Northrop Grumman Corporation — Form 10-Q Summary
Business context and reporting period
Northrop Grumman provides aerospace, defense electronics, information systems, cybersecurity, intelligence, and technical services, primarily to the U.S. government. The filing covers the three months ended March 31, 2012, compared with the three months ended March 31, 2011. The four reportable segments are Aerospace Systems, Electronic Systems, Information Systems, and Technical Services.
| Metric | Q1 2012 | Q1 2011 | Change |
|---|
| Sales | $6.198 billion | $6.734 billion | Down 8% |
| Operating income | $796 million | $811 million | Down 2% |
| Operating margin | 12.8% | 12.0% | Up 80 bps |
| Earnings from continuing operations | $506 million | $496 million | Up 2% |
| Diluted EPS | $1.96 | $1.67 from continuing operations | Up 17% |
| Net earnings | $506 million | $530 million | Down 5% |
| Cash used in continuing operations | $105 million | $112 million provided | Down $217 million |
| Free cash flow from continuing operations | $(186) million | $(11) million | Lower by $175 million |
Financial position, cash flow, debt, and liquidity
- Cash and cash equivalents were $2.682 billion at March 31, 2012, compared with $3.002 billion at December 31, 2011.
- Long-term debt, net of current portion, was $3.933 billion; total debt including the current portion had a carrying value of approximately $3.938 billion and fair value of $4.687 billion.
- Total liabilities were $14.512 billion and shareholders’ equity was $10.541 billion at March 31, 2012.
- Operating cash flow from continuing operations was negative primarily because of working-capital usage, including an $807 million trade working-capital outflow. Capital expenditures were $81 million.
- Investing activities provided $169 million, principally from $250 million of short-term investment maturities, while financing activities used $384 million.
- The company repurchased 4.36 million shares for $263 million and paid $127 million of dividends during the quarter. Approximately $1.4 billion remained under the share-repurchase authorization at March 31, 2012.
- Management stated that expected operating cash generation, supplemented if necessary by credit facilities or capital markets borrowings, should be sufficient for at least the next 12 months to service debt, fund capital expenditures and pension contributions, repurchase shares, and pay dividends.
Material changes versus the prior comparable period
- Sales declined $536 million, with lower volume across all four segments. Aerospace Systems and Information Systems each contributed approximately $200 million of the consolidated decline.
- Operating income decreased modestly despite higher segment operating income. The principal offset was a lower net pension adjustment, which contributed $32 million in 2012 versus $103 million in 2011.
- Operating margin improved because of contract performance improvements, cost-reduction initiatives, and lower product and service cost ratios.
- Favorable cumulative catch-up contract-estimate adjustments increased operating income by $265 million in Q1 2012 versus $144 million in Q1 2011. The filing states that no individual contract adjustment was material.
- The effective tax rate declined to 33.1% from 34.6%, primarily due to domestic manufacturing deductions and amended-return benefits, partly offset by the expiration of research tax credits.
- Weighted-average diluted shares declined to 258.0 million from 296.9 million, primarily reflecting share repurchases and the 2011 shipbuilding spin-off, supporting the increase in diluted EPS.
- The former shipbuilding business was spun off to Huntington Ingalls Industries effective March 31, 2011. Q1 2011 included $34 million of net earnings from discontinued operations and a $1.4 billion cash contribution from the spin-off; Q1 2012 did not.
- Effective January 1, 2012, the missile business was transferred from Aerospace Systems to Technical Services, and prior-period segment information was recast.
Segment results and backlog
| Segment | Q1 2012 sales | Q1 2012 operating income | Margin |
|---|
| Aerospace Systems | $2.383 billion | $279 million | 11.7% |
| Electronic Systems | $1.724 billion | $304 million | 17.6% |
| Information Systems | $1.844 billion | $205 million | 11.1% |
| Technical Services | $750 million | $70 million | 9.3% |
- Electronic Systems produced the largest operating-income improvement, up $67 million, driven by unusually large performance improvements on several programs.
- Total backlog was $39.134 billion at March 31, 2012, down from $39.515 billion at December 31, 2011. Funded backlog was $25.040 billion and unfunded backlog was $14.094 billion.
- Contract awards booked during the quarter were approximately $5.8 billion, including awards for E-2D, F-35, LAIRCM, and Joint National Integration Center programs.
Outlook, commentary, risks, contingencies, and unusual items
- Management expects continued pressure from reduced defense spending, troop drawdowns, program restructuring, and potential program cancellations. The President’s fiscal 2013 DoD base-budget request represented a slight real decline from fiscal 2012.
- Management identified possible sequestration in January 2013 as a significant risk that could materially affect personnel, suppliers, customers, programs, and the company’s financial outlook. The filing does not provide quantified full-year guidance.
- Management expects opportunities in long-range strike, missile defense, command and control, communications, cybersecurity, information technology, technical services, intelligence, and international and homeland-security programs.
- The F-35 program transitioned to a units-of-delivery revenue-recognition method beginning with LRIP lot 5, resulting in costs being inventoried until delivery and contributing to lower Aerospace Systems sales.
- Northrop Grumman is pursuing approximately $179 million of claims against the U.S. Postal Service related to its flats sequencing systems program. The USPS has asserted counterclaims of approximately $341 million. The company expects litigation, and the ultimate outcome and any potential loss cannot currently be estimated.
- Environmental remediation costs were estimated at $308 million to $748 million before recoveries; $336 million was accrued at March 31, 2012. Management did not expect future remediation expenditures to have a material adverse effect.
- The company had $184 million of standby letters of credit, $169 million of bank guarantees, and $109 million of surety bonds outstanding.
- The IRS was examining federal tax returns for 2007 through 2009. The filing states that other ordinary-course legal matters were not expected to be material, except that the USPS dispute remains uncertain.
- The interim financial statements were reviewed, not audited, by Deloitte & Touche LLP. Management concluded that disclosure controls were effective and reported no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether the negative operating cash flow and $186 million negative free cash flow are temporary working-capital effects or signal sustained cash-conversion pressure.
- The sustainability of the $265 million of favorable contract-estimate adjustments and the unusually large Electronic Systems performance improvements.
- The effect of defense-budget reductions, sequestration, F-35 delivery timing, Global Hawk and other program changes, and troop drawdowns on revenue and backlog conversion.
- The potential financial exposure and timing of the USPS claims and approximately $341 million USPS counterclaims.
- The reconciliation between reported segment operating income and consolidated operating income, particularly pension adjustments and unallocated corporate expenses.
- Future pension funding, environmental remediation costs, tax examination outcomes, and the company’s continued capacity to fund dividends and share repurchases while maintaining liquidity.
