Northrop Grumman Corporation — Form 10-Q Summary
Business context and reporting period
This unaudited Form 10-Q covers the three and six months ended June 30, 2012. Northrop Grumman provides defense and government technology products and services through Aerospace Systems, Electronic Systems, Information Systems, and Technical Services. The U.S. government, principally the Department of Defense, is the company’s primary customer.
Key financial metrics
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Sales | $6.274 billion | $6.560 billion | $12.472 billion | $13.294 billion |
| Operating income | $774 million | $841 million | $1.570 billion | $1.652 billion |
| Operating margin | 12.3% | 12.8% | 12.6% | 12.4% |
| Net earnings | $480 million | $520 million | $986 million | $1.050 billion |
| Diluted EPS | $1.88 | $1.81 | $3.84 | $3.59 |
Q2 sales declined 4% year over year, while six-month sales declined 6%. Q2 operating income fell 8%, primarily because of lower volume and a $64 million reduction in the net FAS/CAS pension adjustment. Six-month operating income declined 5%, despite higher segment operating income. Segment operating income was $782 million in Q2, essentially flat year over year, and $1.571 billion for the six months, up 4%.
Net earnings declined because of lower operating income and the absence of the $34 million after-tax discontinued-operation benefit recorded in the first half of 2011. Diluted EPS increased because weighted-average diluted shares declined to 254.7 million in Q2 and 256.5 million for the six months, versus 287.2 million and 292.2 million, respectively, in the prior-year periods.
Cash provided by continuing operations was $876 million in Q2 2012 versus cash used of $34 million in Q2 2011, and $771 million for the first six months versus $78 million in the prior-year period. Six-month free cash flow from continuing operations was $639 million versus cash used of $139 million in 2011, after capital expenditures of $132 million and $217 million, respectively.
At June 30, 2012, cash and cash equivalents were $3.148 billion, compared with $3.002 billion at December 31, 2011. Long-term debt was $3.932 billion, with total debt including the current portion of approximately $3.937 billion. Total shareholders’ equity was $10.715 billion, compared with $10.336 billion at year-end 2011.
The company repurchased $555 million of common stock during the first six months and paid $265 million of dividends. The quarterly dividend was increased to $0.55 per share in May 2012. Approximately $1.1 billion remained under the repurchase authorization at June 30, 2012.
Material changes versus the prior comparable period
- Product sales fell 11% in Q2 and 11% for the first six months, while service sales increased 1% in both periods.
- Information Systems sales declined 9% in both periods, driven by lower F-22 and JTRS AMF activity, program completions, lower in-theater funding, and the sale of the County of San Diego contract. Segment operating margin improved to 10.9% in Q2 from 9.3% and to 11.0% for the six months from 9.4%.
- Aerospace Systems sales declined 3% in Q2 and 6% year to date, reflecting lower F-35, B-2, F/A-18, restricted space-program, and weather-satellite activity. Q2 operating margin declined to 12.1% from 12.9%.
- Electronic Systems sales declined 3% in Q2 and 4% year to date, largely because the company de-emphasized domestic postal automation. Six-month operating income increased 11%, supported by performance improvements on several programs.
- Technical Services sales increased 1% in Q2 but declined 5% year to date. Operating margin improved to 9.5% in Q2 and 9.4% year to date, aided by risk reduction and improved contract performance.
- The missile business, principally the ICBM program, was transferred from Aerospace Systems to Technical Services effective January 1, 2012; prior periods were recast.
- Aggregate favorable contract-estimate adjustments increased operating income by $222 million in Q2 and $487 million for the first six months, compared with $201 million and $345 million, respectively, in 2011. These adjustments are material contributors to reported profitability.
- Backlog increased to $41.547 billion at June 30, 2012, from $39.515 billion at December 31, 2011. Six-month contract awards were approximately $14.6 billion, including NATO AGS, James Webb Space Telescope, E-2D Advanced Hawkeye, and Global Hawk awards.
Guidance, outlook, risks and unusual items
The filing does not provide specific numerical revenue or earnings guidance. Management expects cash generated from operations, supplemented if necessary by credit facilities or capital-market borrowings, to fund debt service, capital expenditures, pension contributions, share repurchases, dividends, and contractual obligations for at least the next 12 months.
Management identified significant uncertainty from potential federal budget reductions and sequestration scheduled under the Budget Control Act of 2011. If implemented, sequestration could reduce revenue, profits, and cash flow and could delay, reduce, or cancel programs. The company also cited continued troop drawdowns, lower defense spending, program cancellations, customer funding delays, and supplier and subcontractor stress as risks.
The company commenced litigation against the United States concerning its approximately $875 million fixed-price USPS flats sequencing systems contract. Northrop Grumman is seeking up to approximately $179 million, while the USPS Contracting Officer asserted claims of approximately $341 million. The outcome and any potential loss cannot currently be predicted or estimated.
Environmental remediation liabilities accrued at June 30, 2012 were $338 million, within a reasonably possible future-cost range of $312 million to $732 million before expected government-contract recoveries. Standby letters of credit, bank guarantees, and surety bonds totaled $205 million, $229 million, and $99 million, respectively.
The company expects recently enacted pension-funding interest-rate changes to reduce required pretax pension contributions for 2013 through 2016 by approximately $1.5 billion in aggregate versus the amount previously disclosed, although voluntary contributions remain possible. The filing states that required contributions may rise after 2016, resulting in little net effect over a 10-year period.
Important facts for investors to verify
- Assess the sustainability of earnings given the $487 million of favorable contract-estimate adjustments recognized in the first half.
- Monitor the effect of sequestration, defense-budget reductions, program cancellations, and customer funding delays on backlog conversion and future margins.
- Review the USPS flats sequencing systems litigation, including the company’s $179 million claims and the government’s approximately $341 million counterclaims.
- Reconcile cash-flow presentation between the financial statements and MD&A, particularly the reported Q2 continuing-operating cash flow of $876 million and the six-month amount of $771 million.
- Evaluate pension obligations, the $4.067 billion pension and post-retirement liability, required versus voluntary contributions, and the effect of revised funding assumptions.
- Track backlog quality, including the $25.945 billion funded and $15.602 billion unfunded components, rather than relying solely on total backlog.
- Confirm the pace and remaining authorization for share repurchases and the effect of reduced share count on EPS.