Northrop Grumman Corporation: 2018 Q3 Form 10-Q Summary
Business context and reporting period
Quarterly report for the three and nine months ended September 30, 2018. Northrop Grumman is a global security and aerospace company serving primarily the U.S. government, including the Department of Defense and intelligence community, with additional international, state, local and commercial customers.
On June 6, 2018, the company completed its $7.7 billion cash acquisition of Orbital ATK, renamed Northrop Grumman Innovation Systems, and established it as a fourth reportable sector. Results include Innovation Systems from the merger date onward. The 2017 comparative results were recast for ASC 606 revenue recognition and ASU 2017-07 pension presentation.
Key financial metrics
| Metric | Q3 2018 | Q3 2017 | Change |
|---|---|---|---|
| Sales | $8.085 billion | $6.569 billion | 23% |
| Operating income | $1.178 billion | $837 million | 41% |
| Operating margin | 14.6% | 12.7% | 190 bps |
| Net earnings | $1.144 billion | $643 million | 78% |
| Diluted EPS | $6.54 | $3.67 | 78% |
| Effective tax rate | 7.5% | 17.8% | Down 10.3 points |
| Metric | Nine months 2018 | Nine months 2017 | Change |
|---|---|---|---|
| Sales | $21.939 billion | $19.452 billion | 13% |
| Operating income | $2.855 billion | $2.572 billion | 11% |
| Operating margin | 13.0% | 13.2% | Down 20 bps |
| Net earnings | $2.572 billion | $1.848 billion | 39% |
| Diluted EPS | $14.68 | $10.52 | 40% |
| Operating cash flow | $1.450 billion | $1.006 billion | 44% |
| Free cash flow | $664 million | $356 million | 87% |
At September 30, 2018, cash and cash equivalents were $1.228 billion, compared with $11.225 billion at December 31, 2017, principally reflecting the Orbital ATK acquisition, debt repayment and other financing activity. Long-term debt was $13.889 billion, compared with $14.399 billion at year-end 2017; total debt, including current maturities and short-term borrowings, was approximately $14.4 billion. Commercial paper outstanding was $499 million, and $117 million was outstanding under a U.K. subsidiary credit facility. The company had no borrowings under its $2.0 billion revolving credit facility and stated that available liquidity and operating cash flow should fund operations for at least the next 12 months.
Net contract assets increased to $3.914 billion from $1.704 billion at December 31, 2017, primarily due to the acquisition, higher restricted-program activity and higher F-35 volume. Backlog was $52.6 billion, compared with $42.6 billion at December 31, 2017; management expected approximately 50% of backlog to convert to revenue within 12 months and 75% within 24 months.
Material changes versus the prior comparable period
- Orbital ATK contributed $1.415 billion of Q3 sales and $161 million of operating income, and $1.815 billion of nine-month sales and $200 million of operating income.
- Aerospace Systems Q3 sales rose 5% and operating income rose 9%; nine-month sales and operating income each rose 9%, supported by Manned Aircraft and Autonomous Systems programs.
- Mission Systems Q3 sales increased 3% and operating income increased 11%; nine-month sales and operating income increased 2%.
- Technology Services Q3 sales declined 12% and operating income declined 10%; nine-month sales declined 9% and operating income declined 13%, reflecting program completions and an unfavorable adjustment on the VITA program.
- Q3 operating income benefited from a $223 million reduction in corporate cost claims and increased estimated recovery of environmental remediation costs. This benefit was partly offset by $97 million of merger-related depreciation and amortization.
- Net earnings benefited from higher segment operating income, pension benefits, lower corporate expense and a lower tax rate, partly offset by $60 million of higher interest expense in Q3 and $196 million of higher interest expense for the nine-month period.
- Net favorable contract estimate-at-completion adjustments were $149 million in Q3 and $408 million for the nine months, compared with $114 million and $357 million, respectively, in the prior-year periods.
Guidance, outlook, commentary and risks
The filing does not provide a clear updated quantitative financial outlook or formal earnings guidance. Management cited increased U.S. national-security appropriations, but noted continuing uncertainty regarding federal budgets, appropriations, the debt ceiling, geopolitical conditions, trade policies and tariffs.
Management expects the Orbital ATK acquisition to broaden capabilities, create revenue and cost synergies and support emerging customer requirements. The purchase-price allocation remains preliminary; final valuations for certain real estate, intangible assets, tax matters and legal, environmental and contract reserves could result in material adjustments.
- Material exposure exists to U.S. government funding, procurement decisions, contract changes, claims, terminations and cost disallowances.
- Contract accounting relies on estimates of total revenue and costs at completion; changes can produce significant cumulative adjustments or loss provisions.
- Significant contingencies include the FSS litigation, government investigations involving time-charging practices and legacy Orbital ATK accounting, and environmental matters at Bethpage, New York.
- Estimated reasonably possible future environmental remediation costs were $455 million to $835 million, excluding amounts expected to be recovered through government-contract overhead charges. Bethpage-related additional costs cannot currently be estimated.
- The company identified risks related to acquisition integration, cybersecurity, suppliers, international operations, intellectual property, pensions, taxes, hazardous operations and potential changes in goodwill or other long-lived asset values.
- The company expects to adopt the lease accounting standard on January 1, 2019 using the optional transition method and does not expect a material impact on annual results of operations or cash flows, although the balance-sheet impact had not yet been determined.
Most important facts for investors to verify
- Whether Innovation Systems integration, synergy realization and the final purchase-price allocation materially change earnings, debt, goodwill or intangible assets.
- Whether the elevated net contract assets convert to cash as expected and whether backlog converts at the stated rate.
- The sustainability of Q3 earnings, particularly the $223 million corporate benefit, favorable EAC adjustments and unusually low 7.5% tax rate.
- Debt reduction, interest expense, commercial-paper usage and liquidity following the acquisition.
- Technology Services program declines and any further effects from the VITA termination or other contract completions.
- Developments in Bethpage remediation, government investigations, FSS litigation, Orbital ATK-related securities litigation and SEC matters.
- The effect of U.S. government appropriations, continuing resolutions, procurement changes and geopolitical or trade developments on future orders and revenue.