[July 27, 2011] NORTHROP GRUMMAN CORP /DE/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW Northrop Grumman Corporation (herein referred to as "Northrop Grumman", the "company", "we", "us", or "our") provides technologically advanced, innovative products, services, and integrated solutions in aerospace, electronics, information and services to our global customers. We participate in many high-priority defense and government services technology programs in the United States (U.S.) and abroad as a prime contractor, principal subcontractor, partner, or preferred supplier. We conduct most of our business with the U.S. Government, principally the Department of Defense (DoD). We also conduct business with local, state, and foreign governments and domestic and international commercial customers. The following discussion should be read along with the unaudited condensed consolidated financial statements included in this Form 10-Q, as well as our Annual Report on Form 10-K for the year ended December 31, 2010, and the Form 8-K filed on June 17, 2011, which recast certain portions of our 2010 Form 10-K to reflect the spin-off of our Shipbuilding business as discontinued operations. The Form 10-K and Form 8-K dated June 17, 2011, provide a more thorough discussion of our products and services, industry outlook, and business trends. See further discussions in the "Consolidated Operating Results" and "Segment Operating Results" sections that follow. Business Outlook and Operational Trends - Except as discussed below under "Economic Opportunities, Challenges, and Risks", there have been no material changes to our products and services, industry outlook, or business trends from those disclosed in our 2010 Form 10-K other than the spin-off of our Shipbuilding business to our shareholders effective March 31, 2011, which is reflected in our Form 8-K dated June 17, 2011. Economic Opportunities, Challenges, and Risks - The U.S. Government's continued focus on addressing federal budget deficits and the growing national debt suggests a changing environment for our industry. Although defense spending is expected to remain a national priority within the federal budget, a fiscally constrained environment could prompt the government to seek additional deficit reduction by moderating discretionary spending, of which defense constitutes the majority share. The Administration and Congress are engaged in vigorous discussion over alternative approaches to reduce the federal deficit and curtail spending. Some revision to current national security spending could emerge in forthcoming budget plans and appropriations as these negotiations continue. Further exacerbating this situation, the government has not finalized its plans for dealing with the impending debt ceiling limitation which, if not resolved reportedly by early August 2011, would limit the government's ability to pay its bills on a timely basis. President Obama and Congress are working on various alternative plans to extend the debt ceiling limitation, but there can be no assurance at this time when and how this matter will be resolved or its effects on the overall U.S. economy or federal budgets. In this context, the DoD is currently conducting a strategic review intended to guide its budgeting decisions. Our company awaits the results of this review, as well as the outcomes of the broader federal budget discussion, as these decisions are expected to shape planning directions across the industry. Force levels in Iraq have shrunk significantly. In late June 2011, the President announced his plans for a troop withdrawal from Afghanistan that would remove roughly a third of the U.S. troops currently in country by the summer of 2012. These events reflect reduced spending on the counterinsurgency warfare that has driven much of U.S. defense near term requirements over the last decade. Elements of our industry that have gained significantly through war spending might expect that impact to decline going forward. An emerging DoD focus on the need for U.S. capabilities to counter advancing threats in anti-access and area denial scenarios could present a key focal point for future investments. The recently retired Secretary of Defense, Robert Gates, laid these out in a speech on June 4, 2011, in which he noted that modernization programs would be critical in the future. The U.S. will continue to maintain a range of powerful military capabilities to support -22--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION U.S. national security interests, even amidst potentially rising economic difficulties, and will have an enduring need for many of the sophisticated capabilities that we provide. Northrop Grumman's development portfolio includes such key areas as long range strike, missile defense, cybersecurity, unmanned systems, defense electronics, information systems, satellite communications, directed energy applications, restricted programs, and intelligence surveillance and reconnaissance capabilities, among others. As a result, the company believes it is well positioned to help the DoD meet its critical future capability requirements for protecting U.S. security in the years ahead. Green Initiatives - We could be affected by future laws or regulations related to climate change concerns and other actions known as "green initiatives." In 2009, we established a goal of reducing our greenhouse gas emissions over a five-year period through December 31, 2014. To comply with existing green initiatives and our greenhouse gas emissions goal, we expect to incur capital and operating costs, but at this time, we do not expect that such costs will have a material adverse effect on our financial position, results of operations or cash flows. Recent Developments in U.S. Government Cost Accounting