Northrop Grumman Corporation — Form 10-Q Summary
Business context and reporting period
Unaudited results cover the three months ended March 31, 2011, compared with the same period in 2010. Northrop Grumman provides aerospace, electronics, information systems, and technical services, primarily to the U.S. Government and Department of Defense. The company completed the tax-structured spin-off of its Shipbuilding business to Huntington Ingalls Industries (HII) on March 31, 2011; Shipbuilding is presented as discontinued operations for all periods.
Financial performance and position
| Metric | Q1 2011 | Q1 2010 | Change |
|---|---|---|---|
| Sales and service revenues | $6,734 million | $6,914 million | Down 2.6% |
| Operating income | $811 million | $679 million | Up 19.4% |
| Operating margin | 12.0% | 9.8% | Up 2.2 percentage points |
| Earnings from continuing operations | $496 million | $410 million | Up 21.0% |
| Net earnings | $530 million | $469 million | Up 13.0% |
| Diluted EPS from continuing operations | $1.67 | $1.34 | Up 24.6% |
| Diluted EPS | $1.79 | $1.53 | Up 17.0% |
| Effective tax rate on continuing operations | 34.6% | 32.7% | Up 1.9 percentage points |
Operating improvement reflected lower product and service costs, lower general and administrative expense, improved segment performance, and a substantially higher favorable net pension adjustment of $103 million versus $2 million. Interest expense declined to $58 million from $77 million following the November 2010 debt refinancing.
- Aerospace Systems revenue increased 1% to $2,736 million; operating income increased 2% to $301 million.
- Electronic Systems revenue decreased 4% to $1,808 million, while operating income increased 5% to $237 million and margin improved to 13.1% from 12.0%.
- Information Systems revenue decreased 2% to $2,025 million, while operating income increased 6% to $194 million and margin improved to 9.6% from 8.9%.
- Technical Services revenue decreased 10% to $688 million, largely because NSTec was no longer consolidated, while operating income increased 10% to $54 million.
Cash flow, liquidity, and debt
- Cash provided by continuing operations was $112 million, compared with cash used of $452 million in Q1 2010. The improvement primarily reflected lower working-capital requirements.
- Free cash flow from continuing operations was negative $11 million, after $122 million of capital expenditures and $1 million of outsourcing and related software costs.
- Cash and cash equivalents increased to $4,019 million from $3,701 million at December 31, 2010. The increase included a $1,429 million cash contribution received in connection with the HII spin-off.
- Total debt was approximately $4.0 billion at March 31, 2011, down from approximately $4.7 billion at year-end 2010. The company repaid $750 million of notes at maturity in February 2011.
- Current assets were $9,071 million and current liabilities were $6,161 million. The $2 billion revolving credit agreement had no balance outstanding at March 31, 2011.
- The company paid $137 million of dividends and repurchased approximately $13 million of common stock during the quarter. The board later increased the quarterly dividend from $0.47 to $0.50 per share and increased the share-repurchase authorization to $4.0 billion.
Material changes versus the prior comparable period
- Revenue declined despite higher operating income, as lower activity in Electronic Systems, Information Systems, and Technical Services more than offset Aerospace Systems growth.
- Cost of product sales declined to 73.6% of product sales from 74.3%; cost of service revenues declined to 87.5% from 90.7%; and general and administrative expense declined to 8.4% of revenue from 9.0%.
- Shipbuilding contributed $34 million of discontinued-operation earnings, down from $59 million, partly because of $23 million of nondeductible spin-off transaction costs.
- Effective January 1, 2011, reduced participation in the NSTec joint venture removed $136 million of prior-year quarterly revenue from consolidation and reduced backlog by $1.745 billion.
- Total backlog was $43.7 billion at March 31, 2011, down from $46.8 billion at December 31, 2010. The quarter included $5.3 billion of estimated new awards, including Global Hawk and B-2 program awards.
Outlook, commentary, risks, and unusual items
Management stated that there were no material changes to the products, services, industry outlook, or business trends described in the 2010 Form 10-K other than the HII spin-off. Management expected cash from continuing operations, supplemented by available borrowings if needed, to be sufficient for debt service, contractual obligations, capital expenditures, pension contributions, share repurchases, and dividends.
- Defense spending remained subject to federal deficit reduction, potential DoD efficiency initiatives, program reprioritization, competition, and uncertainty regarding fiscal 2012 and later budgets. The filing noted plans to reduce defense spending from prior plans by $78 billion over five years and broader proposed security-spending reductions.
- The company derived approximately 91% of revenues from the U.S. Government in recent years, creating concentration and appropriation risk. Government contracts may be modified or terminated, and audits may result in disallowed costs, penalties, repayment obligations, or suspension or debarment.
- Contract cost growth, fixed-price contract performance, technical and schedule risks, subcontractor performance, program cancellations, and changes in estimates at completion could reduce margins.
- Environmental remediation costs were estimated at $286 million to $703 million; $316 million was accrued. Management did not expect these matters to have a material adverse effect, but estimates could change with new information or regulatory developments.
- The IRS was examining the company’s federal income tax returns for 2007 through 2009. The filing did not identify a material expected effect.
- The company reported ongoing government investigations and litigation, including environmental and ERISA matters, but stated that no disclosed matter was likely to have a material adverse effect based on available information.
- Spin-off risks include potential tax liabilities if the transaction’s tax assumptions or representations are not sustained, third-party claims against Northrop Grumman for HII obligations, indemnification exposure, and failure to realize expected strategic benefits.
Facts investors should verify
- Whether the favorable $103 million net pension adjustment and lower costs are recurring or substantially benefit only the current period.
- The effect of the HII spin-off, discontinued-operation reclassification, HII indemnities, and remaining Northrop Grumman obligations on future comparability and cash flows.
- Backlog conversion, including the impact of the $1.745 billion NSTec reduction, the mix of funded versus unfunded backlog, and exposure to defense-budget reductions.
- Future working-capital requirements and free cash flow after pension contributions, capital expenditures, dividends, and share repurchases.
- Developments in the federal tax examination, environmental remediation estimates, ERISA litigation, government investigations, and contract-performance contingencies.
- The final Cost Accounting Standards pension rule and its potential effects on recoverable pension costs and cash-flow timing.