Northrop Grumman Corporation — Q2 2015 Form 10-Q Summary
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. Operations are organized into Aerospace Systems, Electronic Systems, Information Systems and Technical Services. This unaudited Form 10-Q covers the three and six months ended June 30, 2015, compared with the corresponding 2014 periods.
Financial performance and position
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|
| Sales | $5.896 billion | $6.039 billion | $11.853 billion | $11.887 billion |
| Operating income | $813 million | $820 million | $1.593 billion | $1.665 billion |
| Operating margin | 13.8% | 13.6% | 13.4% | 14.0% |
| Net earnings | $531 million | $511 million | $1.015 billion | $1.090 billion |
| Diluted EPS | $2.74 | $2.37 | $5.15 | $5.01 |
| Operating cash flow | $626 million | $572 million | $(28) million | $170 million |
| Free cash flow | $511 million | $456 million | $(260) million | $(6) million |
- At June 30, 2015, cash and cash equivalents were $1.907 billion, compared with $3.863 billion at December 31, 2014.
- Long-term debt, including the current portion, had a carrying value of $6.527 billion and a fair value of $6.997 billion, compared with a carrying value of $5.928 billion at year-end 2014.
- Total assets were $24.552 billion and shareholders’ equity was $6.171 billion at June 30, 2015.
- The company issued $600 million of unsecured senior notes in February 2015, due April 15, 2045, with a fixed interest rate of 3.85%.
- The company made a $500 million voluntary pension contribution in the first quarter, which materially reduced year-to-date operating cash flow and free cash flow.
- Capital expenditures were $115 million in Q2 and $232 million year to date.
- The quarterly dividend was increased 14% in May 2015 to $0.80 per share from $0.70.
Material changes versus the prior comparable period
- Q2 sales decreased 2%, while six-month sales were essentially flat. Q2 product sales declined 1% and service sales declined 3%.
- Q2 operating income declined slightly, but the operating margin improved to 13.8% from 13.6%, primarily because of improved performance and favorable contract activity.
- Six-month operating income declined 4%, and the operating margin declined to 13.4% from 14.0%. The principal factors were a lower net FAS/CAS pension adjustment and lower segment operating income.
- Q2 net earnings increased 4%, primarily due to a lower effective tax rate. The Q2 tax rate was 27.9%, compared with 32.4% in 2014, including a $38 million benefit from additional research credits claimed on prior-year tax returns.
- Six-month net earnings declined 7%, reflecting lower operating income and pension-related effects.
- Q2 diluted EPS rose 16% to $2.74, primarily because of higher earnings and substantially lower shares outstanding following repurchases. Six-month diluted EPS increased 3% to $5.15 despite lower net earnings.
- Six-month operating cash flow decreased to an outflow of $28 million from inflow of $170 million, primarily due to the voluntary pension contribution and changes in working capital.
- Share repurchases totaled $1.916 billion during the first six months, including 6.8 million shares repurchased during Q2 at an average price of $160.02. Approximately $1.502 billion remained available under the repurchase authorization at June 30.
Segment and backlog developments
| Segment | Q2 sales | Q2 operating income | Six-month sales change |
|---|
| Aerospace Systems | $2.512 billion | $322 million | Up $88 million |
| Electronic Systems | $1.683 billion | $265 million | Down $24 million |
| Information Systems | $1.485 billion | $150 million | Down $80 million |
| Technical Services | $720 million | $67 million | Up $61 million |
- Aerospace Systems benefited from higher unmanned and space-program volume and risk retirements on a restricted program.
- Electronic Systems experienced lower sales and margins due to reduced volume, business mix changes and less favorable performance in land and self-protection systems.
- Information Systems sales declined because of lower command-and-control activity, in-theater force reductions and program completion; margins improved modestly.
- Technical Services sales increased year to date, primarily from international programs, while operating income remained comparable.
- Total backlog was $37.020 billion at June 30, 2015, down from $38.199 billion at December 31, 2014. Funded backlog was $22.603 billion and unfunded backlog was $14.417 billion.
- Six-month contract awards were estimated at $10.7 billion, including awards for F-35, Saudi Arabian Ministry of National Guard Training Support, E-2D Advanced Hawkeye, B-2 and F/A-18 programs.
Guidance, outlook, risks and unusual items
- The filing does not provide a clear quantitative full-year earnings, revenue or cash-flow guidance figure. Management expects cash balances, operating cash flow and available financing capacity to fund operations for at least the next 12 months.
- Management cited continuing uncertainty surrounding defense appropriations, Budget Control Act spending caps and the federal debt ceiling. The company depends heavily on U.S. Government funding and contracting activity.
- Contract accounting relies substantially on estimates of total sales, costs and margins. Net favorable cumulative catch-up adjustments contributed $162 million to Q2 operating income and $349 million year to date; future estimate changes could materially affect results.
- Management continues to invest in independent research and development, increasing general and administrative expenses as a percentage of sales.
- The company faces significant pension exposure. Pension and other post-retirement liabilities were $5.871 billion at June 30, and actuarial assumptions, discount rates and asset returns can affect earnings and equity.
- The FSS litigation with the U.S. Postal Service remains unresolved. Northrop Grumman seeks approximately $178 million in claims, while the government has asserted a counterclaim of approximately $410 million, less certain outstanding contract amounts. The ultimate outcome cannot currently be predicted or estimated.
- Environmental remediation costs were estimated at $359 million to $802 million before recoveries; $374 million was accrued for probable costs at June 30.
- Other disclosed risks include contract performance, investigations and claims, cybersecurity threats, supplier and raw-material constraints, international operations, competition, regulatory changes, tax matters, environmental costs and changes in defense priorities.
- The company was evaluating the new revenue recognition standard, with an effective date deferred to January 1, 2018. The filing does not quantify its eventual impact.
- In July 2015, the unsecured credit facility was amended by reducing availability from $1.775 billion to $1.6 billion and extending maturity to July 2020. No balance was outstanding at June 30.
Investor verification checklist
- Verify the sustainability of earnings growth and margin performance excluding tax benefits, pension-accounting effects and cumulative contract-estimate adjustments.
- Monitor conversion of backlog and new awards into sales, particularly as total backlog declined from year-end.
- Assess liquidity after substantial share repurchases, dividends, pension funding and the decline in cash balances.
- Review debt maturities, interest costs and compliance with the credit agreement’s debt-to-capitalization covenant.
- Track Electronic Systems’ margin pressure and the effect of program mix and fixed-price contract performance.
- Follow developments in the FSS litigation, environmental remediation obligations and other government claims.
- Evaluate the potential effect of defense appropriations, sequestration or debt-ceiling actions on contract funding.
- Confirm the eventual adoption method and financial impact of the new revenue recognition standard.
