Northrop Grumman Corporation 2013 Form 10-K Summary
Business context and reporting period
Northrop Grumman is a global security and defense contractor serving primarily the U.S. Government, including the Department of Defense and intelligence community. Its four segments are Aerospace Systems, Electronic Systems, Information Systems, and Technical Services. The filing covers the fiscal year ended December 31, 2013, with comparative results for 2012 and 2011. The 2013 fourth quarter ended December 31, 2013.
U.S. Government sales represented 86% of 2013 revenue, while international sales were $2.5 billion, or 10% of total revenue. The former Shipbuilding business remains presented as discontinued operations following the 2011 spin-off of Huntington Ingalls Industries.
Key financial metrics
| Metric | 2013 | 2012 | Change |
|---|---|---|---|
| Sales | $24.661 billion | $25.218 billion | Down 2% |
| Operating income | $3.123 billion | $3.130 billion | Down $7 million |
| Operating margin | 12.7% | 12.4% | Up 30 bps |
| Earnings from continuing operations | $1.952 billion | $1.978 billion | Down 1% |
| Diluted EPS from continuing operations | $8.35 | $7.81 | Up 7% |
| Cash provided by continuing operations | $2.483 billion | $2.640 billion | Down 6% |
| Free cash flow from continuing operations | $2.119 billion | $2.309 billion | Down 8% |
| Cash and cash equivalents | $5.150 billion | $3.862 billion | Up $1.288 billion |
| Long-term debt, including current portion | $5.930 billion | $3.935 billion | Up $1.995 billion |
| Total assets | $26.381 billion | $26.543 billion | Down $162 million |
2013 fourth-quarter sales were $6.157 billion, operating income was $768 million, net earnings were $478 million, and diluted EPS was $2.12. The company repurchased 6.6 million shares for $699 million during the quarter.
Product sales were $14.033 billion and service sales were $10.628 billion. Product costs represented 75.7% of product sales, and service costs represented 81.5% of service sales. The company contributed $579 million to pension plans, including $500 million of voluntary pre-funding. Capital expenditures were $364 million.
Segment performance
| Segment | 2013 sales | Change versus 2012 | 2013 operating income | 2013 margin |
|---|---|---|---|---|
| Aerospace Systems | $10.014 billion | Up less than 1% | $1.215 billion | 12.1% |
| Electronic Systems | $7.149 billion | Up 3% | $1.226 billion | 17.1% |
| Information Systems | $6.596 billion | Down 10% | $633 million | 9.6% |
| Technical Services | $2.843 billion | Down 6% | $262 million | 9.2% |
Information Systems was the principal source of consolidated pressure, reflecting sequestration, lower funding, in-theater force reductions, and contract completions. Electronic Systems benefited from higher international and space-program activity. Aerospace Systems was broadly stable, with higher F-35, B-2, and E-2D activity offsetting lower Global Hawk and certain space-program volume.
Material changes versus the prior comparable period
- Sales declined $557 million, primarily because Information Systems sales fell $760 million and Technical Services sales fell $176 million. Electronic Systems sales increased $199 million.
- Operating income was approximately flat, but the consolidated operating margin improved to 12.7% from 12.4%, aided by lower general and administrative costs and improved contract margin rates.
- Net favorable cumulative catch-up adjustments from contract estimate changes were $753 million, compared with $985 million in 2012. These adjustments increased 2013 operating income by approximately $2.09 per diluted share.
- Diluted EPS increased principally because of substantial share repurchases. Weighted-average diluted shares declined to 233.9 million from 253.4 million.
- Operating cash flow and free cash flow declined because of higher pension contributions, partly offset by favorable working-capital changes.
- Debt increased following the issuance of $2.85 billion of senior notes. Proceeds were used partly to redeem $850 million of notes due in 2014 and 2015.
- Total backlog declined to $37.0 billion from $40.8 billion. Approximately $19.6 billion was expected to convert to 2014 sales. The company recorded $20.9 billion of net contract awards in 2013, including a $1.0 billion reduction to Information Systems unfunded backlog.
- The quarterly dividend increased to $0.61 per share, and full-year dividends declared increased to $2.38 per share from $2.15.
Guidance, outlook, commentary, risks, and unusual items
Management did not provide a specific numerical 2014 revenue or earnings outlook in the supplied filing text. Management expected cash balances, operating cash flow, and available financing capacity to fund operations for at least the next 12 months. The company expected approximately $74 million of required minimum pension funding and approximately $90 million of other post-retirement benefit funding in 2014, with no additional voluntary pension contribution expected.
Management identified potential opportunities in long-range strike, missile defense, command and control, cybersecurity, unmanned systems, satellite systems, technical services, information technology, homeland security, and international markets. The 2014 defense appropriations legislation provided approximately $572 billion of defense spending, including $487 billion of base defense funding and $85 billion of overseas contingency operations funding, but longer-term funding remained uncertain.
- Sequestration, defense-budget reductions, delayed appropriations, program cancellations, contract terminations, and stop-work orders could reduce future awards, revenue, profit, and cash flow.
- Customer concentration is significant: more than 86% of revenue and 80% of year-end backlog related to the U.S. Government.
- Approximately 47% of 2013 revenue came from fixed-price contracts, exposing the company to cost growth, technical, schedule, supplier, and performance risks.
- Revenue and profit depend substantially on long-term contract estimates, incentive fees, claims, change orders, and cumulative catch-up adjustments.
- Government audits, investigations, procurement regulations, export controls, litigation, environmental matters, and potential False Claims Act exposure could result in penalties, repayment, contract changes, suspension, or debarment.
- The company reported environmental remediation exposure with reasonably possible future costs of $319 million to $806 million, before recoveries through government-contract overhead charges; $338 million was accrued for probable costs.
- The company was involved in significant litigation involving a U.S. Postal Service contract and a Brazilian postal contract. The filing states that the ultimate outcome of the U.S. Postal Service matter could not be predicted or estimated.
- Goodwill was $12.438 billion, approximately half of total assets. No goodwill impairment charges were recorded in 2013, 2012, or 2011.
- 2013 included a $30 million pretax charge related principally to premiums on debt redemptions. The filing also reported no material contract terminations in process and no significant off-balance-sheet arrangements other than operating leases.
The company changed the annual goodwill impairment testing date from November 30 to December 31. The change was applied retrospectively to January 1, 2011 and did not change previously reported amounts. Management and Deloitte & Touche LLP reported effective internal control over financial reporting and issued unqualified audit opinions.
Important facts for investors to verify
- Confirm the sustainability of earnings growth and EPS growth, given that 2013 EPS benefited materially from share repurchases while sales and net earnings declined.
- Evaluate the size, composition, funding status, and sensitivity of pension obligations, including the impact of discount rates and future contributions.
- Review the maturity schedule and interest cost of the increased debt, together with the terms and covenant requirements of the $1.775 billion revolving credit facility.
- Assess backlog quality: funded versus unfunded amounts, expected 2014 conversion, customer concentration, and the $1.0 billion Information Systems backlog adjustment.
- Monitor Information Systems performance, including the effects of sequestration, contract completions, and lower funding.
- Review cumulative catch-up contract adjustments and the assumptions supporting estimated costs and margins on fixed-price programs.
- Track the U.S. Postal Service litigation, Brazilian litigation, environmental remediation estimates, government cost claims, and tax examinations.
- Assess the company’s ability to offset U.S. defense-budget pressure through international growth and newer areas such as cybersecurity, unmanned systems, and space programs.