NORTHROP GRUMMAN CORP annual report, FY2014

Business Context and Reporting Period

Northrop Grumman Corporation is a global security and defense contractor operating through Aerospace Systems, Electronic Systems, Information Systems and Technical Services. Its offerings span unmanned systems, cyber, C4ISR, aircraft, space systems, logistics and modernization. The Form 10-K covers the fiscal year ended December 31, 2014; fourth-quarter information is also disclosed.

The U.S. Government represented approximately 84% of 2014 sales, while international sales, including foreign military sales, were $3.0 billion, or 13% of sales. The company had approximately 64,300 employees at year-end.

Financial Results and Key Metrics

Metric	2014	2013	Change
Sales	$23.979 billion	$24.661 billion	Down 3%
Operating income	$3.196 billion	$3.123 billion	Up 2%
Operating margin	13.3%	12.7%	Up 0.6 points
Net earnings	$2.069 billion	$1.952 billion	Up 6%
Diluted EPS	$9.75	$8.35	Up 17%
Operating cash flow	$2.593 billion	$2.483 billion	Up 4%
Free cash flow	$2.032 billion	$2.119 billion	Down 4%

Fourth-quarter 2014 sales were $6.108 billion, operating income was $762 million, net earnings were $506 million and diluted EPS was $2.48. Fourth-quarter share repurchases totaled 4.5 million shares for $599 million.

Product sales were $14.015 billion and service sales were $9.964 billion. Product costs represented 74.4% of product sales, compared with 75.7% in 2013; service costs represented 79.8% of service sales, compared with 81.5%.

Segment Results

Segment	2014 Sales	2014 Operating Income	2014 Margin	Sales Change
Aerospace Systems	$9.997 billion	$1.315 billion	13.2%	Flat
Electronic Systems	$6.951 billion	$1.148 billion	16.5%	Down 3%
Information Systems	$6.222 billion	$611 million	9.8%	Down 6%
Technical Services	$2.799 billion	$261 million	9.3%	Down 2%

Aerospace Systems benefited from improved performance and $75 million of settlements involving intellectual property and a terminated program. Electronic Systems was affected by lower volume and fewer favorable contract adjustments. Information Systems continued to experience reduced funding, in-theater force reductions and program wind-downs.

Financial Position, Debt and Liquidity

Cash and cash equivalents were $3.863 billion at December 31, 2014, compared with $5.150 billion at year-end 2013.
Long-term debt was $5.928 billion, substantially consisting of fixed-rate debt. The fair value of debt was approximately $6.7 billion.
The company had no borrowings under its $1.775 billion unsecured revolving credit facility and complied with all covenants, including the 65% debt-to-capitalization limit.
Total assets were $26.572 billion and shareholders’ equity was $7.235 billion.
Capital expenditures were $561 million, up from $364 million, primarily because of increased investment in Aerospace Systems facilities and Centers of Excellence.
Contractual obligations totaled $19.566 billion, including $5.925 billion of debt principal, $3.711 billion of debt interest and $7.974 billion of purchase obligations.
Management stated that cash, operating cash flow and available financing are expected to fund operations for at least the next 12 months.

Material Changes Versus the Prior Comparable Period

Sales declined $682 million, primarily from lower Information Systems volume and reduced activity in several Electronic Systems programs.
Operating income increased $73 million and margin expanded despite lower sales, supported by improved contract performance, settlements and a $101 million increase in the net FAS/CAS pension adjustment.
Net favorable cumulative catch-up adjustments declined to $664 million from $753 million, remaining a significant contributor to reported operating results.
The effective tax rate declined to 29.6% from 31.8%, including a $51 million benefit from partial resolution of the 2007-2009 IRS examination.
Weighted-average diluted shares declined to 212.1 million from 233.9 million due to substantial share repurchases, supporting the increase in diluted EPS.
Backlog increased to $38.2 billion from $37.0 billion. Approximately $19.3 billion was expected to convert to 2015 sales. New contract awards were estimated at $25.0 billion.
International sales increased to $3.0 billion from $2.5 billion, and international backlog represented 14% of total backlog at year-end.
Pension and other post-retirement benefit liabilities increased to $6.555 billion from $2.954 billion. Updated mortality assumptions increased benefit obligations by approximately $1.8 billion and contributed to a $2.372 billion other comprehensive loss.
The company repurchased $2.668 billion of common stock in 2014 and authorized an additional $3.0 billion repurchase program after completing the remaining $447 million under the prior authorization.

Guidance, Outlook, Risks and Unusual Items

The filing does not provide clear quantitative revenue or earnings guidance. Management expects continued opportunities in long-range strike, missile defense, command and control, network communications, satellite systems, cyber, technical services and information technology. It also intends to expand international sales, particularly in Australia, the Middle East, Asia and Europe.

Capital expenditures are expected to increase in 2015.
For 2015, the company expected approximately $77 million of minimum pension funding, $68 million of other post-retirement benefit funding and approximately $500 million of additional voluntary pension contributions.
Management identified ongoing uncertainty regarding defense appropriations, sequestration, the federal debt ceiling, program cancellations and changes in U.S. Government priorities.
Approximately half of sales were generated under fixed-price contracts, exposing the company to cost growth, technical performance, schedule, supplier and subcontractor risks.
Other significant risks include dependence on the U.S. Government, cyber and security threats, government audits and compliance requirements, litigation, environmental remediation, pension assumptions, international operations, bid protests and potential goodwill impairment.
Environmental remediation costs were estimated at $363 million to $809 million; $381 million was accrued for probable costs. Standby letters of credit and guarantees totaled $295 million, and surety bonds totaled $163 million.
The company is pursuing claims related to the U.S. Postal Service flats sequencing systems contract and faces related counterclaims of approximately $410 million. The ultimate outcome was not estimable.
The company acquired Qantas Defence Services for a final cash purchase price of $85 million; the acquisition was not material to consolidated results.
The company adopted updated mortality assumptions and recorded a substantial pension-related increase in accumulated other comprehensive loss. Goodwill impairment testing indicated that reporting-unit fair values substantially exceeded carrying values, and no impairment charges were recorded.

Important Facts for Investors to Verify

Whether future U.S. defense appropriations and sequestration decisions affect backlog conversion, contract awards and Information Systems activity.
The sustainability of operating margins given lower sales, declining favorable contract adjustments and reliance on contract estimates.
The timing and cash impact of the planned $500 million voluntary pension contribution and the company’s materially higher pension deficit.
Whether increased capital expenditures reduce free cash flow or support future growth and contract capacity.
The pace of share repurchases, dividend funding and the effect of continued share reduction on per-share results.
The resolution and potential financial exposure from the Postal Service litigation, environmental matters, tax examinations and government cost claims.
The conversion of the $38.2 billion backlog, including the $16.8 billion unfunded portion, into funded orders and revenue.
The impact of the new revenue-recognition standard, effective January 1, 2017, on contract accounting and reported results.