Northrop Grumman Corporation — 2017 First-Quarter Form 10-Q
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. Reported results cover the three months ended March 31, 2017, compared with the same period in 2016. Reportable segments were Aerospace Systems, Mission Systems and Technology Services. The interim financial statements were reviewed, not audited, by Deloitte & Touche LLP.
Financial Performance and Position
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Total sales | $6.267 billion | $5.956 billion | 5% |
| Operating income | $832 million | $739 million | 13% |
| Operating margin | 13.3% | 12.4% | Up 0.9 percentage points |
| Net earnings | $640 million | $556 million | 15% |
| Diluted EPS | $3.63 | $3.03 | 20% |
| Effective tax rate | 17.2% | 17.8% | Down 0.6 percentage points |
| Net cash used in operating activities | $439 million | $60 million | Higher use of $379 million |
| Free cash flow | $(655) million | $(358) million | Lower by $297 million |
Product sales increased 11% to $4.114 billion, while service sales declined 2% to $2.717 billion. Product and service operating costs were $5.541 billion at the segment level, before reconciliation items and corporate expenses.
Cash and cash equivalents were $1.403 billion at March 31, 2017, down from $2.541 billion at December 31, 2016. Total assets were $25.413 billion and total shareholders’ equity was $5.558 billion. Long-term debt had a carrying value of approximately $7.1 billion and an estimated fair value of $7.6 billion. The company had $1.6 billion of available unsecured revolving credit capacity with no balance outstanding and was in compliance with its credit covenants.
Capital expenditures were $216 million. Financing uses included $229 million of share repurchases and $166 million of cash dividends. The quarterly dividend was $0.90 per share. The company repurchased 924,604 shares during the quarter at an average price of $233.65, leaving $2.503 billion under the 2015 repurchase authorization.
Segment Results and Material Changes
| Segment | Q1 2017 Sales | Sales Change | Q1 2017 Operating Income | Margin |
|---|---|---|---|---|
| Aerospace Systems | $2.898 billion | 13% | $312 million | 10.8% |
| Mission Systems | $2.739 billion | 2% | $353 million | 12.9% |
| Technology Services | $1.194 billion | (2%) | $131 million | 11.0% |
- Aerospace Systems drove consolidated sales growth, principally through higher Manned Aircraft volume, increased F-35 deliveries and higher restricted sales. Its margin declined because of contract mix and the timing of risk reductions on Space programs.
- Mission Systems sales increased modestly from higher Sensors and Processing volume, including communications and F-35 programs. Operating income was unchanged and margin declined slightly.
- Technology Services sales declined because several programs completed in 2016, but operating income and margin improved due to better performance.
- Consolidated margin benefited substantially from a $136 million net FAS/CAS pension adjustment, compared with $74 million in the prior-year quarter. Management attributed the increase to higher CAS expense and lower FAS expense.
- Aggregate favorable contract estimate-at-completion adjustments were $160 million, partly offset by $45 million of unfavorable adjustments, for net favorable adjustments of $115 million versus $129 million in Q1 2016. No individual contract adjustment was material.
- Backlog declined modestly during the quarter; the filing does not provide a clear total backlog value in the supplied text.
Guidance, Outlook, Risks and Unusual Items
- Management expects cash, operating resources and available financing to be sufficient to fund operations for at least the next 12 months.
- Absent discrete tax benefits or legislative changes, management expects an annual effective tax rate of approximately 30%. The 2017 quarter benefited from $47 million of excess share-based compensation tax benefits, a $42 million benefit related to IRS examination resolution, and a $22 million benefit from additional prior-year research credits.
- The federal government was operating under a continuing resolution through April 28, 2017. Potential appropriations delays, program restrictions, a government shutdown or failure to raise the debt ceiling could delay awards and payments, restrict new program starts, or require continued performance without timely payment.
- The company remains highly dependent on U.S. Government contracts and faces risks from changing defense budgets, contract cost estimates, performance obligations, subcontractors, cyber threats, competition, bid protests and international operations.
- Material legal contingencies include the Flats Sequencing Systems litigation with the U.S. Postal Service, for which the company seeks approximately $178 million and the government has asserted a counterclaim of approximately $410 million. The ultimate outcome and potential loss cannot be predicted or reasonably estimated.
- Environmental remediation costs were estimated at $399 million to $790 million, with $402 million accrued and $207 million of related costs deferred as of March 31, 2017. Management does not expect currently identified projects to have a material adverse effect.
- The company had $205 million of standby letters of credit and guarantees and $202 million of surety bonds outstanding.
- The company expects to adopt the new revenue recognition standard on January 1, 2018, retrospectively, and does not currently expect a material effect on results or cash flows. It expects some contracts currently accounted for using units-of-delivery to shift to cost-to-cost recognition, potentially accelerating revenue and increasing retained earnings at adoption.
Important Facts for Investors to Verify
- Whether the favorable margin performance is sustainable after the unusually significant FAS/CAS pension benefit and discrete tax benefits.
- Conversion of the first-quarter $655 million negative free cash flow into cash generation during the remainder of 2017, particularly given increased working-capital use.
- Developments in U.S. Government appropriations, continuing resolutions, the debt ceiling and their effects on contract awards, funding and collections.
- Changes in total funded and unfunded backlog, which the supplied filing text describes only as modestly lower.
- Exposure and reserve adequacy for the USPS FSS litigation, Brazilian litigation, environmental remediation and other government cost claims.
- The impact of the January 1, 2018 revenue recognition adoption, including contract balances, retained earnings and timing of sales and margin recognition.
- Progress of the $2.503 billion remaining share repurchase authorization and the company’s ability to fund repurchases and dividends while operating cash flow is negative.