Northrop Grumman Corporation — Q3 2013 Form 10-Q Summary
Business Context and Reporting Period
Northrop Grumman is a global security company serving primarily the U.S. Government, including the Department of Defense and intelligence community. Its four segments are Aerospace Systems, Electronic Systems, Information Systems, and Technical Services. This unaudited Form 10-Q covers the three and nine months ended September 30, 2013, compared with the corresponding 2012 periods.
Key Financial Metrics
| Metric | Q3 2013 | Q3 2012 | 9M 2013 | 9M 2012 |
|---|---|---|---|---|
| Sales | $6.106 billion | $6.270 billion | $18.504 billion | $18.742 billion |
| Operating income | $790 million | $736 million | $2.355 billion | $2.306 billion |
| Operating margin | 12.9% | 11.7% | 12.7% | 12.3% |
| Net earnings | $497 million | $459 million | $1.474 billion | $1.445 billion |
| Diluted EPS | $2.14 | $1.82 | $6.22 | $5.67 |
| Cash flow from operations | $950 million | $812 million | $1.279 billion | $1.583 billion |
| Free cash flow from operations | $860 million | $748 million | $1.101 billion | $1.387 billion |
At September 30, 2013, cash and cash equivalents were $4.944 billion versus $3.862 billion at December 31, 2012. Long-term debt, net of current portion, was $5.928 billion versus $3.930 billion at year-end 2012. Total liabilities were $18.049 billion and shareholders’ equity was $9.356 billion.
The company issued $2.85 billion of senior notes in May 2013 and used part of the proceeds to redeem $850 million of earlier notes. It also entered into a new $1.775 billion five-year unsecured revolving credit facility; no balance was outstanding at September 30, and the company was in compliance with its covenants.
Material Changes Versus the Prior Comparable Period
- Q3 sales declined 3%; nine-month sales declined 1%. The decline was concentrated in Information Systems and Technical Services, partly offset by growth in Electronic Systems and nine-month growth in Aerospace Systems.
- Q3 operating income increased 7%, and the margin expanded 120 basis points to 12.9%. Nine-month operating income increased 2%, with margin up 40 basis points.
- Net earnings increased 8% in Q3 and 2% for the nine months. Diluted EPS increased 18% in Q3 and 10% year to date, helped by earnings growth and substantial share repurchases.
- Operating cash flow decreased 19% for the nine months, principally because of higher pension contributions and working-capital changes. Q3 operating cash flow increased due in part to the absence of a $300 million voluntary pension contribution made in Q3 2012.
- The company made $561 million of pension contributions during the first nine months, including a $500 million voluntary contribution in April 2013.
- Backlog declined to $37.518 billion at September 30, 2013, from $40.809 billion at December 31, 2012. New awards were $16.2 billion, or $15.2 billion net after a $1.0 billion reduction to Information Systems unfunded backlog.
- The company repurchased $1.661 billion of common stock during the first nine months and had $3.8 billion remaining under its $4.0 billion authorization at September 30. The quarterly dividend was increased 11% to $0.61 per share.
Segment Performance
| Segment | Q3 Sales | Q3 Operating Income | 9M Sales | 9M Operating Income |
|---|---|---|---|---|
| Aerospace Systems | $2.484 billion | $330 million | $7.582 billion | $936 million |
| Electronic Systems | $1.774 billion | $273 million | $5.266 billion | $891 million |
| Information Systems | $1.619 billion | $162 million | $4.982 billion | $474 million |
| Technical Services | $713 million | $67 million | $2.152 billion | $201 million |
Aerospace Systems benefited from favorable contract estimate adjustments and improved performance despite lower Q3 volume. Electronic Systems had higher sales but lower Q3 operating income due to fewer favorable adjustments. Information Systems experienced lower funding, program completions, and sequestration-related effects. Technical Services had lower sales but improved Q3 operating income due to favorable contract adjustments.
Outlook, Commentary, Risks, and Unusual Items
- Management did not provide a specific quantitative earnings or revenue forecast in the supplied filing text. It stated that cash balances and operating cash flow, supplemented by borrowing if needed, should fund operations for at least the next 12 months.
- Management expects the U.S. budget environment and sequestration to produce lower awards, revenues, profits, and cash flows over time. FY 2014 appropriations remained uncertain, and a continuing resolution could restrict new program starts.
- Potential government shutdowns, debt-ceiling disruptions, delayed customer payments, program cancellations, stop-work orders, and reduced defense funding were identified as material risks.
- Contract estimate revisions increased operating income by $236 million in Q3 and $657 million for the nine months, compared with $214 million and $701 million, respectively, in 2012. No individual contract adjustment was material.
- The Q3 effective tax rate was 31.0%, compared with 34.0% in 2012; the reduction included benefits related to the 2012 federal tax return and reinstated research tax credits.
- The company is pursuing claims against the U.S. Government related to the approximately $875 million USPS flats sequencing systems contract while facing government counterclaims of approximately $410 million and a separate False Claims Act matter. The ultimate outcome cannot be predicted.
- Environmental remediation costs were estimated at $321 million to $812 million, with $341 million accrued at September 30, 2013. The company also had $188 million of standby letters of credit, $224 million of bank guarantees, and $165 million of surety bonds outstanding.
- The company’s disclosure controls were effective as of September 30, 2013, and no material change in internal control over financial reporting was reported.
Important Facts for Investors to Verify
- Whether sequestration, continuing resolutions, or subsequent defense appropriations reduce funding for Northrop Grumman’s major programs.
- The sustainability of operating margins given the large contribution from favorable cumulative contract estimate adjustments.
- Backlog conversion, particularly the decline in total backlog and the reduction of Information Systems unfunded backlog.
- Cash generation after pension funding, share repurchases, dividends, capital expenditures, and debt service.
- Debt levels and interest expense following the 2013 senior-note issuance and refinancing activity.
- The outcome and potential financial exposure from the USPS litigation, False Claims Act allegations, tax examinations, and environmental matters.