Business Context and Reporting Period
Northrop Grumman Corporation filed this Form 10-K for the fiscal year ended December 31, 2017. The company is a global defense and security contractor operating through Aerospace Systems, Mission Systems, and Technology Services. Approximately 85% of 2017 sales came from the U.S. Government, principally the Department of Defense and intelligence community.
The filing also provides unaudited fourth-quarter data. Fourth-quarter 2017 sales were $6.634 billion, operating income was $767 million, net earnings were $178 million, and diluted earnings per share were $1.01.
Key Financial Metrics
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Sales | $25.803 billion | $24.508 billion | Up 5% |
| Operating income | $3.299 billion | $3.193 billion | Up 3% |
| Operating margin | 12.8% | 13.0% | Down 20 bps |
| Net earnings | $2.015 billion | $2.200 billion | Down 8% |
| Diluted EPS | $11.47 | $12.19 | Down 6% |
| Net cash from operations | $2.613 billion | $2.813 billion | Down 7% |
| Free cash flow | $1.685 billion | $1.893 billion | Down 11% |
| Cash and equivalents | $11.225 billion | $2.541 billion | Up $8.684 billion |
| Long-term debt, including current portion | $15.266 billion | $7.070 billion | Up $8.196 billion |
| Total backlog | $42.878 billion | $45.339 billion | Down 5% |
Capital expenditures were $928 million, compared with $920 million in 2016. The company declared $3.90 per common share of dividends in 2017, increased the quarterly dividend to $1.00 per share, and repurchased $393 million of common stock. Approximately $2.3 billion remained under the share repurchase authorization at year-end.
Segment Performance
| Segment | 2017 Sales | 2017 Operating Income | 2017 Margin |
|---|---|---|---|
| Aerospace Systems | $11.955 billion | $1.259 billion | 10.5% |
| Mission Systems | $11.382 billion | $1.453 billion | 12.8% |
| Technology Services | $4.750 billion | $524 million | 11.0% |
Aerospace Systems sales increased 10%, primarily from higher Manned Aircraft and restricted-program volume. Mission Systems sales increased 4%, led by Sensors and Processing. Technology Services sales declined 2% as several programs were completed, although operating income and margin improved.
Material Changes Versus the Prior Comparable Period
- Sales increased $1.3 billion, driven primarily by Aerospace Systems and Mission Systems.
- Operating income increased modestly, but consolidated margin declined because of lower segment margins and higher unallocated corporate expenses.
- Net earnings declined primarily because the 2017 Tax Cuts and Jobs Act generated $300 million of tax expense, including a deferred-tax-asset write-down, and because interest expense increased following new debt issuance.
- The company issued $8.25 billion of unsecured senior notes in October 2017 to finance the pending Orbital ATK acquisition. Total debt increased to $15.266 billion from $7.070 billion.
- Operating cash flow and free cash flow declined, principally reflecting a $500 million voluntary pre-tax pension contribution made in December 2017.
- Total backlog declined $2.461 billion to $42.878 billion; approximately $20.3 billion was expected to convert to 2018 sales.
- Net estimate-at-completion adjustments declined to $363 million from $494 million. The 2017 amount included a $56 million favorable adjustment on a restricted Aerospace Systems program and $54 million recognized to date on a cost claim.
Guidance, Outlook, Commentary, Risks, and Unusual Items
The filing does not provide a clear numerical earnings or revenue forecast. Management described the defense environment as supported by persistent global security threats but subject to uncertainty involving U.S. appropriations, sequestration, continuing resolutions, the debt ceiling, government shutdowns, geopolitical conditions, and customer priorities.
The company expected the Orbital ATK acquisition to close in the first half of 2018 after regulatory approvals. The transaction was valued at approximately $7.8 billion in cash plus assumed net debt of approximately $1.4 billion. Certain 2020, 2022, 2025, and 2047 notes required mandatory redemption at 101% of principal if the acquisition was not completed by the applicable deadline.
- Tax reform: The 2017 Tax Act increased 2017 tax expense by $300 million and reduced the effective tax rate benefit otherwise expected from lower future U.S. corporate tax rates. Certain tax amounts remained provisional.
- Government concentration: Changes in U.S. Government defense spending, appropriations, contract priorities, termination decisions, or payment timing could materially affect results.
- Contract risk: Approximately 45% of 2017 sales were from fixed-price contracts, which expose the company to cost growth, schedule delays, technical performance issues, and subcontractor risk.
- Acquisition and leverage: Integration, regulatory approval, execution, and increased interest obligations associated with Orbital ATK could affect liquidity and results.
- Legal and environmental contingencies: The company disclosed ongoing investigations and litigation, including U.S. Government matters, the FSS contract dispute, Brazil litigation, and extensive Bethpage environmental remediation. The company could not estimate the cumulative range of potential additional Bethpage liabilities.
- Environmental reserves: Reasonably possible future remediation costs were estimated at $405 million to $792 million, with $410 million accrued and $207 million deferred as expected to be recoverable through government-contract overhead charges.
- Pension exposure: Pension and other post-retirement benefit plan liabilities totaled $5.511 billion. Results and cash requirements remain sensitive to discount rates, asset returns, mortality assumptions, and required funding.
- Accounting changes: The company adopted ASC Topic 606 revenue guidance on January 1, 2018 using full retrospective application. The filing states that the standard was not expected to have a material effect on results or cash flows, although selected 2016 and 2017 amounts were recast for comparison.
Important Facts for Investors to Verify
- Confirm the closing, financing, accounting treatment, and post-close integration results of the Orbital ATK acquisition.
- Assess whether the higher debt balance and mandatory redemption provisions affect leverage, interest expense, buybacks, dividends, and liquidity.
- Monitor U.S. defense appropriations, continuing resolutions, debt-ceiling actions, shutdown risks, and funding for major Northrop Grumman programs.
- Evaluate backlog quality, including the $22.373 billion funded and $20.505 billion unfunded components, and the expected 2018 conversion.
- Review the effect of ASC 606 retrospective adoption on reported revenue, margins, contract assets and liabilities, and period-to-period comparability.
- Track tax-reform true-ups, IRS examinations, and unrecognized tax benefits, including potential reductions of up to $115 million in unrecognized benefits and up to $30 million in tax expense within the following twelve months.
- Follow Bethpage remediation requirements, environmental reserves, government investigations, contract claims, and other litigation exposures.
- Consider sensitivity to contract estimate changes, fixed-price program performance, pension assumptions, interest rates, cybersecurity threats, and supplier execution.