Northrop Grumman Corporation — Q1 2015 Form 10-Q
Business context and reporting period
Northrop Grumman is a global security company 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. This unaudited quarterly filing covers the three months ended March 31, 2015, compared with the same period in 2014.
Financial performance and condition
| Metric | Q1 2015 | Q1 2014 | Change |
|---|---|---|---|
| Total sales | $5.957 billion | $5.848 billion | Up 2% |
| Operating income | $780 million | $845 million | Down 8% |
| Operating margin | 13.1% | 14.4% | Down 1.3 points |
| Net earnings | $484 million | $579 million | Down 16% |
| Diluted EPS | $2.41 | $2.63 | Down 8% |
| Net cash used in operating activities | $(654) million | $(402) million | Higher use of $252 million |
| Free cash flow | $(771) million | $(462) million | Higher use of $309 million |
Product sales increased 2% to $3.429 billion, while service sales increased 4% to $2.528 billion. General and administrative expense rose to $635 million from $542 million, principally due to higher independent research and development. The effective tax rate increased to 31.3% from 26.3%, primarily because Q1 2014 included a $51 million tax benefit related to partial resolution of an IRS examination.
At March 31, 2015, cash and cash equivalents were $2.646 billion, compared with $3.863 billion at December 31, 2014. Total debt, including the current portion, had a carrying value of approximately $6.528 billion, compared with $5.928 billion at year-end 2014. The company issued $600 million of 3.85% unsecured senior notes due 2045. Its $1.775 billion unsecured credit facility had no outstanding balance, and the company reported compliance with its covenants.
Operating cash flow was negatively affected by a $500 million voluntary pension contribution, working-capital changes and a $440 million cash outflow for retiree benefits. Capital expenditures were $117 million, compared with $60 million in the prior-year quarter. The company paid $156 million in dividends and repurchased $825 million of common stock. The quarterly dividend was $0.70 per share, up from $0.61.
Material changes versus the prior comparable period
- Sales rose $109 million, or 2%, led by Aerospace Systems, Electronic Systems and Technical Services.
- Operating income declined $65 million as segment operating income fell to $735 million from $757 million and the net FAS/CAS pension adjustment declined to $83 million from $110 million.
- Segment margin decreased to 12.3% from 12.9%. Aerospace Systems margin fell to 12.6% from 13.4%, and Electronic Systems margin fell to 14.7% from 16.3%. Information Systems margin improved to 10.5% from 10.3%; Technical Services margin declined to 8.8% from 9.8%.
- Net favorable contract-estimate adjustments contributed $187 million of operating income, compared with $197 million in Q1 2014. No individual contract adjustment was material.
- Total backlog increased modestly to $38.353 billion from $38.199 billion at December 31, 2014. New awards were estimated at $6.1 billion, including awards for the Ministry of the National Guard Training Support, F-35, E-2D, B-2 and F/A-18 programs.
- Share repurchases totaled 5.3 million shares during the quarter. The remaining authorization under the 2014 repurchase program was $2.6 billion at March 31, 2015.
Guidance, outlook, risks and unusual items
The filing does not provide specific full-year earnings, sales or cash-flow guidance. Management stated that cash balances, operating cash flow and potential borrowings are expected to be sufficient to fund operations for at least the next 12 months.
Management highlighted uncertainty surrounding U.S. defense appropriations, the Budget Control Act spending caps and the federal debt ceiling. The company remains highly dependent on U.S. Government contracts. Other stated risks include contract-performance and estimate risk, changes in procurement laws, cyber and security threats, supplier and material constraints, international operations, pension actuarial assumptions, tax matters, litigation, environmental obligations and potential suspension or debarment from government contracts.
The $500 million voluntary pension contribution was the principal unusual cash item. Pension expense increased materially, and changes in discount-rate and mortality assumptions reduced the FAS/CAS pension adjustment. Environmental remediation liabilities were accrued at $377 million, within a reasonably possible future-cost range of $362 million to $795 million. Significant litigation includes the FSS contract dispute with the U.S. Government, for which the company reported that the ultimate outcome cannot currently be predicted or estimated.
The company is evaluating adoption of the new revenue-recognition standard, ASU 2014-09, which was scheduled to become effective January 1, 2017, subject to possible deferral. The filing states that interim results are not necessarily indicative of full-year results.
Important facts for investors to verify
- Whether lower operating margins in Aerospace Systems and Electronic Systems persist, particularly from program mix and performance issues.
- The timing and amount of future operating cash flow after the large pension contribution and ongoing shareholder distributions.
- Debt repayment plans, interest costs and the effect of the new $600 million senior-note issuance on leverage.
- Progress and funding of the $38.353 billion backlog, including the proportion that is funded versus unfunded.
- Resolution of IRS tax matters, which could reduce unrecognized tax benefits by up to $75 million and income tax expense by up to $40 million, excluding interest.
- Developments in the FSS litigation, Brazilian postal litigation, environmental remediation obligations and other government claims.
- Potential effects of defense-budget negotiations, appropriations delays, sequestration-related constraints and the federal debt ceiling on contract awards and performance.