Northrop Grumman Corporation 2016 Second-Quarter Form 10-Q Summary
Business context and reporting period
Northrop Grumman is a global security company serving primarily the U.S. government, including the Department of Defense and intelligence community. Its three reportable segments are Aerospace Systems, Mission Systems, and Technology Services. The filing covers the quarter and six months ended June 30, 2016; interim financial statements are unaudited.
Financial performance and position
| Metric | Three months ended June 30, 2016 | Year-over-year change | Six months ended June 30, 2016 | Year-over-year change |
|---|---|---|---|---|
| Sales | $6.000 billion | Up 2% | $11.956 billion | Up 1% |
| Operating income | $797 million | Down 2% | $1.536 billion | Down 4% |
| Operating margin | 13.3% | Down from 13.8% | 12.8% | Down from 13.4% |
| Net earnings | $517 million | Down 3% | $1.073 billion | Up 6% |
| Diluted EPS | $2.85 | Up 4% | $5.88 | Up 14% |
| Operating cash flow | $604 million | Down 4% | $544 million | Improved from $(28) million |
Six-month free cash flow was $73 million, compared with negative $260 million in the prior-year period. Capital expenditures were $471 million, including $239 million for the purchase of facilities previously leased by Mission Systems. Cash and cash equivalents were $1.139 billion at June 30, 2016, versus $2.319 billion at December 31, 2015.
Long-term debt, including the current portion, had a carrying value of approximately $6.390 billion and a fair value of $7.352 billion. The company had no borrowings under its $1.6 billion unsecured revolving credit facility, which matures in July 2020, and was in compliance with its covenants. Total liabilities were $18.400 billion and shareholders’ equity was $5.681 billion at quarter-end.
The company repurchased $682 million of common stock during the first six months and paid $322 million of cash dividends. The quarterly dividend was increased 13% in May 2016 to $0.90 per share. The 2015 repurchase authorization had $3.6 billion remaining at June 30, 2016.
Material changes versus the prior comparable period
- Aerospace Systems sales increased 4% for both the quarter and six months, but operating income declined 2% and 5%, respectively, primarily because of lower Manned Aircraft margins and contract mix.
- Mission Systems sales increased 2% in the quarter and 1% year to date; operating income increased 1% and 2%, respectively.
- Technology Services sales declined 2% in the quarter and 3% year to date. Quarterly operating income increased 2%, while six-month operating income declined 2%.
- Aggregate net favorable estimate-at-completion adjustments declined to $137 million in the quarter and $266 million for the six months, from $162 million and $349 million, respectively, in the prior-year periods.
- Year-to-date net earnings benefited from an $84 million tax benefit related to adoption of ASU 2016-09 for employee share-based payments. The effective tax rate declined to 23.7% from 29.5%.
- Operating cash flow improved principally because the prior-year period included a $500 million voluntary pension contribution, as well as changes in working capital and the stock-compensation accounting adoption.
- Total backlog increased during the first six months, with higher Aerospace Systems backlog, a high single-digit percentage decline in Technology Services backlog, and a modest decline in Mission Systems backlog. The company recorded various awards, including a portion of the B-21 Long-Range Strike Bomber program.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide a clear quantitative full-year earnings, sales, cash-flow or margin guidance figure. Management states that cash balances, operating cash flow and, if needed, credit facilities are expected to fund operations for at least the next 12 months.
Management noted uncertainty regarding fiscal 2017 appropriations. A continuing resolution could restrict new contract or program starts and limit planned program budgets; a government shutdown was also identified as a possibility. The company remains substantially dependent on U.S. government contracts.
In July 2016, after the reporting date, the company entered into a U.S. government contract modification on an Aerospace Systems program that resolved most previously disclosed requests for equitable adjustment. Amounts recognized through June 30 were not material.
Also after quarter-end, the Joint Committee on Taxation approved resolution of the company’s 2007–2011 federal tax examinations. Northrop Grumman expected to record in the third quarter a reduction of approximately $115 million in unrecognized tax benefits and approximately $40 million in income tax expense. Additional tax matters could reduce unrecognized tax benefits by up to $70 million and income tax expense by up to $45 million within the following twelve months.
Material risk areas include U.S. government funding and procurement decisions, contract cost growth and estimate changes, litigation and government claims, pension assumptions and asset returns, cyber and security threats, subcontractor performance, competition and bid protests, environmental obligations, international operations, tax matters, and the ability to meet contract performance obligations.
The company disclosed ongoing FSS contract litigation involving claims and counterclaims with the U.S. government; the ultimate outcome and any potential loss could not be predicted or estimated. Environmental remediation obligations had a reasonably possible future cost range of $361 million to $771 million, with $371 million accrued. Standby letters of credit and guarantees totaled $280 million, and surety bonds totaled $151 million.
Most important facts for investors to verify
- Whether operating margin pressure, particularly in Aerospace Systems, persists as contract mix and risk-reduction timing change.
- The conversion of backlog, including B-21-related awards, into funded orders, revenue and cash flow.
- The sustainability of cash generation after the $239 million facilities purchase and elevated capital expenditures.
- The impact of the expected third-quarter tax benefits and any additional tax resolutions.
- Exposure to continuing-resolution or government-shutdown scenarios and changes in defense appropriations.
- Potential developments in the FSS litigation, environmental remediation estimates and other government cost claims.
- The effect of the 2016 segment reorganization and accounting changes on future period comparability.