Northrop Grumman Corporation — FY2016 Form 10-K Summary
Business context and reporting period
Annual report for the fiscal year ended December 31, 2016, filed January 30, 2017. Northrop Grumman is a global defense and security contractor serving primarily the U.S. Department of Defense and intelligence community. Reportable segments were Aerospace Systems, Mission Systems, and Technology Services. The company employed approximately 67,000 people and generated 84% of sales from the U.S. Government.
Key financial metrics
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Sales | $24.508 billion | $23.526 billion | Up 4% |
| Operating income | $3.193 billion | $3.076 billion | Up 4% |
| Operating margin | 13.0% | 13.1% | Down 0.1 points |
| Net earnings | $2.200 billion | $1.990 billion | Up 11% |
| Diluted EPS | $12.19 | $10.39 | Up 17% |
| Effective tax rate | 24.7% | 28.7% | Down 4.0 points |
| Operating cash flow | $2.813 billion | $2.162 billion | Up 30% |
| Free cash flow | $1.893 billion | $1.691 billion | Up 12% |
| Cash and equivalents | $2.541 billion | $2.319 billion | Up $222 million |
| Long-term debt | $7.070 billion | $6.496 billion | Up $574 million |
| Total backlog | $45.339 billion | $35.923 billion | Up 26% |
Capital expenditures were $920 million, compared with $471 million in 2015. The company reported $6.818 billion of pension and other post-retirement benefit liabilities and total shareholders’ equity of $5.259 billion at year-end.
Segment performance and material changes
- Aerospace Systems: Sales increased 9% to $10.828 billion; operating income increased 3% to $1.236 billion. Margin declined to 11.4% from 12.1%, primarily because of lower margins on Manned Aircraft programs. Higher Triton, Global Hawk, F-35, E-2D, and restricted-program activity supported sales.
- Mission Systems: Sales increased 2% to $10.928 billion; operating income increased 2% to $1.445 billion; margin remained 13.2%. Results included a $21 million gain on the sale of a commercial cyber security business and a $49 million forward-loss provision on an Advanced Capabilities program.
- Technology Services: Sales were essentially flat at $4.825 billion and operating income was $512 million, compared with $514 million. Management expects KC-10-related sales to wind down in 2017 as the contract nears completion.
- Net estimate-at-completion adjustments contributed $494 million of operating income in 2016, down from $580 million in 2015 and $664 million in 2014.
- Net earnings benefited from higher operating income and a lower tax rate. The 2016 tax rate included an $85 million share-based compensation tax benefit, a $40 million IRS examination resolution benefit, and a $33 million foreign earnings repatriation benefit; management indicated these items were not representative of the longer-term tax rate.
- Weighted-average diluted shares declined 6% to 180.5 million because of repurchases. The company repurchased $1.547 billion of common stock in 2016 and had $2.7 billion remaining under its authorization at year-end. Annual dividends declared increased to $3.50 per share from $3.10.
Liquidity, debt, outlook, and risks
Management stated that cash, operating cash flow, and available borrowing capacity were expected to fund operations for at least the next 12 months. Approximately $18.2 billion of the $45.3 billion backlog was expected to convert to sales in 2017. Capital expenditure commitments were $657 million at year-end.
In December 2016, the company issued $750 million of 3.20% unsecured senior notes due 2027 and redeemed $200 million of existing debt, recording a $14 million pre-tax charge. It also had $135 million outstanding under a variable-rate credit facility. Total contractual obligations were $21.872 billion, including $7.097 billion of debt principal, $4.039 billion of debt interest, and $8.748 billion of purchase obligations.
The outlook remained dependent on U.S. defense appropriations, congressional budget actions, continuing resolutions, sequestration, debt-ceiling developments, and the priorities of the incoming Administration and Congress. Major risks include customer concentration, contract funding delays or termination, fixed-price contract cost growth, adverse estimate-at-completion revisions, subcontractor and supplier performance, cybersecurity threats, procurement and compliance investigations, environmental remediation, pension assumptions and funding requirements, competition and bid protests, and international regulatory and geopolitical exposure.
Environmental remediation liabilities were accrued at $385 million, against a reasonably possible future cost range of $379 million to $774 million. The company disclosed significant litigation involving the U.S. Postal Service flats sequencing systems contract, including company claims of approximately $178 million and government counterclaims of approximately $410 million; the ultimate outcome could not be predicted or reasonably estimated. Management did not believe other pending matters were likely to have a material adverse effect.
The company adopted ASU 2016-09, resulting in an $85 million 2016 tax benefit and corresponding cash-flow presentation changes. It expected to adopt the new revenue standard in 2018 and did not expect a material effect on results or cash flows, although certain contracts could experience accelerated revenue recognition.
Important facts for investors to verify
- Whether U.S. defense appropriations, continuing resolutions, sequestration, and new Administration priorities alter program funding or backlog conversion.
- The sustainability of the 2016 tax rate after excluding discrete benefits and the potential resolution of remaining IRS examinations, including up to $40 million of possible future tax benefits.
- Performance and cost growth on fixed-price development programs, particularly the Mission Systems program with the $49 million forward-loss provision.
- The quality and funding status of the $45.3 billion backlog, including the large unfunded component of $23.173 billion.
- Pension and post-retirement obligations, including $7.9 billion of combined funded-status deficits and sensitivity to discount rates and investment returns.
- Future cash deployment among debt reduction, pension contributions, dividends, capital expenditures, and share repurchases.
- Developments in the USPS flats sequencing systems litigation, environmental remediation, government audits, and other contingent liabilities.
- Execution of the KC-10 contract wind-down and the effect of program transitions on Technology Services revenue.