Northrop Grumman Corporation — Q2 2020 Form 10-Q Summary
Business context and reporting period
Northrop Grumman is a global aerospace 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 six months ended June 30, 2020, compared with the corresponding 2019 periods. Effective January 1, 2020, the company reorganized into four reportable segments: Aeronautics Systems, Defense Systems, Mission Systems and Space Systems.
The financial statements received a review from Deloitte & Touche LLP, which reported no material modifications necessary for conformity with U.S. GAAP.
Financial performance and key metrics
| Metric | Q2 2020 | Q2 2019 | Change | Six months 2020 | Six months 2019 |
|---|---|---|---|---|---|
| Sales | $8.884 billion | $8.456 billion | 5% | $17.504 billion | $16.645 billion |
| Operating income | $994 million | $946 million | 5% | $1.928 billion | $1.882 billion |
| Operating margin | 11.2% | 11.2% | Flat | 11.0% | 11.3% |
| Net earnings | $1.005 billion | $861 million | 17% | $1.873 billion | $1.724 billion |
| Diluted EPS | $6.01 | $5.06 | 19% | $11.16 | $10.11 |
| Operating cash flow | Not separately provided | Not separately provided | $1.344 billion | $694 million | |
| Free cash flow | Not separately provided | Not separately provided | $803 million | $158 million |
- Q2 sales growth was led by Space Systems, up 15%, and Aeronautics Systems, up 7%. Mission Systems increased 2%, while Defense Systems declined 2%.
- Six-month segment operating income was $1.998 billion, up 1%, while segment margin declined to 11.4% from 11.8%.
- Net earnings benefited from a $103 million increase in the FAS non-service pension benefit in Q2 and higher returns on marketable securities. The six-month pension benefit increased by $205 million.
- Product sales increased 10% in Q2, while service sales decreased 7%, reflecting program lifecycle shifts and completion of certain service programs.
- Aggregate net favorable contract estimate-at-completion adjustments contributed $112 million of operating income in Q2 and $236 million for the six-month period, compared with $158 million and $296 million, respectively, in 2019.
Financial position, debt and liquidity
- Cash and cash equivalents were $4.178 billion at June 30, 2020, compared with $2.245 billion at December 31, 2019.
- Total assets were $43.475 billion and total shareholders’ equity was $9.712 billion at June 30, 2020.
- Carrying value of long-term debt was approximately $16.1 billion, compared with $13.9 billion at year-end 2019; estimated fair value was $19.0 billion.
- In March 2020, the company issued $2.25 billion of unsecured senior notes, including notes due in 2030, 2040 and 2050, primarily for general corporate purposes, debt repayment and working capital.
- No commercial paper was outstanding and no balance was outstanding under the $2.0 billion 2018 credit facility. A U.K. subsidiary had approximately $62 million outstanding under a facility maturing in December 2020.
- The company stated that cash, operating cash flow and available financing sources are expected to fund operations for at least the next 12 months.
- Capital expenditures were $541 million in the first six months, compared with $536 million in the prior-year period.
- Share repurchases were $490 million and cash dividends paid were $469 million during the first six months. The quarterly dividend was increased 10% to $1.45 per share in May 2020; $2.8 billion remained under the 2018 repurchase authorization at June 30.
Backlog and material changes versus the prior period
- Backlog was $70.0 billion at June 30, 2020, up 8% from $64.8 billion at December 31, 2019. Approximately 40% was expected to convert to revenue within 12 months and 65% within 24 months.
- Second-quarter and year-to-date net awards were $14.8 billion and $22.7 billion, respectively. Significant awards included restricted programs, Next Gen OPIR, E-2D, commercial satellites and Triton.
- Space Systems backlog increased 48% to $23.8 billion, while backlog declined 5% at Aeronautics Systems, 6% at Defense Systems and 5% at Mission Systems.
- The company’s new segment structure and the reclassification of certain unallowable costs to unallocated corporate expense were applied retrospectively to segment information. The change did not affect consolidated operating results.
- Year-to-date operating margin declined primarily because of lower Aeronautics Systems margin. Aeronautics Systems operating income fell 6% despite 4% sales growth, while Mission Systems and Space Systems operating income increased 6% and 7%, respectively.
Guidance, outlook, commentary and risks
- The filing does not provide a clear numerical full-year revenue, earnings or cash-flow guidance range.
- Management stated that COVID-19 reduced Q2 revenue and operating income, particularly at Aeronautics Systems and Mission Systems, but impacts were less significant than initially expected. Based on information available at filing, management did not expect COVID-19 to materially reduce second-half revenue or operating income, while acknowledging substantial uncertainty.
- COVID-19 risks include absenteeism, facility restrictions, supplier disruption, reduced productivity, program delays, changing government priorities and uncertainty over recovery of related costs. The company was seeking reimbursement under the CARES Act and contract provisions.
- The company is highly dependent on U.S. government funding, appropriations and contract awards. Other risks include fixed-price contract cost growth, estimate changes, subcontractor performance, cybersecurity, international operations, workforce availability, pension assumptions, tax matters and environmental liabilities.
- A significant contingency involves U.S. government questions regarding interest-rate assumptions used in the company’s CAS pension calculations for 2013–2019 and current forward pricing. A material adverse outcome is reasonably possible, but no loss range could be estimated.
- Bethpage, New York environmental matters involved $570 million of accrued remediation costs and $452 million of reasonably possible future costs in excess of accruals at June 30, 2020. Additional remediation requirements and potential natural-resource, personal-injury and property-damage claims could materially increase costs; cumulative exposure was not estimable.
- In the Flats Sequencing System litigation, the U.S. government’s counterclaim had been reduced to approximately $193 million. Trial was postponed because of COVID-19 and was scheduled to resume in October 2020. The company stated that the outcome could not be predicted or reasonably estimated.
- Environmental remediation costs, government cost claims, tax examinations and other legal proceedings remain subject to uncertainty. The company stated that other pending matters were not expected to have a material adverse effect based on information available at June 30, 2020.
Important facts for investors to verify
- Whether COVID-19 disruptions, supplier constraints and cost-recovery efforts affected second-half results more materially than management expected.
- Conversion of the $70.0 billion backlog into funded orders, revenue and cash, particularly the large unfunded Space Systems backlog.
- Exposure from the CAS pension-assumption inquiry and any resulting government claims or contract-pricing changes.
- Changes in estimated contract costs, unfavorable EAC adjustments and margin pressure on Aeronautics Systems and other fixed-price programs.
- Developments in Bethpage environmental proceedings and the Flats Sequencing System litigation.
- Debt maturities, interest costs and the company’s planned balance among debt repayment, dividends, share repurchases and capital investment.
- Reliance on U.S. government appropriations and the effect of future defense-budget, procurement and program-priority decisions.