NORTHROP GRUMMAN CORP annual report, FY2010

Northrop Grumman Corporation — FY2010 Form 10-K Summary

Business context and reporting period

Annual report for the fiscal year ended December 31, 2010, filed February 8, 2011. Northrop Grumman provided aerospace, electronics, information systems, shipbuilding, and technical services, primarily to the U.S. Government and Department of Defense. The company operated through five segments: Aerospace Systems, Electronic Systems, Information Systems, Shipbuilding, and Technical Services.

U.S. Government revenue, including Foreign Military Sales, represented approximately 92.3% of 2010 revenue. International revenue represented approximately 4.6% of total revenue. The filing was audited by Deloitte & Touche LLP, which issued unqualified opinions on the financial statements and internal controls.

Financial performance and key metrics

Metric	2010	2009	Change
Sales and service revenues	$34.757 billion	$33.755 billion	+3%
Operating income	$3.070 billion	$2.483 billion	+24%
Operating margin	8.8%	7.4%	+140 bps
Earnings from continuing operations	$2.038 billion	$1.573 billion	+30%
Net earnings	$2.053 billion	$1.686 billion	+22%
Diluted EPS from continuing operations	$6.77	$4.87	+39%
Net cash from operating activities	$2.453 billion	$2.133 billion	+15%
Free cash flow	$1.677 billion	$1.411 billion	+19%

Product sales increased 4% to $21.776 billion, while service revenue increased 1% to $12.981 billion. Product cost as a percentage of product sales improved to 77.2% from 79.3%, while service cost increased to 90.8% from 89.9%. Segment operating income was $3.326 billion, or 9.6% of sales, compared with 8.7% in 2009.

Aerospace Systems revenue increased 5% to $10.910 billion; operating income increased 17% to $1.256 billion.
Electronic Systems revenue declined less than 1% to $7.613 billion; operating income increased 6% to $1.023 billion.
Information Systems revenue declined 2% to $8.395 billion; operating income increased 21% to $756 million.
Shipbuilding revenue increased 8% to $6.719 billion; operating income increased 9% to $325 million.
Technical Services revenue increased 16% to $3.230 billion; operating income increased 28% to $206 million.

Cash, debt, liquidity, and capital allocation

Cash and cash equivalents were $3.701 billion at year-end, compared with $3.275 billion in 2009.
Total debt was approximately $4.819 billion, compared with $4.282 billion in 2009. Debt represented 35.6% of shareholders’ equity.
The company issued $1.5 billion of unsecured senior debt and repurchased approximately $1.1 billion of debt, recording a $231 million pre-tax redemption charge.
The undrawn revolving credit facility provided $2.0 billion of committed capacity through August 2012; the company was in compliance with its covenants.
Capital expenditures were $770 million. The company repurchased $1.177 billion of common stock, or approximately 19.7 million shares, and paid $545 million in dividends.
The quarterly dividend increased from $0.43 to $0.47 per share, resulting in $1.84 of dividends declared per share for 2010.
The company contributed $894 million to pension plans, including $830 million of voluntary contributions. It expected approximately $722 million of pension and post-retirement funding in 2011, including an additional voluntary pension contribution of approximately $500 million.

Material changes versus the prior comparable period

Revenue growth and performance improvements increased segment operating income by 14%, while lower GAAP pension expense and organizational cost reductions also supported margins.
The effective tax rate declined to 21.5% from 30.6%, primarily because of approximately $296 million of net tax benefits from an IRS settlement covering 2004–2006. This benefit was unusual and may not recur.
The company recorded a $113 million charge related to winding down the Avondale, Louisiana shipbuilding facility. It estimated additional future restructuring and shutdown-related costs of approximately $310 million.
Backlog declined to $64.2 billion from $69.2 billion. Approximately 48% of 2010 year-end backlog was expected to convert to revenue in 2011. Aerospace Systems backlog was reduced by $1.1 billion following restructuring of the NPOESS program.
The company continued preparing for a potential tax-free spin-off of Shipbuilding into Huntington Ingalls Industries; the segment remained classified in continuing operations at year-end.
Headquarters relocation activity began, including the fourth-quarter purchase of a 334,407-square-foot facility in Falls Church, Virginia.

Fourth-quarter 2010 highlights

Revenue was $8.607 billion, compared with $8.925 billion in the fourth quarter of 2009.
Operating income was $788 million, compared with $631 million in the prior-year quarter.
Earnings from continuing operations were $376 million, or $1.27 diluted EPS, compared with $375 million, or $1.19 diluted EPS, in the fourth quarter of 2009.
The quarter included the $231 million pre-tax debt-redemption charge and a $440 million pension contribution.

Guidance, outlook, risks, contingencies, and unusual items

Management expected 2011 operating cash flow, cash on hand, and available credit to fund debt service, capital expenditures, taxes, pension and post-retirement contributions, dividends, and continued share repurchases. The filing did not provide a clear numerical revenue or earnings guidance range.

Management anticipated increasing pressure on U.S. and allied defense budgets. Proposed Department of Defense reductions and restructuring could affect programs including the F-35, for which Northrop Grumman was a major subcontractor.
Key opportunities included unmanned systems, long-range strike, missile defense, satellite communications, cybersecurity, intelligence, surveillance and reconnaissance, and technical services.
Approximately 33% of revenue was generated from firm fixed-price contracts, exposing the company to cost growth, technical, schedule, supplier, and performance risk.
Environmental remediation costs were estimated at $280 million to $674 million; $316 million was accrued at year-end.
The company faced a False Claims Act complaint relating to alleged misuse of Hurricane Katrina recovery funds. The complaint sought at least $835 million plus penalties and potentially treble damages. The Department of Justice had not decided whether to intervene, and management could not assure that the matter would have no material adverse effect.
Other risks included government budget reductions or contract termination, audits and investigations, shipbuilding quality issues, pension funding and actuarial assumptions, cybersecurity, nuclear operations, litigation, supply-chain disruptions, and possible impairment of goodwill.
Contract revenue and profit depended substantially on estimates of costs and revenues at completion under percentage-of-completion accounting; changes in estimates could materially affect reported results.

Most important facts for investors to verify

Whether the proposed Shipbuilding separation was completed and its effect on consolidated results, debt, pensions, and cash flows.
Subsequent changes to U.S. defense budgets, F-35 quantities, NPOESS, and other major program funding.
The resolution and potential financial exposure from the Hurricane Katrina False Claims Act and insurance disputes.
Actual 2011 conversion of the $64.2 billion backlog into revenue, including the funded versus unfunded composition.
Whether Avondale shutdown and restructuring costs remained within the estimated $310 million and were accepted as allowable by government contracting authorities.
Future pension contributions, funded status, actuarial assumptions, and the recoverability of pension costs under government contracts.
The recurring earnings power excluding the $296 million tax benefit, $231 million debt-redemption charge, and $113 million Avondale charge.