Northrop Grumman Corporation — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016; interim financial statements are unaudited. Northrop Grumman is a global security company focused primarily on U.S. government defense and intelligence customers. Reportable segments are Aerospace Systems, Mission Systems and Technology Services.
Financial performance
| $ in millions, except per-share data | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|
| Sales | $6,155 | $5,979 | $18,111 | $17,832 |
| Operating income | $826 | $794 | $2,362 | $2,387 |
| Operating margin | 13.4% | 13.3% | 13.0% | 13.4% |
| Net earnings | $602 | $516 | $1,675 | $1,531 |
| Diluted EPS | $3.35 | $2.75 | $9.23 | $7.89 |
| Operating cash flow | $738 | $557 | $1,282 | $529 |
- Q3 sales increased 3%, operating income increased 4%, net earnings increased 17% and diluted EPS increased 22% year over year.
- Year-to-date sales increased 2%, while operating income declined 1% and operating margin contracted 40 basis points. Net earnings increased 9% and diluted EPS increased 17%.
- The effective tax rate declined to 21.7% from 29.2% in Q3 and to 23.0% from 29.4% year to date. The decline primarily reflected a $42 million IRS examination benefit, the research tax credit, and $85 million of excess share-based compensation tax benefits recognized following adoption of ASU 2016-09.
- Aggregate net favorable estimate-at-completion adjustments contributed $121 million of Q3 operating income and $387 million year to date, compared with $112 million and $461 million, respectively, in the prior-year periods.
Cash flow, liquidity and capital structure
- Nine-month operating cash flow was $1.282 billion and free cash flow was $674 million, calculated as operating cash flow of $1.282 billion less $608 million of capital expenditures.
- Capital expenditures increased from $334 million to $608 million, including $239 million for the purchase of facilities previously leased by Mission Systems.
- Cash and cash equivalents were $1.103 billion at September 30, 2016, down from $2.319 billion at December 31, 2015. Accounts receivable increased to $3.659 billion from $2.841 billion.
- Long-term debt, net of current portion, was $6.387 billion; total debt including the current portion had a carrying value of approximately $6.390 billion and a fair value of $7.337 billion.
- The company had no balance outstanding under its $1.6 billion unsecured revolving credit facility, which matures in July 2020, and was in compliance with its covenants. Management expects cash, operating cash flow and available borrowings to fund operations for at least the next 12 months.
- Nine-month financing cash outflows were $1.893 billion, including $1.149 billion of share repurchases and $482 million of dividends. The company repurchased 2.2 million shares during Q3 for $471 million, leaving $3.115 billion under the 2015 authorization at September 30.
- The quarterly dividend was increased 13% in May 2016 to $0.90 per share.
Segment performance and material changes
| Q3 2016 | Sales | Operating income | Margin |
|---|
| Aerospace Systems | $2,782 million, up 9% | $311 million, up 4% | 11.2%, down from 11.7% |
| Mission Systems | $2,698 million, down 1% | $351 million, down 1% | 13.0%, unchanged |
| Technology Services | $1,190 million, flat | $130 million, up 2% | 10.9%, up from 10.7% |
- Aerospace Systems benefited from higher Manned Aircraft and Autonomous Systems volume, increased F-35 deliveries and E-2D Advanced Hawkeye full-rate production; margins declined mainly because of Manned Aircraft contract mix.
- Mission Systems reflected lower Sensors and Processing and Advanced Capabilities volume in Q3, partly offset by higher Cyber and ISR activity. Year-to-date margin improved modestly to 13.1%.
- Technology Services benefited from improved performance, but management stated that higher KC-10 volume is not a long-term trend because the contract is expected to wind down in 2017.
- The company streamlined its organization from four sectors to three effective January 1, 2016. Prior-period segment information was recast for comparability.
- Total backlog increased during the first nine months, with higher Aerospace Systems and Mission Systems backlog and a modest decline in Technology Services. Awards included a portion of the B-21 Long-Range Strike Bomber program; the filing does not provide a clear total backlog amount in the supplied text.
Outlook, risks and unusual items
- The U.S. government was operating under a continuing resolution funding activities at fiscal 2016 levels through December 9, 2016. The timing of fiscal 2017 appropriations remained uncertain, creating risks of delayed program starts, budget limitations or a government shutdown.
- Key risks include dependence on U.S. government contracts, appropriations and procurement decisions; contract cost growth and estimate changes; fixed-price performance obligations; cybersecurity threats; subcontractor and supplier performance; competition and bid protests; international operations; pension assumptions and asset returns; environmental liabilities; tax matters; and legal or government investigations.
- The company resolved most of the previously disclosed Aerospace Systems requests for equitable adjustment through a July 2016 U.S. government contract modification. Remaining claims and requests were not material at September 30.
- Significant contingencies include the FSS litigation involving an approximately $410 million government counterclaim, Brazilian postal litigation, environmental remediation obligations with estimated future costs of $389 million to $796 million, and $286 million of standby letters of credit and guarantees plus $170 million of surety bonds.
- The company accrued $394 million for environmental remediation at September 30, 2016 and stated that currently identified remediation projects are not expected to materially affect financial position, earnings or cash flow.
- The company adopted ASU 2016-09 in 2016. It recognized an $85 million year-to-date tax benefit and an $85 million increase in operating cash flow related to the adoption. It expects to adopt the new revenue recognition standard in 2018 and was evaluating its effects.
- No discrete individual contract estimate adjustment was material, although aggregate EAC adjustments materially affected reported results. No material contract terminations were anticipated.
Investor verification points
- Verify the sustainability of earnings benefits from the lower tax rate, including the $42 million IRS resolution benefit and $85 million share-based compensation tax benefit.
- Assess the quality and recurrence of cash flow, particularly the effects of working capital, pension-related items, ASU 2016-09 and the unusually large year-over-year comparison.
- Monitor Aerospace Systems contract margins, EAC adjustments, F-35 and other program deliveries, and the effect of contract mix and risk reductions.
- Review total funded and unfunded backlog, including the B-21 award, and determine expected conversion into revenue.
- Evaluate exposure to continuing-resolution funding, fiscal 2017 appropriations, government shutdown risk and customer concentration.
- Review debt maturities, pension and post-retirement liabilities of $6.009 billion, environmental contingencies and the unresolved FSS litigation.
