Northrop Grumman Corporation: 2011 Q3 Form 10-Q Summary
Business context and reporting period
Northrop Grumman provides aerospace, defense electronics, information systems, cybersecurity, and technical services, primarily to the U.S. Government. This unaudited Form 10-Q covers the three and nine months ended September 30, 2011, with comparisons to the same 2010 periods. The former Shipbuilding segment was spun off as Huntington Ingalls Industries effective March 31, 2011 and is presented as discontinued operations.
Key financial metrics
| Metric | Three months ended Sept. 30, 2011 | Three months ended Sept. 30, 2010 | Nine months ended Sept. 30, 2011 | Nine months ended Sept. 30, 2010 |
|---|---|---|---|---|
| Sales and service revenues | $6,612 million | $7,071 million | $19,906 million | $21,240 million |
| Operating income | $825 million | $723 million | $2,477 million | $2,152 million |
| Operating margin | 12.5% | 10.2% | 12.4% | 10.1% |
| Earnings from continuing operations | $520 million | $448 million | $1,536 million | $1,598 million |
| Diluted EPS from continuing operations | $1.86 | $1.51 | $5.34 | $5.28 |
| Net earnings | $520 million | $497 million | $1,570 million | $1,677 million |
Revenue declined 6.5% in the quarter and 6.3% year to date. Operating income increased 14.1% in the quarter and 15.1% year to date, reflecting improved program performance, lower product and service cost ratios, and a substantially higher net pension adjustment. Continuing-operations net margin was approximately 7.9% in the quarter and 7.7% year to date.
- Segment performance: Aerospace Systems revenue declined 5% in the quarter and 4% year to date, while operating margin improved to 11.8% from 11.2% in the quarter. Electronic Systems revenue increased 2% in the quarter but declined 4% year to date; its operating margin improved to 15.4% from 13.9% in the quarter. Information Systems revenue declined 8% in the quarter and 5% year to date. Technical Services revenue declined 22% in the quarter and 17% year to date, primarily because NSTec was no longer consolidated.
- Cash flow: Cash provided by continuing operations was $948 million in the quarter and $1,026 million for the first nine months, compared with $816 million and $916 million, respectively, in 2010. Free cash flow from continuing operations was $839 million in the quarter and $700 million year to date, compared with $692 million and $610 million.
- Balance sheet and liquidity: September 30 cash and cash equivalents were $2,946 million, compared with $3,701 million at December 31, 2010. Long-term debt, including the current portion, totaled $3,959 million; the filing reports fair value of $4,760 million. The company had no borrowings under its $1.5 billion five-year facility or $500 million 364-day revolving facility and was in compliance with its covenants.
- Capital allocation: Year-to-date cash uses included $1,598 million for share repurchases, $750 million for debt repayment, $414 million for dividends, and $324 million for capital expenditures. The quarterly dividend was increased from $0.47 to $0.50 per share. Approximately $2.4 billion remained under the share repurchase authorization at September 30.
- Backlog: Total backlog was approximately $42.0 billion, including $24.9 billion funded and $17.0 billion unfunded, versus $46.8 billion at December 31, 2010. The decrease includes a $1.7 billion NSTec adjustment and a $1.5 billion reduction for restructuring and termination of certain space programs.
Material changes versus the prior comparable period
- Revenue declined primarily because of lower space and aircraft program volume, reduced Information Systems activity, and the loss of consolidated NSTec revenue. NSTec contributed $451 million of revenue in the first nine months of 2010 but none in 2011.
- Operating profitability improved despite lower revenue. Segment operating margin rose to 11.8% from 10.7% in the quarter and to 11.5% from 10.6% year to date.
- The net pension adjustment contributed $100 million of operating income in the quarter and $302 million year to date, compared with an expense of $1 million and income of $2 million in the comparable 2010 periods.
- Electronic Systems recorded a $25 million loss provision on its Flat Sequencing System contract following a dispute with the U.S. Postal Service. Information Systems recorded a $15 million provision for overhead rates due to its declining sales base.
- The 2010 year-to-date comparison benefited from an approximately $298 million IRS tax settlement benefit. Excluding that benefit, the 2010 nine-month effective tax rate was approximately 33.5%, compared with 33.2% in 2011.
- The company received a $1,429 million cash contribution in connection with the Shipbuilding spin-off, repaid $750 million of notes at maturity, and repurchased 28.4 million shares for approximately $1,654 million during the first nine months.
Guidance, outlook, commentary, risks, and unusual items
Management stated that cash generated from continuing operations, supplemented if necessary by credit facilities or capital-market borrowings, is expected to be sufficient through 2011 and the ensuing year to service debt, fund capital expenditures and pension contributions, continue share repurchases, and pay dividends. The filing does not provide a specific revenue or EPS forecast.
- The Budget Control Act of 2011, potential defense-spending reductions, continuing-resolution uncertainty, and possible automatic spending cuts were identified as significant risks to future program funding, procurement timing, revenue, and cash flow.
- The company derives approximately 91% of revenue from the U.S. Government and is exposed to changes in government priorities, appropriations, contract delays, and government termination rights.
- Cybersecurity, classified-information protection, supplier financial health, capital-market volatility, and counterparty performance were identified as material risk areas.
- Environmental remediation costs were estimated at $300 million to $729 million; $328 million was accrued at September 30, 2011. Management did not expect these matters to have a material adverse effect, but estimates may change.
- Outstanding financial arrangements included $210 million of standby letters of credit, $189 million of bank guarantees, and $141 million of surety bonds.
- The company reported various government investigations, litigation, and environmental matters, including Orange County groundwater litigation and ERISA-related litigation, but stated that none was expected to have a material adverse effect based on information available at the filing date.
Important facts for investors to verify
- Whether defense-budget reductions and potential sequestration materially affect program awards, backlog conversion, and customer payment timing.
- Whether improved margins are sustainable after the unusually favorable pension adjustment and despite lower revenue.
- The status and ultimate cost of the Flat Sequencing System dispute, Information Systems overhead provision, and other contract estimate changes.
- The composition and conversion risk of the $42.0 billion backlog, particularly the $17.0 billion unfunded portion and space-program reductions.
- Future pension funding requirements, environmental remediation costs, government investigations, and litigation exposure.
- The effect of continued share repurchases and dividends on cash balances, leverage, and long-term capital allocation.