Northrop Grumman Corporation — FY2018 Form 10-K 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 fiscal year ended December 31, 2018, with comparative information for 2017 and 2016. The company operated through Aerospace Systems, Innovation Systems, Mission Systems, and Technology Services.
On June 6, 2018, Northrop Grumman completed its $7.7 billion cash acquisition of Orbital ATK, renamed Northrop Grumman Innovation Systems. Innovation Systems contributed results from the merger date through year-end.
Financial performance and key metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Sales | $30.095 billion | $26.004 billion | +16% |
| Operating income | $3.780 billion | $3.218 billion | +17% |
| Operating margin | 12.6% | 12.4% | +20 bps |
| Net earnings | $3.229 billion | $2.869 billion | +13% |
| Diluted EPS | $18.49 | $16.34 | +13% |
| Effective tax rate | 13.7% | 32.2% | Lower |
| Operating cash flow | $3.827 billion | $2.613 billion | +46% |
| Free cash flow | $2.578 billion | $1.685 billion | +53% |
| Capital expenditures | $1.249 billion | $928 million | +35% |
| Total backlog | $53.5 billion | $42.6 billion | +26% |
Reported earnings included a $655 million mark-to-market pension and other postretirement benefit expense, compared with a $536 million benefit in 2017. Excluding the after-tax mark-to-market impact, adjusted net earnings were $3.724 billion and adjusted diluted EPS was $21.33, increases of 51% and 52%, respectively.
Segment sales and operating income were: Aerospace Systems $13.096 billion and $1.411 billion; Innovation Systems $3.276 billion and $343 million; Mission Systems $11.709 billion and $1.520 billion; and Technology Services $4.297 billion and $443 million. Technology Services sales declined 8%, while Aerospace Systems and Mission Systems sales increased 8% and 2%, respectively.
At December 31, 2018, cash and cash equivalents were $1.579 billion, including approximately $250 million held outside the United States. Total debt was $14.400 billion, compared with $15.266 billion at year-end 2017. The company had $198 million of commercial paper outstanding, $108 million drawn under a foreign credit facility, and no borrowings under its $2.0 billion revolving credit facility. Management stated that available cash, operating cash flow, and financing sources should be sufficient for at least the next 12 months.
Shareholders received $821 million of cash dividends in 2018. The company repurchased $1.263 billion of common stock and had $4.284 billion remaining under repurchase authorizations at year-end, including a new $3.0 billion authorization.
Material changes versus the prior comparable period
- Orbital ATK added $3.276 billion of reported sales and $343 million of operating income for the post-acquisition period. The acquisition also increased goodwill by approximately $6.2 billion and created $1.525 billion of purchased intangible assets.
- Reported sales growth was partly acquisition-driven; on a pro forma basis, Innovation Systems sales increased from $4.8 billion in 2017 to $5.6 billion in 2018.
- Net estimate-at-completion adjustments increased to a net favorable $577 million from $360 million. The 2018 amount included $69 million of favorable adjustments on multiple restricted Aerospace Systems programs.
- The effective tax rate declined primarily because of the reduced U.S. corporate tax rate under the 2017 Tax Cuts and Jobs Act and higher research credits. The 2017 rate included $285 million of tax expense related to the tax law.
- Operating cash flow and free cash flow improved substantially, while investing cash use increased to $8.878 billion, principally because of the $7.657 billion net cash cost of the Orbital ATK acquisition.
- Cash declined from $11.225 billion to $1.579 billion, reflecting the acquisition, debt repayments, capital expenditures, share repurchases, and dividends.
- The company adopted ASC Topic 606 and ASU 2017-07 retrospectively and changed its pension actuarial gain and loss accounting method. The pension accounting change reduced 2018 reported net earnings by $93 million and materially reclassified amounts between retained earnings and accumulated other comprehensive income.
- Backlog increased by $10.9 billion, with approximately $26.6 billion expected to convert to sales in 2019 and approximately 75% of year-end backlog expected to convert within 24 months.
Guidance, outlook, management commentary, risks, and unusual items
The filing does not provide a clear numerical 2019 earnings, sales, margin, or cash-flow guidance range. Management described demand as supported by heightened global security threats across undersea, air, space, and cyber domains. The company also cited uncertainty surrounding U.S. appropriations, budget caps, continuing resolutions, the debt ceiling, government shutdowns, international trade policy, geopolitical conditions, and Brexit.
- U.S. government sales represented 82% of 2018 sales, making the company highly dependent on federal defense and intelligence spending.
- Approximately half of 2018 sales were under fixed-price contracts, which expose the company to cost growth, schedule delays, technical issues, supplier performance, and potential losses.
- Contract accounting depends on estimates of revenue, costs, incentives, claims, and performance. Changes in estimates can materially affect reported sales and operating income.
- The company faces integration, execution, control, litigation, and synergy-realization risks following the Orbital ATK acquisition. The acquired business was excluded from management’s internal-control assessment and the auditor’s internal-control audit for 2018.
- Material contingencies include the U.S. Postal Service flats sequencing systems litigation, Bethpage environmental remediation, legacy Orbital ATK securities litigation, tax examinations, government cost claims, and investigations of historical Orbital ATK accounting practices.
- The company reached a preliminary agreement to resolve the Orbital ATK securities litigation for $108 million, subject to final terms and court approval.
- The Department of Justice investigation into certain employee time-charging practices was settled in the fourth quarter of 2018 for a total payment of $30 million.
- Environmental remediation costs had a reasonably possible future cost range of $447 million to $835 million at year-end, with $461 million accrued; potential additional Bethpage liabilities could not be reasonably estimated.
- Goodwill was $18.672 billion, approximately half of total assets. No goodwill or purchased intangible asset impairment was recorded, but impairment remains sensitive to future business conditions and valuation assumptions.
- Operating leases totaling $2.080 billion of minimum commitments were expected to be recognized on the balance sheet upon adoption of the new lease standard on January 1, 2019; the filing estimated approximately $1.4 billion of additional lease assets and liabilities.
Most important facts for investors to verify
- Separate acquisition-driven growth from organic growth, including the pro forma performance and backlog of Innovation Systems.
- Reconcile GAAP earnings and EPS with management’s mark-to-market-adjusted measures and assess the volatility of pension assumptions and plan asset returns.
- Review debt maturities, interest expense, liquidity, and the effect of the substantial reduction in cash following the acquisition.
- Evaluate backlog quality, including funded versus unfunded amounts, expected conversion timing, contract type, and customer appropriations.
- Monitor U.S. government budget actions, continuing resolutions, shutdown risks, and concentration of sales with the federal government.
- Assess fixed-price contract performance, net estimate-at-completion adjustments, and any emerging loss provisions or unfavorable program developments.
- Track Orbital ATK integration, internal-control remediation, goodwill allocation, purchase-price accounting adjustments, and expected synergies.
- Review the status and potential financial exposure of Bethpage environmental matters, the USPS litigation, Orbital ATK securities litigation, tax examinations, and SEC investigations.
- Confirm the impact of the January 1, 2019 lease-standard adoption and any subsequent changes to reported leverage and liabilities.