Northrop Grumman Corporation — Q1 2019 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. The filing covers the unaudited three months ended March 31, 2019, with comparison to March 31, 2018. Results include Innovation Systems, acquired through the $7.7 billion cash acquisition of Orbital ATK on June 6, 2018.
Key financial metrics
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Total sales | $8.189 billion | $6.735 billion | 22% |
| Operating income | $936 million | $848 million | 10% |
| Operating margin | 11.4% | 12.6% | Down 120 bps |
| Net earnings | $863 million | $840 million | 3% |
| Diluted EPS | $5.06 | $4.79 | 6% |
| Effective tax rate | 16.5% | 15.9% | Up 60 bps |
| Net cash used in operating activities | $(913) million | $(237) million | Use increased $676 million |
| Free cash flow | $(1.197) billion | $(542) million | Use increased $655 million |
Segment sales and operating income were: Aerospace Systems $3.496 billion and $382 million; Innovation Systems $1.438 billion and $167 million; Mission Systems $2.886 billion and $383 million; and Technology Services $977 million and $102 million. Segment operating income rose 27% to $967 million, with an 11.8% segment margin versus 11.3% in the prior-year quarter.
Cash and cash equivalents were $755 million at March 31, 2019, compared with $1.579 billion at December 31, 2018. Total assets were $39.751 billion and total shareholders’ equity was $8.739 billion. Long-term debt, including the current portion, had a carrying value of approximately $14.4 billion. Commercial paper borrowings were $1.0 billion, with $1.0 billion of capacity remaining under the $2.0 billion program. The company had no balance outstanding under its $2.0 billion senior unsecured credit facility and was in compliance with its debt covenants.
Capital expenditures were $284 million. The company paid $211 million of dividends and repurchased $60 million of common stock during the quarter. The quarterly dividend was $1.20 per share. Operating lease liabilities recognized upon adoption of ASC 842 totaled $1.327 billion at quarter-end.
Material changes versus the prior comparable period
- Sales increased $1.454 billion, primarily from $1.438 billion of Innovation Systems revenue and higher Aerospace Systems sales. Technology Services sales declined 15% because of program completions.
- Operating income increased $88 million, but operating margin declined because unallocated corporate expense increased by $98 million, including $96 million of acquired intangible amortization and property, plant and equipment step-up depreciation.
- Net earnings benefited from higher operating income but were partially offset by a $54 million reduction in the FAS non-service pension benefit and a higher tax rate.
- Weighted-average diluted shares declined 3%, supporting the 6% increase in diluted EPS.
- Operating cash flow deteriorated primarily because of working-capital movements. Management stated that an ERP conversion delayed approximately $350 million of billings and cash receipts, expected to be recovered in Q2 2019; Innovation Systems used approximately $250 million of operating cash during the quarter.
- Aggregate favorable net estimate-at-completion adjustments contributed $138 million to operating income, compared with $116 million in Q1 2018. No individual contract adjustment was material.
- Backlog increased 7% to $57.3 billion from $53.5 billion at December 31, 2018. Approximately 50% was expected to convert to revenue within 12 months and 75% within 24 months.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide specific quantitative full-year revenue, earnings or cash-flow guidance. Management stated that enacted FY2019 appropriations and the proposed FY2020 national security budget support demand, particularly in space, missiles, missile defense, hypersonics, survivability and cyber. Management expects cash on hand, operating cash generation and available financing sources to fund operations for at least the next 12 months.
Key risks include dependence on U.S. government appropriations, contract cost and estimate changes, fixed-price execution, program delays or cancellations, supplier and workforce constraints, cybersecurity threats, international and geopolitical exposure, Orbital ATK integration, goodwill and long-lived asset impairment, pension assumptions, tax matters, and environmental and legal contingencies.
Significant contingencies include the U.S. Postal Service flats sequencing systems litigation, where the government’s counterclaim was approximately $193 million; a preliminary $108 million settlement of the former Orbital ATK securities litigation, subject to final court approval; ongoing SEC investigations into historical Orbital ATK accounting; and Bethpage environmental matters for which additional costs cannot currently be estimated. Reasonably possible future environmental remediation costs were estimated at $460 million to $836 million, with $473 million accrued at March 31, 2019.
The company adopted ASC 842 lease accounting on January 1, 2019 using the optional transition method. The adoption added right-of-use assets and lease liabilities but had no material effect on earnings or cash flows and did not recast prior periods.
Most important facts for investors to verify
- Whether the expected Q2 recovery of approximately $350 million in delayed billings and cash receipts occurred.
- Whether operating cash flow improves as forecast and whether the quarter’s negative free cash flow reflects normal seasonality or persistent working-capital pressure.
- The sustainability of Innovation Systems’ 11.6% segment operating margin and the progress of Orbital ATK integration.
- The effect of acquired intangible amortization, purchase accounting and other corporate costs on GAAP operating margins.
- Developments in the $108 million securities settlement, SEC investigation, USPS litigation and Bethpage environmental matters.
- Backlog conversion, new awards, U.S. government funding and execution of fixed-price contracts.
- The company’s ability to reduce reliance on commercial paper while funding dividends, repurchases, capital expenditures and debt obligations.