Northrop Grumman Corporation — Q3 2020 Form 10-Q Summary
Business context and reporting period
Northrop Grumman is a global aerospace and defense contractor serving primarily the U.S. government, including the Department of Defense and intelligence community. The unaudited quarterly report covers the three and nine months ended September 30, 2020, with comparisons to the corresponding 2019 periods. Effective January 1, 2020, the company reorganized into four reportable segments: Aeronautics Systems, Defense Systems, Mission Systems and Space Systems.
Key financial metrics
| Metric | Q3 2020 | Q3 2019 | 9M 2020 | 9M 2019 |
|---|
| Sales | $9.083 billion | $8.475 billion | $26.587 billion | $25.120 billion |
| Operating income | $985 million | $951 million | $2.913 billion | $2.833 billion |
| Operating margin | 10.8% | 11.2% | 11.0% | 11.3% |
| Net earnings | $986 million | $933 million | $2.859 billion | $2.657 billion |
| Diluted EPS | $5.89 | $5.49 | $17.05 | $15.60 |
| Operating cash flow | Not provided quarterly | Not provided quarterly | $2.703 billion | $1.833 billion |
| Free cash flow | Not provided quarterly | Not provided quarterly | $1.875 billion | $1.040 billion |
- Q3 sales increased 7%, operating income increased 4%, net earnings increased 6% and diluted EPS increased 7% year over year.
- Nine-month sales increased 6%, operating income increased 3%, net earnings increased 8% and diluted EPS increased 9%.
- Net earnings benefited from higher operating income and a larger FAS non-service pension benefit, partly offset by higher interest expense and income taxes.
- The effective tax rate rose to 15.5% in Q3 and 16.5% year to date, compared with 11.6% and 14.8%, respectively, primarily because of lower research credits.
- At September 30, 2020, cash and cash equivalents were $4.995 billion, compared with $2.245 billion at December 31, 2019.
- Long-term debt carrying value was $16.1 billion, including $1.806 billion of current maturities; estimated fair value was $19.1 billion.
- The company had no commercial paper outstanding and no borrowings under its $2.0 billion 2018 credit facility. A separate subsidiary facility had approximately $64 million outstanding.
Segment performance and material changes
| Segment | Q3 sales change | Q3 operating income change | Q3 margin |
|---|
| Aeronautics Systems | +5% | +9% | 10.1% |
| Defense Systems | -4% | +8% | 11.7% |
| Mission Systems | +10% | +5% | 14.5% |
| Space Systems | +17% | +17% | 10.2% |
- Growth was led by Space Systems, Mission Systems and Aeronautics Systems. Space Systems benefited from restricted programs, Next Generation OPIR, NASA Artemis, launch vehicles and hypersonics.
- Defense Systems sales declined because of lower volume on programs nearing completion, including Hunter sustainment and certain weapons programs, while performance improved.
- Mission Systems margin declined because of the timing of contract estimate-at-completion adjustments and contract mix, despite higher sales.
- Q3 segment operating income increased 10% to $1.049 billion, but total operating margin declined because of higher unallocated corporate expense and a lower net FAS/CAS pension adjustment.
- Aggregate net favorable contract estimate-at-completion adjustments contributed $123 million of revenue-related operating income in Q3 and $359 million for the first nine months, compared with $125 million and $421 million, respectively, in 2019.
Cash flow, capital allocation and backlog
- Nine-month operating cash flow rose 47% to $2.703 billion, principally due to improved trade working capital and higher earnings. The filing notes that CARES Act payroll-tax deferrals and higher Department of Defense progress payments contributed to working-capital improvement.
- Capital expenditures were $828 million, producing free cash flow of $1.875 billion, up 80% from 2019.
- The company issued $2.25 billion of senior notes in March 2020, consisting of notes due in 2030, 2040 and 2050. It repaid $1.0 billion of senior notes at maturity on October 15, 2020, after the reporting date.
- The company paid $711 million of dividends and repurchased $490 million of common stock during the first nine months. No shares were repurchased in Q3. The quarterly dividend was increased 10% to $1.45 per share in May 2020, and $2.8 billion remained under the 2018 repurchase authorization.
- Backlog increased 25% from year-end 2019 to $81.3 billion, including $33.3 billion funded and $47.9 billion unfunded. Approximately 35% is expected to convert to revenue within 12 months and 55% within 24 months.
- Third-quarter net awards were $20.3 billion, including $13.3 billion for the Ground Based Strategic Deterrent engineering, manufacturing and development program, $1.9 billion for restricted programs and $0.9 billion for F-35.
Guidance, outlook, risks and unusual items
- The filing does not provide a clear quantitative full-year revenue, earnings or cash-flow guidance figure.
- Management stated that Q3 revenue and operating income were not significantly affected by COVID-19 and did not currently expect a significant direct impact on Q4 revenue or operating income. However, COVID-19 remained a material uncertainty affecting absenteeism, facilities, suppliers, program schedules, cost recovery and government funding.
- Management expects cash, operating cash flow and available financing capacity to be sufficient to fund operations for at least the next 12 months.
- Fiscal 2021 appropriations had not been enacted; a continuing resolution funded the government generally at fiscal 2020 levels through December 11, 2020. Funding levels and timing remained uncertain.
- Bethpage, New York environmental remediation requirements were being reconsidered and could increase costs materially. Environmental remediation accruals were $563 million, with $439 million of reasonably possible future costs in excess of accrued amounts, excluding expected recoveries.
- The U.S. government questioned the company’s interest-rate assumptions for CAS pension expense for 2013–2019 and the current forward-pricing-rate proposal. The company stated that a material adverse outcome was reasonably possible but that a loss range could not currently be estimated.
- The long-running Flats Sequencing Systems litigation with the U.S. government includes government counterclaims of approximately $193 million; trial was scheduled to resume in November 2020 after a COVID-19-related postponement. The ultimate outcome was not estimable.
- Unrecognized tax benefits increased by approximately $294 million during the first nine months; up to $50 million could decrease within the following 12 months.
- Other principal risks include dependence on U.S. government spending, contract-cost and estimate changes, fixed-price execution, cybersecurity, supply-chain disruption, international operations, environmental liabilities, pension assumptions, tax matters and legal proceedings.
Most important facts for investors to verify
- Whether the unusually strong backlog growth, particularly the $30.6 billion of unfunded Space Systems backlog, converts into funded orders and revenue as expected.
- The sustainability of operating performance excluding favorable contract estimate-at-completion adjustments and pension-related benefits.
- The effect of higher debt and the October 2020 $1.0 billion maturity repayment on future interest expense and capital allocation.
- Whether COVID-19, supply-chain issues, government appropriations or continuing resolutions affect program schedules, costs or cash collections.
- Potential exposure from CAS pension-assumption questions, Bethpage environmental matters and other unresolved legal or government claims.
- The treatment and recoverability of COVID-19-related costs, including CARES Act Section 3610 reimbursements and increased Department of Defense progress payments.
