Business Context and Reporting Period
Northrop Grumman Corporation filed this Form 10-K for the fiscal year ended December 31, 2019, including fourth-quarter results. The company is a global defense and security contractor serving primarily the U.S. government, especially the Department of Defense and intelligence community. At year-end 2019, reportable sectors were Aerospace Systems, Innovation Systems, Mission Systems, and Technology Services. Effective January 1, 2020, the company realigned into Aeronautics Systems, Defense Systems, Mission Systems, and Space Systems.
The 2019 results include a full year of Innovation Systems, acquired through the $7.7 billion Orbital ATK transaction completed June 6, 2018. The company had approximately 90,000 employees and generated 83% of sales from the U.S. government.
Key Financial Metrics
| Metric | 2019 | 2018 | Change |
|---|---|---|---|
| Sales | $33.841 billion | $30.095 billion | 12% increase |
| Operating income | $3.969 billion | $3.780 billion | 5% increase |
| Operating margin | 11.7% | 12.6% | Down 90 basis points |
| Net earnings | $2.248 billion | $3.229 billion | 30% decrease |
| Diluted EPS | $13.22 | $18.49 | 29% decrease |
| Net cash from operating activities | $4.297 billion | $3.827 billion | 12% increase |
| Free cash flow | $3.033 billion | $2.578 billion | 18% increase |
| Cash and cash equivalents | $2.245 billion | $1.579 billion | Increase |
| Total debt | $13.879 billion | $14.400 billion | Decrease |
| Total backlog | $64.840 billion | $53.500 billion | 21% increase |
Fourth-quarter 2019 sales were $8.721 billion and operating income was $1.136 billion. Fourth-quarter net loss was $409 million, or $(2.43) diluted EPS, primarily reflecting fourth-quarter mark-to-market pension and other postretirement benefit accounting.
2019 segment sales and operating income were: Aerospace Systems $13.862 billion and $1.434 billion; Innovation Systems $6.119 billion and $671 million; Mission Systems $12.263 billion and $1.639 billion; and Technology Services $4.110 billion and $457 million.
Approximately 51% of 2019 sales were from fixed-price contracts and 49% from cost-type contracts. Company-sponsored research and development expense was $953 million, or 2.8% of sales.
Material Changes Versus the Prior Comparable Period
- Sales increased $3.746 billion, primarily because 2019 included a full year of Innovation Systems sales, along with higher sales at Aerospace Systems and Mission Systems. Technology Services sales declined 4% because of program completions.
- Segment operating income increased $462 million, or 13%, and segment margin was approximately unchanged at 11.6%. Mission Systems margin improved to 13.4% from 13.0%; Aerospace Systems margin declined to 10.3% from 10.8%.
- Reported net earnings declined primarily because mark-to-market pension and other postretirement benefit expense increased to $1.800 billion from $655 million. The expense was driven principally by a lower discount rate and updated mortality assumptions.
- Excluding mark-to-market impacts, adjusted net earnings were $3.606 billion versus $3.724 billion, a 3% decrease, and adjusted diluted EPS was $21.21 versus $21.33.
- Operating cash flow increased $470 million, while free cash flow increased $455 million. Capital expenditures were $1.264 billion, compared with $1.249 billion in 2018.
- Investing cash use declined substantially because 2018 included $7.657 billion of cash paid for the Orbital ATK acquisition. Financing cash use declined to $2.424 billion from $4.595 billion, reflecting lower debt repayments and share repurchases.
- Total backlog increased $11.340 billion to $64.840 billion. Management expected approximately 45% of year-end backlog to convert to revenue within 12 months and 70% within 24 months.
- The quarterly dividend was increased 10% in May 2019 to $1.32 per share. The company repurchased $744 million of common stock during 2019 and had approximately $3.330 billion remaining under its repurchase programs at December 31, 2019.
Guidance, Outlook, Commentary, Risks, and Unusual Items
The filing does not provide clear numerical 2020 revenue, earnings, margin, or cash-flow guidance. Management stated that capabilities in space, missiles, missile defense, hypersonics, counter-hypersonics, low-observable technology, and cyber position the company for profitable growth. The company also cited a heightened global security environment and enacted fiscal-year 2020 appropriations that were 3% higher than fiscal 2019.
- Liquidity: Management expected cash, operating cash generation, and available borrowing capacity to fund operations for at least the next 12 months. Capital expenditure commitments were $790 million at year-end.
- Debt and liquidity facilities: Total debt was $13.879 billion. No commercial paper was outstanding and no balance was outstanding under the $2.0 billion revolving credit facility. A U.K. subsidiary had approximately $78 million outstanding under a separate credit facility. The company was in compliance with its debt covenants.
- Pension volatility: Pension and other postretirement benefit liabilities were $6.979 billion. The year-end composite pension discount rate fell to 3.39% from 4.31%, creating significant mark-to-market expense and potential future earnings volatility.
- Government concentration and funding: Changes in U.S. defense priorities, appropriations, continuing resolutions, sequestration, debt-limit issues, shutdowns, contract cancellations, or stop-work orders could materially affect results.
- Contract risk: Long-term contract accounting depends on estimates of costs, revenue, incentives, claims, and performance. Fixed-price development contracts carry greater exposure to cost growth. Net favorable estimate-at-completion adjustments were $480 million in 2019, compared with $577 million in 2018.
- Orbital ATK integration and regulatory matters: The FTC requested information in October 2019 concerning potential compliance with the order governing the acquisition in connection with a strategic missile competition. The company stated that it believed it was in compliance but could not predict the impact on procurement.
- Legal and environmental contingencies: The company disclosed the unresolved Flats Sequencing Systems dispute with the U.S. Postal Service, Brazilian litigation, and extensive Bethpage, New York environmental matters. Bethpage requirements and potential costs could increase materially, but the filing does not provide a clear estimate of cumulative potential liability.
- Other unusual items: A $108 million settlement was approved in the former Orbital ATK shareholder litigation, subject to stated conditions. The company also increased unrecognized tax benefits to $1.223 billion, including additions related to revenue-recognition methods and the 2017 Tax Act.
- Accounting change: ASC 842, Leases, was adopted January 1, 2019. It added operating lease assets of $1.511 billion and operating lease liabilities of $1.569 billion, without a material effect on reported earnings or cash flows.
Important Facts for Investors to Verify
- Reconcile reported GAAP earnings and EPS with management’s mark-to-market-adjusted measures, particularly the $1.800 billion 2019 pension and other postretirement benefit expense.
- Assess the sustainability and funding quality of the $64.840 billion backlog, including its $30.277 billion funded and $34.563 billion unfunded components.
- Review debt maturities, including approximately $1.110 billion due in 2020 and $9.532 billion due after 2024, against expected cash generation.
- Monitor the conversion of unbilled receivables of $5.334 billion and net contract assets of $3.097 billion into billings and cash.
- Evaluate exposure to fixed-price contract cost growth, estimate-at-completion adjustments, supplier performance, and development-program execution.
- Follow the FTC compliance matter, the Postal Service litigation, Bethpage environmental proceedings, and the $1.223 billion of unrecognized tax benefits.
- Consider the effect of the January 1, 2020 sector realignment when comparing future segment results with the 2019 presentation.