Northrop Grumman Corporation — 2014 Q2 Form 10-Q Summary
Business Context and Reporting Period
Northrop Grumman is a global security and defense company serving primarily the U.S. government, including the Department of Defense and intelligence community. Its four segments are Aerospace Systems, Electronic Systems, Information Systems and Technical Services. This Form 10-Q covers the three and six months ended June 30, 2014, compared with the corresponding 2013 periods. The financial statements are unaudited.
Financial Results and Key Metrics
| Metric | Q2 2014 | Q2 2013 | Six Months 2014 | Six Months 2013 |
|---|---|---|---|---|
| Sales | $6,039 million | $6,294 million | $11,887 million | $12,398 million |
| Operating income | $820 million | $806 million | $1,665 million | $1,565 million |
| Operating margin | 13.6% | 12.8% | 14.0% | 12.6% |
| Net earnings | $511 million | $488 million | $1,090 million | $977 million |
| Diluted EPS | $2.37 | $2.05 | $5.01 | $4.08 |
| Operating cash flow | $572 million | $328 million | $170 million | $329 million |
| Free cash flow | $456 million | $280 million | $(6) million | $241 million |
Q2 sales declined 4%, while operating income increased 2%, reflecting improved contract performance and lower costs, particularly in services. Six-month sales declined 4%, but operating income increased 6%. Net earnings increased 5% in Q2 and 12% year to date. EPS benefited from both higher earnings and substantially lower share counts following repurchases.
As of June 30, 2014, cash and cash equivalents were $3,476 million, down from $5,150 million at December 31, 2013. Long-term debt was $5,927 million, substantially unchanged from year-end, with reported debt fair value of $6,651 million. The company had no borrowings under its $1.775 billion unsecured credit facility and was in compliance with its covenants. Total current assets were $8,390 million versus current liabilities of $5,414 million.
Material Changes Versus the Prior Comparable Period
- Total sales decreased $255 million in Q2 and $511 million year to date. The largest declines were in Information Systems and Aerospace Systems.
- Information Systems sales fell 8% in Q2 and 7% year to date because of reduced funding across programs, restricted-work reductions and in-theater force reductions; operating income nevertheless increased 9% in Q2 and 1% year to date.
- Aerospace Systems sales declined because of lower Global Hawk, Fire Scout and space-program activity. Q2 operating income decreased 14%, although six-month operating income increased 1%.
- Electronic Systems sales declined 2% in Q2 and 3% year to date. Operating income declined 10% in both periods, driven by lower sales and fewer favorable contract adjustments.
- Technical Services Q2 sales increased 1%, aided by the QDS acquisition, while the ICBM program ramped down. The company acquired Qantas Defence Services for $72 million in February 2014.
- Net favorable cumulative contract-estimate adjustments were $165 million in Q2 and $362 million year to date, compared with $247 million and $421 million, respectively, in 2013. These adjustments materially supported reported operating income but were lower than in the prior-year periods.
- The six-month effective tax rate fell to 29.3% from 32.0%, principally because of a $51 million benefit from partial resolution of the 2007–2009 IRS examination.
- Six-month operating cash flow declined because of adverse trade working-capital changes. The comparison also reflects a $500 million voluntary pension contribution made in April 2013.
- The company repurchased $1.301 billion of common stock during the first six months and paid $280 million of dividends. The quarterly dividend was increased 15% to $0.70 per share in May 2014.
Backlog, Outlook, Risks and Unusual Items
Total backlog was $35.555 billion at June 30, 2014, down 4% from $37.033 billion at December 31, 2013. Funded backlog was $22.176 billion and unfunded backlog was $13.379 billion. Six-month awards totaled approximately $10.2 billion. Subsequent to quarter-end, the company received a $3.6 billion multiyear E-2D Advanced Hawkeye award, which was not included in the reported backlog or second-quarter awards.
The filing does not provide a specific quantitative earnings or sales guidance range. Management stated that available cash and expected operating cash flow, supplemented by financing if needed, should fund operations for at least the next 12 months. The broader outlook remains dependent on U.S. defense budgets, sequestration levels, government funding, program priorities, contract awards and execution.
Key risks include declining or delayed government funding, reduced defense and intelligence spending, contract performance and estimate changes, and dependence on the U.S. government. Pension and post-retirement costs may increase as new mortality assumptions are adopted, potentially increasing liabilities, annual expense and funding requirements. The company also identified risks from timing differences among pension expense, government contract cost recovery and cash funding.
Material legal matters include the USPS flats sequencing systems dispute, in which the government asserted a counterclaim of approximately $410 million, and related False Claims Act litigation. The ultimate outcome and potential loss cannot currently be estimated. Environmental remediation obligations were estimated at $364 million to $790 million of reasonably possible future costs; $383 million was accrued as probable. The company also had $322 million of standby letters of credit and guarantees and $165 million of surety bonds outstanding.
The company is evaluating ASU 2014-09, the new revenue recognition standard, effective January 1, 2017. The filing states that adoption could change the method or timing of revenue recognition for certain contracts, but the financial impact had not yet been determined.
Important Facts for Investors to Verify
- Whether the $3.6 billion E-2D award is incorporated into subsequent backlog and future revenue expectations.
- The sustainability of operating margins given lower sales, reduced favorable contract adjustments and reliance on percentage-of-completion estimates.
- Working-capital trends and the company’s ability to convert earnings into cash after the weak six-month free cash flow result.
- Progress and potential exposure in the USPS/FSS litigation and related False Claims Act matters.
- The effect of revised pension mortality assumptions on liabilities, expense and required funding.
- The expected effect and transition method for ASU 2014-09 revenue recognition.
- Future U.S. defense funding, sequestration, program cancellations, contract awards and timing of appropriations.