Standards (CAS) Pension Recovery Rules - On May 10, 2010, the CAS Board published a Notice of Proposed Rulemaking (NPRM) that if adopted would provide a framework to partially harmonize the CAS rules with the Pension Protection Act of 2006 (PPA) funding requirements. The NPRM would "harmonize" by mitigating the mismatch between CAS costs and PPA-amended Employee Retirement Income Security Act (ERISA) minimum funding requirements. Until the final rule is published, and to the extent that the final rule does not completely eliminate mismatches between ERISA funding requirements and CAS pension costs, government contractors maintaining defined benefit pension plans will continue to experience a timing mismatch between required contributions and pension expenses recoverable under CAS. The final rule is expected to be issued in 2011 and to apply to contracts starting the year following the award of the first CAS covered contract after the effective date of the new rule. This would mean the rule would apply to our contracts in 2012. We anticipate that contractors will be entitled to an equitable adjustment for any additional CAS contract costs resulting from the final rule. Notable Events - Notable events or activities during the six months ended June 30, 2011, included the following: † We completed the spin-off of our Shipbuilding business (Huntington Ingalls Industries or HII) and this business is now reported within discontinued operations. † In connection with the spin-off of HII, we received a cash contribution of $1,429 million. † We reduced our participation in the National Security Technologies (NSTec) joint venture, which resulted in a $1,745 million reduction in contract backlog. † We repaid notes with a face value of $750 million. † We increased the quarterly common stock dividend, from $0.47 per share to $0.50 per share. † We repurchased approximately 15.6 million shares of common stock under an accelerated share repurchase agreement with an initial value of $1.0 billion. CRITICAL ACCOUNTING POLICIES, ESTIMATES, AND JUDGMENTS There have been no material changes to our Critical Accounting Policies, Estimates, or Judgments from those discussed in our Form 8-K dated June 17, 2011, that recast certain portions of our 2010 Form 10-K. -23--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION CONSOLIDATED OPERATING RESULTS Selected financial highlights are presented in the table below: Three Months Six Months Ended June 30 Ended June 30 $ in millions, except per share amounts 2011 2010 2011 2010 Sales and service revenues $ 6,560 $ 7,255 $ 13,294 $ 14,169 Cost of sales and service revenues 5,163 5,884 10,518 11,495 General and administrative expenses 556 621 1,124 1,245 Operating income 841 750 1,652 1,429 Interest expense (53 ) (65 ) (111 ) (142 ) Federal and foreign income tax expense 268 (65 ) 530 134 Discontinued operations (29 ) 34 30 Diluted earnings per share from continuing operations 1.81 2.44 3.48 3.77 Cash (used in) provided by continuing operations (34 ) 552 78 100 Operating Performance Assessment and Reporting We manage and assess the performance of our businesses based on our performance on individual contracts and programs obtained generally from government organizations using the financial measures referred to below, with consideration given to the Critical Accounting Policies, Estimates, and Judgments described in our Form 8-K dated June 17, 2011, that recast certain portions of our 2010 Form 10-K. Our portfolio of long-term contracts is largely flexibly-priced, which means that sales tend to fluctuate in concert with costs across our large portfolio of active contracts, with operating income being a critical measure of operational performance. Due to the Federal Acquisition Regulation (FAR) rules that govern our business, most types of costs are allowable, and we do not focus on individual cost groupings (such as cost of sales or general and administrative costs) as much as we do on total contract costs, which are a key factor in determining contract operating income. As a result, in evaluating our operating performance, we look primarily at changes in sales and service revenues, and operating income, including the effects of significant changes in operating income as a result of changes in contract estimates and the use of the cumulative catch-up method of accounting in accordance with accounting principles generally accepted in the United States of America (GAAP). Unusual fluctuations in operating performance driven by changes in a specific cost element across multiple contracts, however, are described in our analysis. Based on this approach and the nature of our operations, the discussion of results of operations generally focuses around our four segments versus distinguishing between products and services. Our Aerospace Systems and Electronic Systems segments generate predominantly product sales, while the Information Systems and Technical Services segments generate predominantly service revenues. Sales and Service Revenues Sales and service revenues consist of the following: Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Product sales $ 3,709 $ 4,167 $ 7,572 $ 8,191 Service revenues 2,851 3,088 5,722 5,978 Sales and service revenues $ 6,560 $ 7,255 $ 13,294 $ 14,169 Sales and service revenues for the three and six months ended June 30, 2011, decreased $695 million and $875 million, respectively, as compared with the same periods in 2010, reflecting lower sales in all four segments. The decrease in sales and service revenues during the three months ended June 30, 2011, is primarily due to a $250 million decrease at Aerospace Systems from lower volume on manned aircraft programs and civil space -24--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION programs; a $193 million