Northrop Grumman Corporation — Form 10-Q 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. Reportable segments are Aerospace Systems, Electronic Systems, Information Systems, and Technical Services. This filing covers the three and six months ended June 30, 2013, compared with the corresponding 2012 periods. The interim financial statements are unaudited.
Key Financial Metrics
| Metric | Q2 2013 | Q2 2012 | Six Months 2013 | Six Months 2012 |
|---|---|---|---|---|
| Sales | $6.294 billion | $6.274 billion | $12.398 billion | $12.472 billion |
| Operating income | $806 million | $774 million | $1.565 billion | $1.570 billion |
| Operating margin | 12.8% | 12.3% | 12.6% | 12.6% |
| Net earnings | $488 million | $480 million | $977 million | $986 million |
| Diluted EPS | $2.05 | $1.88 | $4.08 | $3.84 |
| Effective tax rate | 32.6% | 34.0% | 32.0% | 33.5% |
| Operating cash flow | $328 million* | $876 million | $329 million | $771 million |
| Free cash flow | $280 million | $825 million | $241 million | $639 million |
*The consolidated cash-flow statement reports six-month operating cash flow of $329 million; the MD&A selected-highlights table reports $328 million for the quarter and $329 million for the six-month period.
- June 30 cash and equivalents were $4.904 billion, versus $3.862 billion at December 31, 2012.
- Long-term debt, net of current portion, was $5.929 billion, versus $3.930 billion at year-end; total debt carrying value was approximately $5.933 billion.
- Total assets were $27.508 billion and shareholders’ equity was $9.558 billion at June 30, 2013.
- Backlog was $37.722 billion, down from $40.809 billion at December 31, 2012, including $23.206 billion funded and $14.516 billion unfunded.
Material Changes Versus the Prior Comparable Period
- Second-quarter sales increased less than 1%, while six-month sales declined 1%, reflecting growth in Aerospace Systems and Electronic Systems offset by declines in Information Systems and Technical Services.
- Second-quarter operating income increased 4%, and operating margin expanded 50 basis points. Six-month operating income declined slightly, with the margin unchanged.
- Second-quarter net earnings increased 2%, while six-month net earnings declined 1%. Diluted EPS increased 9% in the quarter and 6% year to date, primarily because of substantial share repurchases and a lower share count.
- Information Systems sales declined 9% and operating income declined 30% in the quarter; year-to-date sales declined 9% and operating income declined 23%, driven by lower funding, program completions, force reductions, and less favorable contract adjustments.
- Aerospace Systems second-quarter sales increased 9% and operating income increased 15%, supported by F-35, unmanned, and space program volume. Electronic Systems operating margin increased to 18.2% from 15.8%.
- Operating cash flow decreased substantially because of a $500 million voluntary pension contribution in April 2013, partially offset by improved trade working capital.
- Product sales increased, while service sales declined. Product cost as a percentage of product sales improved to 75.2% from 76.6% in the quarter; service cost as a percentage of service sales increased to 81.6% from 80.6%.
Capital Allocation, Debt, and Unusual Items
- In May 2013, the company issued $2.85 billion of unsecured senior notes with maturities in 2018, 2023, and 2043 and fixed rates of 1.75%, 3.25%, and 4.75%, respectively. Proceeds were used partly to redeem $850 million of older notes and for general corporate purposes.
- The debt redemption generated a $30 million pretax charge, principally for redemption premiums.
- The company repurchased $921 million of common stock during the first six months and authorized a new $4.0 billion repurchase program. Management stated a goal of retiring approximately 25% of outstanding shares by the end of 2015, subject to market conditions.
- The quarterly dividend was increased 11% to $0.61 per share from $0.55.
- Six-month pension contributions totaled $543 million, including the $500 million voluntary contribution. Pension and post-retirement liabilities were $5.426 billion at June 30.
- Aggregate favorable contract estimate adjustments increased operating income by $247 million in the quarter and $421 million year to date, compared with $222 million and $487 million, respectively, in the prior-year periods. These adjustments are significant contributors to reported profitability.
Guidance, Outlook, Risks, and Contingencies
- The filing does not provide clear quantitative full-year revenue, earnings, or cash-flow guidance.
- Management expects reduced 2013 defense budget levels and sequestration to result in lower contract awards, with related revenue, earnings, and cash-flow effects likely to trail award reductions.
- Potential FY2014 sequestration, congressional budget delays, continuing resolutions, and the federal debt ceiling could delay funding or customer payments. The company may be required to continue performing on certain contracts even if payments are delayed.
- Management believes cash balances, operating cash flow, and access to credit or capital markets should be sufficient to fund operations for at least the next 12 months.
- The company is pursuing claims against the U.S. Government related to its approximately $875 million Postal Service flats sequencing systems contract. Northrop Grumman seeks approximately $178 million in damages and unpaid amounts, while the government has asserted counterclaims of approximately $410 million. A related False Claims Act complaint could expose the company to treble damages if liability were established; the ultimate outcome could not be estimated.
- Estimated reasonably possible future environmental remediation costs range from $325 million to $779 million. Accrued probable remediation liabilities totaled $347 million at June 30, partly offset by amounts expected to be recoverable through government contract overhead.
- The IRS examination of 2007–2011 tax years had reached a tentative settlement for 2007–2009, subject to review. The company stated that it could record up to an $80 million reduction in unrecognized tax benefits and up to a $50 million reduction in income tax expense within the following 12 months.
- Contract accounting depends on estimates of costs, revenue, risks, and opportunities for long-term contracts. Actual results may differ materially from estimates, and cumulative catch-up adjustments can materially affect quarterly results.
Important Facts for Investors to Verify
- Reconcile the reported $328 million versus $329 million operating cash-flow figures and assess the effect of the voluntary pension contribution on normalized cash generation.
- Evaluate the sustainability of earnings given the $421 million of favorable contract estimate adjustments recognized in the first six months.
- Monitor Information Systems and Technical Services for continued funding reductions, program completions, and margin pressure.
- Assess the effect of sequestration, future defense appropriations, debt-ceiling negotiations, and potential payment delays by the U.S. Government.
- Review the increased debt burden, planned share repurchases, pension funding requirements, and liquidity after capital returns.
- Track the Postal Service contract litigation and False Claims Act matter, environmental remediation obligations, and potential IRS tax benefits.