Northrop Grumman Corporation — 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. Operations comprise Aerospace Systems, Electronic Systems, Information Systems and Technical Services. This unaudited Form 10-Q covers the three and nine months ended September 30, 2014, compared with the same periods in 2013.
Financial performance and position
| Metric | Q3 2014 | Q3 2013 | 9M 2014 | 9M 2013 |
|---|---|---|---|---|
| Sales | $6.0 billion | $6.1 billion | $17.9 billion | $18.5 billion |
| Operating income | $769 million | $790 million | $2.434 billion | $2.355 billion |
| Operating margin | 12.9% | 12.9% | 13.6% | 12.7% |
| Net earnings | $473 million | $497 million | $1.563 billion | $1.474 billion |
| Diluted EPS | $2.26 | $2.14 | $7.28 | $6.22 |
| Operating cash flow | $933 million | $950 million | $1.103 billion | $1.279 billion |
| Free cash flow from operations | $824 million | $860 million | $818 million | $1.101 billion |
- Product sales increased 6% in Q3 and 1% year to date; service sales declined 10% in Q3 and 9% year to date.
- At September 30, 2014, cash and cash equivalents were $3.402 billion, compared with $5.150 billion at December 31, 2013.
- Long-term debt was $5.926 billion, substantially unchanged from December 31, 2013. No amounts were outstanding under the $1.775 billion unsecured credit facility, and the company was in compliance with its covenants.
- Total assets were $25.043 billion and shareholders’ equity was $9.893 billion at September 30, 2014.
- Backlog increased 4% from year-end 2013 to $38.537 billion, including $22.687 billion funded and $15.850 billion unfunded. Nine-month contract awards were estimated at $19.2 billion.
Material changes versus the prior comparable periods
- Q3 sales declined 2% and nine-month sales declined 3%, driven principally by lower Information Systems activity and lower service volume.
- Q3 operating income decreased 3%, but nine-month operating income increased 3%. The nine-month margin expanded to 13.6% from 12.7%.
- Net earnings declined 5% in Q3 but increased 6% year to date. Diluted EPS increased 6% in Q3 and 17% year to date, primarily because of substantial share repurchases that reduced diluted weighted-average shares to 209.2 million in Q3 and 214.8 million year to date.
- Net favorable cumulative contract-estimate adjustments contributed $194 million to Q3 operating income and $556 million year to date, versus $236 million and $657 million, respectively, in the prior-year periods.
- Q3 and year-to-date sales included a $75 million U.S. government settlement related to intellectual property use and a terminated program, recorded in Aerospace Systems product sales.
- HATFA legislation reduced 2014 CAS pension expense, producing a recognized $132 million cumulative reduction in CAS expense and contributing to improved segment results.
- Share repurchases totaled $2.058 billion in the first nine months, and approximately $1.0 billion remained under the repurchase authorization at September 30. The quarterly dividend was increased 15% to $0.70 per share in May 2014.
- Information Systems sales declined 7% in both Q3 and the first nine months, primarily from reduced funding and in-theater force reductions. Electronic Systems nine-month operating income declined 7%, while Aerospace Systems nine-month operating income increased 9%.
Outlook, risks, contingencies and unusual items
- Management stated that cash balances and operating cash flow, supplemented by financing if needed, should be sufficient to fund operations for at least the next 12 months. No specific earnings or revenue guidance was provided in the filing text.
- Federal budget and appropriations uncertainty remains significant. The government was funded under a continuing resolution through December 11, 2014, with a risk of restrictions on new contract or program starts if a continuing resolution continued through fiscal 2015. Sequestration and future defense spending levels also remain uncertain.
- Pension and post-retirement costs are sensitive to discount rates, investment returns, mortality assumptions, healthcare costs and legislation. The company expected updated mortality assumptions to increase FAS liabilities and annual expense, potentially increase CAS expense and create additional funding requirements.
- Environmental remediation costs were estimated at $363 million to $798 million of reasonably possible future costs; $381 million was accrued, partly offset by amounts expected to be recoverable through government-contract overhead charges.
- The company reported $298 million of standby letters of credit and guarantees and $158 million of surety bonds outstanding.
- Significant legal matters included an appeal by the Orange County Water District, ongoing U.S. Postal Service-related FSS contract claims and counterclaims, and Brazilian litigation involving approximately $46 million of claimed damages plus interest and other costs. The False Claims Act portion of the FSS matter was dismissed with prejudice in September 2014.
- ASU 2014-09, the new revenue recognition standard effective January 1, 2017, may change the timing or method of revenue recognition for certain contracts. The company was evaluating the adoption method and impact.
- The company received a $51 million tax benefit from partial resolution of the 2007–2009 IRS examination. Remaining tax matters could reduce unrecognized tax benefits by up to $75 million and income tax expense by up to $40 million, excluding interest, within the following 12 months.
Important facts for investors to verify
- Whether lower service revenue, particularly in Information Systems, continues and how defense funding and appropriations affect backlog conversion.
- The sustainability of reported margins given the $75 million settlement, favorable contract-estimate adjustments and HATFA-related pension effects.
- Future pension liabilities, expense and cash funding requirements after adoption of updated mortality assumptions.
- Cash deployment, remaining share-repurchase authorization, dividend growth and leverage following the decline in cash balances.
- Developments in the Brazilian litigation, remaining FSS-related matters, environmental remediation estimates and other government contract claims.
- The eventual impact and adoption method for ASU 2014-09 on contract revenue, earnings and cash flows.