Northrop Grumman Corporation — 2017 Q2 Form 10-Q Summary
Business context and reporting period
Northrop Grumman is a global security and defense contractor providing autonomous systems, cyber, C4ISR, strike, logistics and modernization solutions. The company conducts most of its business with the U.S. Government, principally the Department of Defense and intelligence community. This unaudited Form 10-Q covers the three and six months ended June 30, 2017, compared with the corresponding 2016 periods.
Key financial metrics
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Sales | $6.375 billion | $6.000 billion | $12.642 billion | $11.956 billion |
| Operating income | $855 million | $797 million | $1.687 billion | $1.536 billion |
| Operating margin | 13.4% | 13.3% | 13.3% | 12.8% |
| Net earnings | $552 million | $517 million | $1.192 billion | $1.073 billion |
| Diluted EPS | $3.15 | $2.85 | $6.78 | $5.88 |
| Effective tax rate | 31.6% | 29.2% | 24.6% | 23.7% |
- Product sales increased 11% year to date to $8.312 billion; service sales declined 1% to $5.445 billion.
- Net cash provided by operating activities was $68 million, down from $544 million in the prior-year period. Free cash flow was negative $365 million versus positive $73 million.
- Capital expenditures were $433 million. Financing cash outflows were $800 million, including $367 million of share repurchases and $341 million of dividends.
- Cash and cash equivalents were $1.383 billion at June 30, 2017, compared with $2.541 billion at December 31, 2016.
- Long-term debt carrying value was approximately $7.1 billion, including $862 million classified as current. The company had no borrowings under its $1.6 billion unsecured credit facility and was in compliance with all covenants.
- Total assets were $25.813 billion and shareholders’ equity was $5.919 billion at June 30, 2017. Pension and other post-retirement liabilities totaled $6.666 billion.
- The quarterly dividend was increased 11% in May 2017 to $1.00 per share. The company had $2.4 billion remaining under its $4.0 billion 2015 repurchase authorization at June 30, 2017.
Material changes versus the prior comparable period
- Second-quarter sales rose 6%, operating income rose 7%, net earnings rose 7% and diluted EPS rose 11%. For the six-month period, sales rose 6%, operating income rose 10%, net earnings rose 11% and diluted EPS rose 15%.
- EPS growth benefited from a 3% quarterly and 4% year-to-date reduction in weighted-average diluted shares resulting from repurchases.
- Aerospace Systems was the primary sales growth driver, with Q2 sales up 14% and six-month sales up 13%. Its margin declined to 10.6% in Q2 from 12.0%, primarily because of contract mix and timing of risk reductions.
- Mission Systems sales increased 3% in both periods, while Q2 operating income increased 7%. Technology Services sales declined 3% in Q2 and 2% year to date as several programs ended or approached completion.
- Reported operating income benefited from a higher net FAS/CAS pension adjustment of $137 million in Q2 and $273 million year to date, compared with $69 million and $143 million, respectively, in 2016.
- Aggregate favorable net estimate-at-completion adjustments declined to $98 million in Q2 and $213 million year to date, from $137 million and $266 million, respectively, in 2016.
- Second-quarter segment operating income included $54 million related to a government cost claim, including $32 million in Mission Systems. The filing states that no individual contract adjustment was material.
- Working-capital investment, principally higher accounts receivable and lower accounts payable and other liabilities, reduced operating cash flow by $1.449 billion year to date.
- Total backlog declined modestly during the first six months of 2017.
Guidance, outlook, commentary, risks and unusual items
- Management expects an annual effective tax rate of approximately 30% on an ongoing basis, absent discrete items or changes in federal tax legislation.
- Cash, operating cash generation and available borrowing capacity are expected to be sufficient to fund operations for at least the next 12 months.
- The filing identifies uncertainty regarding fiscal 2018 appropriations. Failure to enact appropriations or a continuing resolution by September 30, 2017 could lead to a government shutdown, stop-work orders, delayed payments or program cancellations.
- The company is highly dependent on U.S. Government spending and remains exposed to geopolitical conditions, appropriations delays, contract performance and cost-estimation risk, competition, bid protests, cyber threats, supply-chain issues and changes in procurement rules.
- On July 18, 2017, the Armed Services Board of Contract Appeals ruled that the government improperly required the company to treat $253 million of post-retirement benefit costs as unallowable for government contract cost-accounting purposes. The decision could be appealed and would apply only to certain contracts spanning a 20-year period.
- The FSS litigation involves an approximately $410 million government counterclaim and company claims of approximately $178 million; the ultimate outcome cannot be predicted or reasonably estimated.
- Environmental remediation costs were estimated at $389 million to $782 million, with $393 million accrued and $202 million expected to be recoverable through U.S. Government contract overhead charges.
- The company expects to adopt the new revenue standard on January 1, 2018 using retrospective application. It currently expects approximately $200 million of additional 2016 revenue and approximately $70 million lower 2016 operating income upon adoption, with no material ongoing impact on results or cash flows anticipated.
Most important facts for investors to verify
- Whether weak operating cash flow and negative free cash flow are temporary working-capital effects or persist as sales expand.
- The sustainability of reported margins given lower Aerospace Systems margins, declining net EAC adjustments and reliance on pension-accounting benefits.
- The final accounting and recurring impact of the new revenue-recognition standard.
- The outcome and financial effect of the $253 million post-retirement cost ruling, the FSS matters and other government contract claims.
- Fiscal 2018 defense appropriations, potential government shutdown exposure and their effects on funding, backlog conversion and collections.
- Changes in debt, pension obligations, environmental liabilities and liquidity after June 30, 2017.