Northrop Grumman Corporation — Form 10-Q Summary
Business Context and Reporting Period
Quarterly report for the three and six months ended June 30, 2019. Northrop Grumman is a global security and defense contractor focused on autonomous systems, cyber, C4ISR, space, strike, logistics and modernization. Most revenue is generated from U.S. government contracts, principally the Department of Defense and intelligence community.
The company operated through four sectors: Aerospace Systems, Innovation Systems, Mission Systems and Technology Services. Innovation Systems represents the former Orbital ATK business acquired on June 6, 2018; therefore, reported year-over-year comparisons are affected by partial-period inclusion in 2018.
Key Financial Metrics
| $ in millions, except per-share amounts | Q2 2019 | Q2 2018 | Change | Six months 2019 | Six months 2018 |
|---|---|---|---|---|---|
| Sales | $8,456 | $7,119 | 19% | $16,645 | $13,854 |
| Operating income | $946 | $817 | 16% | $1,882 | $1,665 |
| Operating margin | 11.2% | 11.5% | Down 30 bps | 11.3% | 12.0% |
| Net earnings | $861 | $789 | 9% | $1,724 | $1,629 |
| Diluted EPS | $5.06 | $4.50 | 12% | $10.11 | $9.29 |
| Effective tax rate | 16.2% | 19.2% | Down 300 bps | 16.4% | 17.5% |
Cash and cash equivalents were $1.1 billion at June 30, 2019, compared with $1.6 billion at December 31, 2018. Six-month operating cash flow was $694 million, compared with $638 million in the prior-year period. Capital expenditures were $536 million, producing free cash flow of $158 million versus $134 million in 2018.
Total debt carrying value was approximately $14.4 billion, including $13.8 billion of long-term debt and $299 million of commercial paper. The company had no borrowings under its $2.0 billion 2018 credit facility and was in compliance with its debt covenants. Total assets were $39.6 billion and shareholders’ equity was $9.2 billion at June 30, 2019.
Backlog was $63.0 billion, including $31.8 billion funded and $31.2 billion unfunded. Management expected to recognize approximately 40% of backlog as revenue within 12 months and 65% within 24 months.
Material Changes Versus the Prior Comparable Period
- Sales increased primarily from the addition of a full quarter or full six months of Innovation Systems, as well as growth in Mission Systems and Aerospace Systems. Technology Services declined year to date because of program completions.
- Segment operating income increased 26% in both the quarter and first half, while segment margin improved to 11.6% from 10.9% in the quarter and to 11.7% from 11.1% year to date.
- GAAP operating margin decreased because of higher amortization of acquired intangible assets and depreciation related to the Orbital ATK purchase-price step-up. These costs increased unallocated corporate expense by $40 million in the quarter and $138 million year to date.
- Net earnings benefited from higher operating income and a lower tax rate, but were partly offset by lower non-service pension benefits and lower other income.
- Weighted-average diluted shares declined 3%, supporting a 12% quarterly and 9% year-to-date increase in diluted EPS. Six-month share repurchases totaled $231 million; the quarterly dividend was increased 10% to $1.32 per share.
- The effective tax rate benefited from higher research credits. Second-quarter 2019 included $36 million of current-year research credits and $15 million of prior-year credits.
- Net favorable estimate-at-completion adjustments were $158 million in the quarter and $296 million year to date, compared with $143 million and $259 million, respectively, in 2018.
Outlook, Commentary, Risks and Unusual Items
Management stated that enacted fiscal 2019 appropriations and the proposed $750 billion fiscal 2020 national security budget support demand. The company highlighted space, missiles, missile defense, hypersonics, counter-hypersonics, survivability and cyber as areas supporting continued profitable growth. Cash on hand, operating cash flow and available financing were expected to fund operations for at least the next 12 months.
- Second-quarter net awards were $13.5 billion and year-to-date net awards were $25.8 billion. Significant awards included $4.1 billion for F-35, $3.6 billion for 24 E-2D aircraft and related equipment, $843 million for space programs, $316 million for Global Hawk and $265 million for hypersonic weapons.
- The Orbital ATK purchase-price allocation was finalized in the quarter, including a $220 million increase in acquired intangible assets and a $36 million reduction in goodwill. The filing stated that prior-period financial results were not materially affected.
- The company adopted ASC 842 lease accounting on January 1, 2019. This added $1.3 billion of operating lease liabilities and $1.3 billion of right-of-use assets, with no material impact on earnings or cash flow.
- The company agreed in principle to resolve the Orbital ATK securities class action for $108 million, subject to terms and conditions, and is pursuing insurance coverage.
- Environmental remediation costs had a reasonably possible future-cost range of $532 million to $1.018 billion at June 30, 2019, with $547 million accrued. Bethpage, New York, remediation requirements may change and costs may increase materially.
- The FSS litigation with the U.S. government remained unresolved. Northrop Grumman seeks approximately $178 million, while the government’s counterclaim was approximately $193 million; trial was scheduled to begin February 3, 2020. The filing stated that the outcome could not be predicted or reasonably estimated.
- Key risks include dependence on U.S. government funding, appropriations delays, contract cost growth and estimates, fixed-price execution, cybersecurity, supplier performance, competition, workforce availability, international operations, litigation, environmental liabilities, pension assumptions, tax exposure and integration of Orbital ATK.
Investor Verification Checklist
- Verify the quality and sustainability of revenue and margin growth excluding the acquisition-related contribution from Innovation Systems.
- Assess conversion of the $63.0 billion backlog into funded orders, revenue and cash flow, particularly the $31.2 billion unfunded portion.
- Monitor working-capital use, including the $5.7 billion of unbilled receivables and the impact on operating cash flow.
- Review debt maturities, commercial-paper reliance, interest costs and leverage following the Orbital ATK acquisition.
- Evaluate the sustainability of favorable EAC adjustments and the extent to which quarterly earnings depend on contract estimates.
- Track Bethpage environmental exposure, the $108 million Orbital ATK litigation settlement, the FSS proceedings and related insurance recoveries.
- Confirm future U.S. defense appropriations and program awards, especially for F-35, space, missiles and hypersonics.
- Consider the effect of research credits and other tax benefits on the reported effective tax rate.