Northrop Grumman Corporation — 2014 Q1 Form 10-Q Summary
Business context and reporting period
Quarterly report for the three months ended March 31, 2014. Northrop Grumman is a global security company serving primarily the U.S. Government, including the Department of Defense and intelligence community, through Aerospace Systems, Electronic Systems, Information Systems and Technical Services.
Financial performance and condition
| Metric | Q1 2014 | Q1 2013 | Change |
|---|---|---|---|
| Total sales | $5.848 billion | $6.104 billion | Down 4% |
| Operating income | $845 million | $759 million | Up 11% |
| Operating margin | 14.4% | 12.4% | Up 200 basis points |
| Net earnings | $579 million | $489 million | Up 18% |
| Diluted EPS | $2.63 | $2.03 | Up 30% |
| Effective tax rate | 26.3% | 31.3% | Down 500 basis points |
| Operating cash flow | $(402) million | $1 million | Declined |
| Free cash flow from operations | $(462) million | $(39) million | Declined |
Cash and cash equivalents were $3.885 billion at March 31, 2014, compared with $5.150 billion at December 31, 2013. Long-term debt was $5.927 billion, with no borrowings under the $1.775 billion unsecured credit facility. The company was in compliance with its debt covenants. Total assets were $25.535 billion and shareholders’ equity was $10.569 billion.
Operating cash flow was affected primarily by a $1.098 billion increase in trade working capital, including a $531 million increase in accounts receivable and a $755 million decrease in accounts payable and accruals. Capital expenditures were $60 million. Financing uses included $570 million of share repurchases and $132 million of dividends. The quarterly dividend was $0.61 per share.
Material changes versus the prior comparable period
- Sales decreased $256 million, with lower sales in all four segments. Service sales declined 8%, while product sales declined 1%.
- Operating income increased despite lower sales, primarily because of improved contract performance, favorable contract estimate adjustments and a larger FAS/CAS pension adjustment.
- Net favorable cumulative catch-up adjustments increased to $197 million from $174 million. These adjustments increased operating income by approximately $0.58 per diluted share in 2014.
- Aerospace Systems operating income increased 20% to $324 million and its margin rose to 13.4%, despite lower volume in space and unmanned programs.
- Electronic Systems operating income decreased 9% to $268 million and margin declined to 16.3%, partly because the prior-year period benefited from a $26 million reserve reversal.
- Information Systems sales declined 6% to $1.577 billion, reflecting lower funding across multiple programs; margin remained broadly stable at 10.3%.
- Technical Services operating income increased 5% to $68 million, while sales declined 3%.
- The effective tax rate benefited from a $51 million tax benefit related to partial resolution of the 2007–2009 IRS examination; the prior-year period included $20 million of research tax credits.
- Weighted-average diluted shares declined to 220.4 million from 241.0 million, reflecting share repurchases.
- Total backlog declined 2% to $36.237 billion from $37.033 billion at December 31, 2013. First-quarter contract awards were estimated at $4.9 billion.
- The company acquired Qantas Defence Services for $72 million in cash; the acquired business was renamed Northrop Grumman Integrated Defence Services and was included in Technical Services.
Guidance, outlook, commentary and risks
Management stated that available cash, operating cash flow and potential financing are expected to be sufficient to fund operations for at least the next 12 months. The filing does not provide specific quarterly or full-year earnings, revenue or cash-flow guidance.
The company highlighted uncertainty regarding U.S. defense spending, sequestration levels, future budget decisions and program funding. Reduced funding and in-theater force reductions affected Information Systems sales, while program delivery timing affected Electronic Systems.
Pension and post-retirement costs remain a material risk. Proposed updated mortality tables were expected to increase future FAS and CAS benefit liabilities and annual expense, and could require additional plan funding. Pension-cost recovery timing under U.S. Government contracts may also affect cash flow.
Significant contingencies include the USPS flats sequencing systems litigation, in which the government asserted a counterclaim of approximately $410 million, and related False Claims Act litigation. The company stated that the outcomes and any potential losses cannot currently be predicted or estimated. Other disclosed matters include Brazilian litigation involving approximately $49 million of asserted damages, environmental remediation liabilities, and possible future remediation costs estimated at $320 million to $782 million before recoveries. The company stated that, apart from the FSS matters, pending matters were not expected to have a material adverse effect.
Management reported effective disclosure controls and procedures as of March 31, 2014, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether favorable contract estimate adjustments, particularly the $197 million first-quarter net benefit, are recurring or nonrecurring.
- Whether working-capital use and negative operating cash flow reverse as customer collections and payment timing normalize.
- The effect of defense budget decisions, sequestration and program funding reductions on sales and backlog conversion.
- The status and potential exposure of the USPS/FSS litigation and related False Claims Act claims.
- The impact of updated mortality assumptions on pension liabilities, expense and required contributions.
- Remaining authorization under the share repurchase program, reported at approximately $2.5 billion at March 31, 2014, and its effect on share count and liquidity.
- The composition and quality of the $36.237 billion backlog, including the $13.480 billion unfunded portion.