Northrop Grumman Corporation — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2012. The filing was reviewed by Deloitte & Touche and was not audited. Northrop Grumman is a global security company organized into Aerospace Systems, Electronic Systems, Information Systems, and Technical Services, with the U.S. government as its primary customer.
Financial Performance
| Metric | Q3 2012 | Q3 2011 | 9M 2012 | 9M 2011 |
|---|---|---|---|---|
| Sales | $6.270 billion | $6.612 billion | $18.742 billion | $19.906 billion |
| Operating income | $736 million | $825 million | $2.306 billion | $2.477 billion |
| Operating margin | 11.7% | 12.5% | 12.3% | 12.4% |
| Earnings from continuing operations | $459 million | $520 million | $1.445 billion | $1.536 billion |
| Diluted EPS | $1.82 | $1.86 | $5.67 | $5.45 |
| Cash from continuing operations | $812 million | $948 million | $1.583 billion | $1.026 billion |
| Free cash flow from continuing operations | $748 million | $839 million | $1.387 billion | $700 million |
Product sales were $3.487 billion in Q3 and $10.227 billion year to date; service sales were $2.783 billion in Q3 and $8.515 billion year to date. The effective tax rate increased to 34.0% in Q3 and 33.7% year to date, compared with 31.1% and 33.2%, respectively, primarily because research tax credits expired and prior-year tax returns were finalized.
Financial Position, Debt and Capital Allocation
- September 30 cash and cash equivalents were $3.525 billion, compared with $3.002 billion at December 31, 2011.
- Long-term debt, net of current portion, was $3.931 billion; total debt carrying value, including the current portion, was approximately $3.936 billion.
- Total liabilities were $14.315 billion and shareholders’ equity was $10.947 billion.
- Nine-month financing cash use was $1.121 billion, including $846 million of share repurchases and $401 million of dividends. The quarterly dividend was increased to $0.55 per share in May 2012.
- The company repurchased 13.6 million shares for $846 million during the first nine months. Approximately $2.0 billion remained under the repurchase authorization at September 30.
- In September 2012, the company entered into a new 364-day, $500 million revolving credit facility. Management stated that cash, operating cash flow, and available financing were expected to fund operations for at least the next 12 months. The company was in compliance with its credit covenants.
- Nine-month pension contributions were $349 million, including a voluntary $300 million contribution; post-retirement medical and life-plan contributions were $75 million.
Material Changes Versus Prior Comparable Period
- Sales declined 5% in Q3 and 6% year to date, reflecting lower U.S. government spending, portfolio-shaping actions, and reduced activity in several programs.
- Operating income declined 11% in Q3 and 7% year to date. Q3 margin contracted to 11.7%, while year-to-date margin was broadly stable at 12.3%.
- Q3 segment sales declined in Electronic Systems, Information Systems, and Technical Services, partially offset by 5% growth in Aerospace Systems. Year-to-date sales declined in all four segments.
- Year-to-date segment operating income increased 1% to $2.301 billion, supported by improved contract performance and cost management, despite lower volume. Electronic Systems and Technical Services improved year to date, while Aerospace Systems declined.
- Net favorable cumulative catch-up adjustments to contract estimates increased operating income by $214 million in Q3 and $701 million year to date, compared with $196 million and $541 million in the prior-year periods. These adjustments are significant contributors to reported earnings.
- Cash from continuing operations increased year to date because of lower working-capital use and lower pension contributions than in 2011. Q3 cash flow was lower because of the $300 million voluntary pension contribution.
- Backlog increased to $41.009 billion at September 30 from $39.515 billion at December 31, 2011, including $25.636 billion funded and $15.373 billion unfunded backlog. Nine-month contract awards were estimated at $20.2 billion.
- The company completed the prior-year spin-off of its shipbuilding business, Huntington Ingalls Industries. There were no discontinued-operation earnings in 2012, compared with $34 million in the first nine months of 2011.
Outlook, Risks, Contingencies and Unusual Items
- Management highlighted substantial uncertainty from the Budget Control Act, potential sequestration, continuing resolutions, defense-budget reductions, and the drawdown of overseas forces. Sequestration, if implemented as then mandated, was expected to reduce revenue, profit, and cash flow and could result in goodwill impairment.
- Program changes or cancellations affecting Global Hawk, F-35, and other defense programs could negatively affect future results. The company expects opportunities in cybersecurity, unmanned systems, missile defense, command and control, communications, space, and modernization.
- The company filed a lawsuit against the U.S. government regarding an approximately $875 million USPS flats sequencing systems contract. Northrop Grumman seeks up to approximately $179 million and disputes approximately $341 million of asserted government claims. The outcome and any potential loss could not be estimated.
- Environmental remediation costs were estimated at $310 million to $737 million before recoveries; $335 million was accrued at September 30, with certain costs expected to be recovered through U.S. government contract overhead charges.
- The company had $207 million of standby letters of credit, $225 million of bank guarantees, and $93 million of surety bonds outstanding. No material contract terminations or guarantee defaults were identified.
- Revised pension funding rules were expected to reduce required pretax pension contributions for 2013–2016 by approximately $1.5 billion in aggregate versus the prior estimate, although voluntary contributions remained possible.
- Major accounting estimates involve percentage-of-completion contract accounting, estimated contract costs and margins, pension obligations, environmental liabilities, and recoverability of deferred costs. Actual results may differ materially from estimates.
Investor Verification Items
- Verify the sustainability of earnings excluding the $701 million year-to-date favorable contract-estimate adjustments.
- Assess exposure to sequestration, defense-budget reductions, continuing resolutions, and program-specific cancellations or delays.
- Review backlog quality, particularly the $15.373 billion of unfunded backlog and the timing of conversion to revenue.
- Monitor the USPS litigation, environmental remediation range, government cost claims, and other contingent liabilities.
- Reconcile cash generation with pension contributions, share repurchases, dividends, and debt obligations.
- Evaluate the effect of lower FAS/CAS pension adjustments, higher tax rates, and the F/A-18 contract transition on future margins.