Northrop Grumman Corporation — FY2012 Form 10-K Summary
Business context and reporting period
Annual report for the fiscal year ended December 31, 2012, filed February 4, 2013. Northrop Grumman is a global security and defense contractor organized into Aerospace Systems, Electronic Systems, Information Systems, and Technical Services. The company primarily serves the U.S. Government, Department of Defense, and intelligence community; U.S. Government revenue represented 90.0% of total 2012 revenue.
Results exclude the former Shipbuilding business, which was spun off as Huntington Ingalls Industries in March 2011 and is reported as discontinued operations for prior periods. The missile business was transferred from Aerospace Systems to Technical Services effective January 1, 2012, with prior periods recast.
Financial performance and position
| Metric | 2012 | 2011 | Change |
|---|---|---|---|
| Sales | $25.218 billion | $26.412 billion | Down 5% |
| Operating income | $3.130 billion | $3.276 billion | Down 4% |
| Operating margin | 12.4% | 12.4% | Flat |
| Earnings from continuing operations | $1.978 billion | $2.086 billion | Down 5% |
| Diluted EPS from continuing operations | $7.81 | $7.41 | Up 5% |
| Cash from continuing operations | $2.640 billion | $2.347 billion | Up 12% |
| Free cash flow from continuing operations | $2.309 billion | $1.855 billion | Up 25% |
| Year-end cash and equivalents | $3.862 billion | $3.002 billion | Up $860 million |
| Long-term debt, including current portion | $3.935 billion | $3.940 billion | Substantially flat |
| Total assets | $26.543 billion | $25.411 billion | Up 4% |
Net earnings were $1.978 billion in 2012 compared with $2.118 billion in 2011, which included $32 million from discontinued operations. The effective tax rate increased to 33.3% from 32.3%, principally because research tax credits were not recognized until legislation was enacted in January 2013.
Segment operating income increased 4% to $3.176 billion, and segment operating margin increased to 12.6% from 11.6%. Electronic Systems was the primary contributor to improvement. Consolidated operating income was reduced by the lower net FAS/CAS pension adjustment, which declined to $132 million from $400 million.
- Aerospace Systems: Sales of $9.977 billion, essentially flat; operating income of $1.218 billion and margin of 12.2%, both comparable with 2011.
- Electronic Systems: Sales decreased 6% to $6.950 billion, while operating income increased 11% to $1.187 billion and margin rose to 17.1%, reflecting performance improvements, particularly in combat avionics.
- Information Systems: Sales declined 7% to $7.356 billion; operating income decreased 1% to $761 million, while margin improved to 10.3%.
- Technical Services: Sales declined 5% to $3.019 billion; operating income increased 3% to $268 million and margin rose to 8.9%.
At December 31, 2012, total backlog was $40.809 billion versus $39.515 billion in 2011. Approximately $21.4 billion was expected to convert to sales in 2013. Funded backlog was $25.7 billion and unfunded backlog was $15.1 billion.
Fourth-quarter 2012 results
| Metric | Q4 2012 | Q4 2011 |
|---|---|---|
| Sales | $6.476 billion | $6.506 billion |
| Operating income | $824 million | $799 million |
| Net earnings | $533 million | $548 million |
| Diluted EPS | $2.14 | $2.09 |
During the fourth quarter, the company repurchased 7.3 million shares for $487 million. The quarterly dividend was $0.55 per share, and $1.5 billion remained under the share repurchase authorization at year-end.
Liquidity, debt, cash flow, and obligations
Management stated that cash balances, operating cash flow, and available borrowing capacity should be sufficient to fund operations for at least the next 12 months. No borrowings were outstanding under the $1.5 billion five-year revolving facility or the $500 million 364-day facility at year-end, and the company was in compliance with all covenants. The principal credit agreement limits consolidated debt to capitalization to 65%.
- Capital expenditures were $331 million, compared with $492 million in 2011.
- Pension contributions were $367 million, including $300 million of voluntary prefunding, compared with $1.084 billion in 2011.
- Contractual obligations totaled $15.265 billion, including $3.924 billion of long-term debt principal, $2.485 billion of interest payments, $6.907 billion of purchase obligations, and $1.071 billion of operating lease commitments.
- Standby letters of credit, bank guarantees, and surety bonds totaled $193 million, $295 million, and $168 million, respectively.
Liquidity was supported by strong operating cash generation, but the company had significant pension and post-retirement liabilities of $6.085 billion at year-end, up from $4.079 billion. The discount rate reduction increased reported benefit obligations and contributed to accumulated other comprehensive loss of $4.787 billion.
Material changes, outlook, and risks
- Sales declined because of lower government spending, reduced overseas contingency activity, program wind-downs, and portfolio-shaping actions. Management emphasized affordability, cost reduction, and improved contract performance.
- Net favorable cumulative catch-up adjustments to contract estimates increased operating income by $985 million in 2012, compared with $738 million in 2011. These adjustments were spread across the contract portfolio; no individual adjustment was material to the annual earnings statement.
- Management identified potential sequestration, federal budget reductions, continuing resolutions, and uncertainty over the debt ceiling as significant threats to future revenue, profit, cash flow, contract funding, and goodwill valuations. The filing stated that sequestration as then contemplated would likely reduce revenue, profit, and cash flow.
- Information Systems was the most goodwill-sensitive reporting unit. Its estimated fair value exceeded carrying value by approximately 5%, with $5.3 billion of goodwill. No goodwill impairment was recorded in 2012.
- The company expects continued opportunities in long-range strike, missile defense, command and control, communications, satellite systems, cybersecurity, information technology, technical services, and international programs, but provided no quantified revenue or earnings guidance in the supplied filing text.
- The company faces substantial customer concentration, fixed-price contract cost-growth risk, government audit and procurement risk, cybersecurity threats, supplier and subcontractor risk, pension volatility, environmental liabilities, litigation, and potential contract termination or stop-work orders.
- A significant legal contingency involves the USPS postal automation contract. Northrop Grumman sought approximately $178 million in claims, while the United States counterclaimed for approximately $410 million; the ultimate outcome could not be predicted or estimated.
- Environmental remediation costs were estimated at $314 million to $746 million before recoveries; $342 million was accrued for probable costs at year-end.
Important facts for investors to verify
- Reconcile continuing-operations results with total net earnings and confirm the treatment of the 2011 Shipbuilding spin-off.
- Assess the sustainability of operating margins given the decline in sales and the material contribution from contract estimate adjustments.
- Review the timing and funding status of the $40.8 billion backlog, especially the $15.1 billion unfunded portion and the concentration in government customers.
- Evaluate exposure to sequestration, defense-budget reductions, continuing resolutions, and contract cancellations or delays.
- Review pension assumptions, the $6.1 billion benefit liability, expected 2013 contributions, and the sensitivity of results to discount-rate changes.
- Follow the USPS litigation, environmental matters, government cost audits, and potential indemnification obligations.
- Confirm cash deployment priorities, including the remaining $1.5 billion repurchase authorization, dividends, debt maturities, and voluntary pension contributions.