Northrop Grumman Corporation — Q1 2018 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 months ended March 31, 2018. Reported 2017 comparatives were recast for the retrospective adoption of ASC Topic 606, Revenue from Contracts with Customers, and ASU 2017-07 regarding pension-cost presentation.
Financial performance and position
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Total sales | $6.735 billion | $6.410 billion | 5% |
| Operating income | $854 million | $862 million | (1)% |
| Operating margin | 12.7% | 13.4% | Down 70 bps |
| Net earnings | $739 million | $650 million | 14% |
| Diluted EPS | $4.21 | $3.69 | 14% |
| Effective tax rate | 15.2% | 17.5% | Down 230 bps |
| Net cash used in operating activities | $237 million | $439 million | Improved $202 million |
| Free cash flow | $(542) million | $(655) million | Improved $113 million |
Sales growth was led by Aerospace Systems and Mission Systems, partly offset by lower Technology Services sales. Segment operating income increased 3% to $762 million, but segment margin declined to 11.3% from 11.6%. Aggregate favorable contract estimate-at-completion adjustments were $116 million, compared with $141 million in the prior-year quarter.
- Aerospace Systems sales increased 10% to $3.280 billion; operating income increased 6% to $341 million, while margin declined to 10.4% from 10.8%.
- Mission Systems sales increased 3% to $2.883 billion; operating income increased 3% to $371 million and margin was 12.9% versus 12.8%.
- Technology Services sales declined 4% to $1.144 billion; operating income declined 5% to $122 million and margin was 10.7% versus 10.8%.
Cash and cash equivalents were $10.369 billion at March 31, 2018, compared with $11.225 billion at December 31, 2017. Total debt had a carrying value of approximately $15.3 billion and an estimated fair value of $15.4 billion. Shareholders’ equity was $7.680 billion. The company paid $198 million of dividends and made no share repurchases during the quarter. The quarterly dividend was increased 10% to $1.10 per share in January 2018.
Backlog was $42.3 billion at March 31, 2018, compared with $42.6 billion at December 31, 2017. Management expects approximately 50% of backlog to convert to revenue within 12 months and 75% within 24 months. Approximately 85% of quarterly sales were attributable to the U.S. Government.
Material changes versus the prior comparable period
- Revenue increased 5%, but operating income decreased 1% because higher segment earnings were more than offset by a $27 million reduction in the net FAS service/CAS pension adjustment and lower margins.
- Net earnings and diluted EPS rose 14%, aided by the lower U.S. corporate tax rate, a $138 million increase in the net FAS non-service pension benefit, higher interest income, and higher segment operating income. These benefits were partly offset by $68 million of additional interest expense.
- Operating cash use improved but remained negative, reflecting working-capital requirements and the company’s historical pattern of heavier cash generation in the second half of the year. Capital expenditures increased to $305 million from $216 million.
- Net contract assets increased 40% to $2.390 billion, principally due to higher sales on restricted programs and collection timing on certain Manned Aircraft programs.
- Retained earnings increased by $1.064 billion from the adoption of ASU 2018-02, which reclassified stranded tax effects from accumulated other comprehensive loss. The adoption had no material effect on operating results or cash flow.
Outlook, commentary, risks, contingencies, and unusual items
The company stated that cash, operating cash generation, and available borrowing capacity are expected to fund operations for at least the next 12 months. It did not provide new quantitative annual revenue or earnings guidance in the filing.
Northrop Grumman expected to close its approximately $7.8 billion cash acquisition of Orbital ATK, plus assumption of approximately $1.4 billion of net debt, in the first half of 2018 after regulatory approvals. The transaction was expected to be funded with debt financing completed in October 2017 and cash on hand. Orbital ATK was planned to become a fourth sector, Northrop Grumman Innovation Systems.
- Defense spending could be affected by future budget debates, appropriations delays, changes in the debt ceiling, or changes in political and economic priorities. The FY2018 Omnibus Appropriations Act provided approximately $700 billion for national security.
- Material exposure exists to U.S. Government concentration, contract cost estimates, fixed-price contract performance, funding reductions, procurement rules, investigations, litigation, cyber threats, supplier performance, international and geopolitical conditions, and pension assumptions.
- The company disclosed ongoing FSS litigation with the U.S. Postal Service. The United States sought to reduce its counterclaim to approximately $193 million; the ultimate outcome could not be predicted or reasonably estimated.
- Bethpage environmental remediation matters could require additional costs, penalties, damages, or other relief. The company could not estimate the range of reasonably possible additional costs arising from potential changes to remediation requirements.
- Estimated future environmental remediation costs ranged from $410 million to $789 million at March 31, 2018; accrued costs were $416 million, with $211 million of deferred costs expected to be recoverable through U.S. Government contract overhead charges.
- An ongoing Department of Justice investigation concerns alleged employee time-charging practices. Potential damages, penalties, sanctions, suspension, or debarment could not be predicted.
- The company estimated that IRS examinations could reduce unrecognized tax benefits by up to $115 million and income tax expense by up to $30 million within the following 12 months.
- The company maintained $1.6 billion of available unsecured credit capacity with no balance outstanding and was in compliance with its debt covenants. Standby letters of credit and guarantees totaled $192 million, and surety bonds totaled $196 million.
Important facts for investors to verify
- Completion, financing, integration costs, and anticipated benefits of the Orbital ATK acquisition.
- Conversion of the $42.3 billion backlog into funded orders, revenue, and cash flow, including the proportion that is unfunded.
- Operating-margin trends, particularly Aerospace Systems performance and the sustainability of contract estimate-at-completion adjustments.
- Working-capital requirements, negative first-quarter free cash flow, capital expenditures, and cash needs associated with the acquisition.
- Debt balances, refinancing requirements, interest expense, and post-acquisition leverage.
- Outcomes of the FSS litigation, Department of Justice investigation, Bethpage environmental matters, and other government claims.
- Effects of ASC Topic 606 and pension-accounting changes on period-to-period comparability and future revenue and margin timing.