Northrop Grumman Corporation — Form 10-Q Summary
Business context and reporting period
Northrop Grumman is a global security and defense contractor serving primarily the U.S. government, including the Department of Defense and intelligence community. The filing covers the three and nine months ended September 30, 2019. Reportable sectors were Aerospace Systems, Innovation Systems, Mission Systems and Technology Services. Innovation Systems reflects the Orbital ATK acquisition completed June 6, 2018. The company announced a sector realignment effective January 1, 2020; the reported financial information is not presented on that future basis.
The interim financial statements were reviewed by Deloitte & Touche and were not audited. Approximately 83% of nine-month sales came from the U.S. government.
Financial performance and key metrics
| Metric | Q3 2019 | Q3 2018 | 9M 2019 | 9M 2018 |
|---|---|---|---|---|
| Sales | $8.475 billion | $8.085 billion | $25.120 billion | $21.939 billion |
| Operating income | $951 million | $1.172 billion | $2.833 billion | $2.837 billion |
| Operating margin | 11.2% | 14.5% | 11.3% | 12.9% |
| Net earnings | $933 million | $1.244 billion | $2.657 billion | $2.873 billion |
| Diluted EPS | $5.49 | $7.11 | $15.60 | $16.40 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $1.833 billion | $1.450 billion |
| Free cash flow | Not provided for quarter | Not provided for quarter | $1.040 billion | $664 million |
- Product sales increased 8% in the quarter and 20% year to date; service sales increased 1% and 2%, respectively.
- Q3 sales rose 5%, but operating income fell 19%, primarily because of higher unallocated corporate expense, lower pension-related benefit adjustments and lower segment operating income.
- Year-to-date sales increased 14%, largely from a full nine months of Innovation Systems sales and growth in Aerospace Systems and Mission Systems. Year-to-date operating income was essentially flat.
- General and administrative expense as a percentage of sales improved to 9.2% from 10.1% in the quarter and to 9.2% from 10.3% year to date.
- The effective tax rate was 11.6% in Q3 and 14.8% year to date, compared with 8.8% and 14.0%, respectively, in the prior-year periods.
Segment performance
| Segment | Q3 sales | Q3 operating income | 9M sales | 9M operating income |
|---|---|---|---|---|
| Aerospace Systems | $3.458 billion | $324 million | $10.344 billion | $1.067 billion |
| Innovation Systems | $1.584 billion | $164 million | $4.520 billion | $500 million |
| Mission Systems | $3.029 billion | $398 million | $9.043 billion | $1.189 billion |
| Technology Services | $1.067 billion | $136 million | $3.088 billion | $351 million |
- Aerospace Systems sales increased, but Q3 operating income declined 14% due primarily to lower favorable estimate-at-completion adjustments and program performance issues.
- Innovation Systems Q3 sales increased 12% and operating income increased 2%; year-to-date results are not directly comparable because the 2018 period includes only post-acquisition results.
- Mission Systems Q3 sales increased 4% with essentially flat operating income; year-to-date operating income increased 6%.
- Technology Services Q3 operating income increased 23%, while nine-month sales declined 4% because of program completions.
Liquidity, capital resources and balance sheet
- Cash and cash equivalents were $1.127 billion at September 30, 2019, down from $1.579 billion at December 31, 2018.
- Long-term debt was $13.826 billion, compared with $13.883 billion at year-end 2018. Commercial paper outstanding was $399 million; the company had no borrowings under its $2.0 billion 2018 credit facility.
- The company had $2.0 billion of operating credit capacity, reduced by commercial paper borrowings, and was in compliance with its debt covenants. In October 2019, the principal credit facility maturity was extended from August 2023 to August 2024.
- Capital expenditures were $793 million year to date, broadly comparable with $786 million in 2018.
- Financing cash outflows included $500 million of long-term debt repayments, $444 million of share repurchases and $658 million of dividends. The quarterly dividend was increased 10% to $1.32 per share in May 2019.
- The 2015 repurchase authorization had $600 million remaining at September 30, 2019; total remaining authorization under the disclosed programs was $3.632 billion at the end of Q3.
- Backlog increased 22% to $65.0 billion from $53.5 billion at December 31, 2018. Management expected approximately 40% of backlog to convert to revenue within 12 months and 65% within 24 months.
Material changes, outlook and unusual items
- Operating results benefited from cost management and Orbital ATK integration synergies, but comparisons were affected by acquisition timing and the absence of a $223 million prior-year benefit from finalization of certain cost claims.
- Year-to-date unallocated corporate expense increased substantially, including higher purchased-intangible amortization and property, plant and equipment step-up depreciation associated with the Orbital ATK acquisition.
- Net favorable estimate-at-completion adjustments were $125 million in Q3 and $421 million year to date, compared with $149 million and $408 million, respectively, in the prior-year periods. These contract-estimate changes can materially affect reported results.
- The company stated that cash on hand and operating cash flow, supplemented by credit facilities, commercial paper or capital markets financing if needed, should fund operations for at least the next 12 months. No formal quantitative earnings or revenue guidance is provided in the filing text.
- Management cited demand opportunities in space, missiles, missile defense, hypersonics, counter-hypersonics, low-observable technology and cyber. FY2020 appropriations had not been enacted as of September 30, 2019; a continuing resolution funded the government at FY2019 levels through November 21, 2019.
- The FTC requested information in October 2019 regarding potential compliance with conditions imposed on the Orbital ATK acquisition in connection with a strategic missile competition. Management stated it believes the company remains compliant but could not predict the impact on the competition.
- Environmental remediation estimates were $528 million to $997 million of reasonably possible future costs, with $543 million accrued and $423 million deferred as potentially recoverable through U.S. government contract overhead. Bethpage remediation requirements could change and costs could increase materially.
- The company disclosed a proposed $108 million resolution of an Orbital ATK securities class action, subject to conditions, and continuing insurance coverage litigation.
- Effective January 1, 2019, the company adopted ASC 842 for leases, recording $1.511 billion of operating lease right-of-use assets and $1.564 billion of operating lease liabilities without a material impact on earnings or cash flows.
Most important facts for investors to verify
- Whether backlog conversion, new awards and U.S. defense appropriations support continued revenue growth, particularly under continuing-resolution or delayed-budget conditions.
- The sustainability of segment margins and the extent to which favorable contract estimate-at-completion adjustments recur.
- The impact of corporate costs, pension accounting adjustments, acquisition-related amortization and integration performance on GAAP earnings.
- Potential exposure from Bethpage environmental remediation, the FTC inquiry, the Orbital ATK securities litigation and other government claims.
- Cash conversion, working-capital requirements and the company’s ability to fund debt service, dividends, repurchases and capital expenditures while maintaining liquidity.
- The effect of the January 2020 sector realignment on segment comparability and future reporting.