reasonably estimated.
- The company was subject to ordinary-course investigations, claims and litigation, including a Brazilian postal matter; management did not believe matters other than the FSS matters were likely to have a material adverse effect.
- The company planned to adopt the new revenue recognition standard retrospectively on January 1, 2018. It expected the standard to increase 2016 revenue by approximately $200 million and decrease 2016 operating income by approximately $70 million on a recast basis, while not expecting a material effect on future results or cash flows.
Investor Verification Items
- Verify completion, funding, final purchase accounting and post-close leverage associated with the Orbital ATK acquisition.
- Assess the effect of the $8.25 billion debt issuance on interest expense, maturities, liquidity and capital allocation.
- Evaluate the sustainability of earnings affected by favorable EAC adjustments, pension accounting differences and discrete tax benefits.
- Monitor working-capital conversion, receivables, inventory growth and the decline in operating and free cash flow.
- Review backlog levels and mix, especially given the modest year-to-date decline and dependence on U.S. Government appropriations.
- Track Aerospace Systems contract margins, restricted programs, F-35 and other major program performance, and Technology Services program completions.
- Review the status and potential exposure of the FSS litigation, environmental obligations and other government cost claims.
- Confirm the impact of retrospective adoption of the revenue recognition standard and the subsequent adoption of pension-cost presentation requirements.