decrease at Electronic Systems from lower volume on land and self protection systems programs and targeting systems programs; and a $145 million decrease at Technical Services from the reduced participation in the NSTec joint venture effective January 1, 2011, resulting in no sales recorded for the joint venture in 2011, compared to $152 million in the same period in 2010. The decrease in sales and service revenues during the six months ended June 30, 2011, is primarily due to a $210 million decrease at Aerospace Systems from lower sales volume on manned aircraft programs and civil space programs; a $267 million decrease at Electronic Systems from land and self protection systems programs; and a $220 million decrease at Technical Services from the reduced participation in the NSTec joint venture effective January 1, 2011, resulting in no sales recorded for the joint venture in 2011, compared to $288 million in the same period in 2010. See "Segment Operating Results" below for further information. Cost of Sales and Service Revenues and General and Administrative Expenses Cost of sales and service revenues and general and administrative expenses are comprised of the following: Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Cost of sales and service revenues Cost of product sales $ 2,662 $ 3,078 $ 5,504 $ 6,068 % of product sales 71.8 % 73.9 % 72.7 % 74.1 % Cost of service revenues 2,501 2,806 5,014 5,427 % of service revenues 87.7 % 90.9 % 87.6 % 90.8 % General and administrative expenses 556 621 1,124 1,245 % of total sales and service revenues 8.5 % 8.6 % 8.5 % 8.8 % Cost of sales and service revenues and general and administrative expenses $ 5,719 $ 6,505 $ 11,642 $ 12,740 Cost of Product Sales and Service Revenues - The decrease in cost of product sales as a percentage of product sales for the three and six months ended June 30, 2011, as compared with the same periods in 2010, is primarily due to performance improvements in Aerospace Systems and Electronic Systems. The decrease in cost of service revenues as a percentage of service revenues for the three and six months ended June 30, 2011, as compared with the same periods in 2010, is primarily due to performance improvements in Technical Services resulting from the effects of reduced participation in the NSTec joint venture. Effective January 1, 2011, the company reduced its participation in this joint venture, and as a result no longer consolidates sales or cost of sales for the joint venture. General and Administrative Expenses - In accordance with industry practice and the regulations that govern the cost accounting requirements for government contracts, most general corporate expenses incurred at both the segment and corporate locations are considered allowable and allocable costs on government contracts. For most components of the company, these costs are allocated to contracts in progress on a systematic basis and contract performance factors include this cost component as an element of cost. General and administrative expenses as a percentage of total sales and service revenues decreased to 8.5 percent for the three and six months ended June 30, 2011, from 8.6 percent and 8.8 percent, respectively, for the comparable periods in 2010, primarily due to lower independent research and development and bid and proposal costs. Operating Income We consider operating income to be an important measure for evaluating our operating performance and, as is typical in the industry, we define operating income as revenues less the related cost of producing the revenues and general and administrative expenses. We also further evaluate operating income for each of the business segments in which we operate. -25--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION We internally manage our operations by reference to "segment operating income." Segment operating income is defined as operating income before unallocated corporate expenses and net pension adjustment, neither of which affect the operating results of segments, and the reversal of royalty income, which is classified as "other, net" for financial reporting purposes. Segment operating income is one of the key metrics we use to evaluate operating performance. Segment operating income is not, however, a measure of financial performance under GAAP, and may not be defined and calculated by other companies in the same manner. The table below reconciles segment operating income to total operating income: Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Segment operating income $ 784 $ 791 $ 1,505 $ 1,497 Unallocated corporate expenses (38 ) (40 ) (48 ) (65 ) Net pension adjustment 99 1 202 3 Royalty income adjustment (4 ) (2 ) (7 ) (6 ) Total operating income $ 841 $ 750 $ 1,652 $ 1,429 Segment Operating Income - Segment operating income for the three months ended June 30, 2011, decreased $7 million, or 1 percent, as compared with the same period in 2010. Segment operating income was 12.0 percent and 10.9 percent of sales and service revenues for the three months ended June 30, 2011 and 2010, respectively. Segment operating income for the six months ended June 30, 2011, increased $8 million, or 1 percent, as compared with the same period in 2010. Segment operating income was 11.3 percent and 10.6 percent of sales and service revenues for the six months ended June 30, 2011 and 2010, respectively. Performance improvements at Aerospace Systems and Electronic Systems and the effects of the reduced participation in the NSTec joint venture at Technical Services more than offset the reduction in segment operating income resulting from lower sales volume at all four segments and contributed to the rate improvement in 2011. See "Segment Operating Results" below for further information. Unallocated Corporate Expenses - Unallocated corporate expenses generally include the portion of corporate expenses not considered allowable or allocable under applicable CAS and FAR rules, and therefore not allocated to the segments, such as management and administration, legal, environmental, certain compensation and retiree benefits, and other expenses. Unallocated corporate expenses for the three months ended June 30, 2011, decreased by $2 million, which is comparable to the same period in 2010. Unallocated corporate expenses for the six months ended June 30, 2011, decreased by $17 million as compared to the same period in 2010, primarily due to higher estimated recoveries of prior year overhead expenses, lower state income taxes and lower stock based compensation expense, partially offset by higher costs related to environmental remediation. Net Pension Adjustment - Net pension adjustment reflects the difference between pension expense determined in accordance with GAAP and pension expense allocated to the operating segments determined in accordance with CAS. For the three months ended June 30, 2011 and 2010, the net pension adjustment resulted in income of $99 million and $1 million, respectively. For the six months ended June 30, 2011 and 2010, the net pension adjustment resulted in income of $202 million and $3 million, respectively. The increase in net pension adjustment for 2011 is primarily due to improved return on plan assets in 2010. Royalty Income Adjustment - Royalty income is included in segment operating income and reclassified to other income for financial reporting purposes. Interest Expense Interest expense for the three months ended June 30, 2011, decreased $12 million, as compared with the same period in 2010, primarily due to a lower weighted average interest rate resulting from our debt refinancing in November 2010. Interest expense for the six months ended June 30, 2011, decreased $31 million, as compared -26- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION with the same period in 2010, primarily due to a lower weighted average interest rate resulting from our debt refinancing in November 2010. Federal and Foreign Income Tax Expense Our effective tax rate on earnings from continuing operations for the three and six months ended June 30, 2011, was 34.0 percent and 34.3 percent, compared with (9.6) percent and 10.4 percent for the three and six months ended June 30, 2010. For 2010, our effective tax rates differ from the statutory federal rate primarily due to manufacturing deductions, research and development credits, and the tax settlement with the Internal Revenue Service (IRS). In the second quarter of 2010, we recognized net tax benefits of approximately $298 million, primarily as a result of a final settlement with the IRS and the U.S. Congressional Joint Committee on Taxation related to our tax returns for the years ended 2004 through 2006. Excluding the effect of the tax settlement with the IRS in 2010, our effective tax rate on earnings from continuing operations for the three and six months ended June 30, 2010, was 34.5 percent and 33.6 percent, respectively. See Note 7 to the condensed consolidated financial statements in Part I, Item 1. Discontinued Operations Earnings from discontinued operations for the six months ended June 30, 2011 and 2010, were primarily attributable to the Shipbuilding business, which was spun off to our shareholders in March 2011. Earnings from discontinued operations for the six months ended June 30, 2011, increased $4 million as compared with the same period in 2010. Earnings from discontinued operations for the six months ended June 30, 2010, also include a $7 million adjustment to the gain on the December 2009 sale of our Advisory Services Division to reflect purchase price adjustments and the utilization of additional capital loss carry-forwards. Diluted Earnings Per Share From Continuing Operations Diluted earnings per share from continuing operations for the three months ended June 30, 2011, was $1.81 per share, as compared with $2.44 per share for the same period in 2010. Earnings per share are based on weighted average diluted shares outstanding of 287.2 million for the three months ended June 30, 2011, and 303.8 million for the same period in 2010. Diluted earnings per share from continuing operations for the six months ended June 30, 2011, was $3.48 per share, as compared with $3.77 per share for the same period in 2010. Earnings per share are based on weighted average diluted shares outstanding of 292.2 million for the six months ended June 30, 2011, and 305.0 million for the same period in 2010. See Note 4 to the condensed consolidated financial statements in Part I, Item 1. The tax settlement with the IRS in the second quarter of 2010 for approximately $298 million discussed above increased our diluted earnings per share from continuing operations on a net basis by approximately $.98 per share for the six months ended June 30, 2010. Cash (Used In) Provided By Continuing Operations For the three months ended June 30, 2011, cash used in continuing operations was $34 million, as compared with $552 million cash provided by continuing operations in the same period in 2010. The decrease of $586 million reflects higher working capital requirements and pension contributions in the 2011 period. For the six months ended June 30, 2011, cash provided by continuing operations was $78 million, as compared to $100 million for the same period in 2010. The decrease of $22 million reflects higher pension contributions in the 2011 period, partially offset by the sale of marketable securities. -27--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION SEGMENT OPERATING RESULTS Basis of Presentation We are aligned into four reportable segments: Aerospace Systems, Electronic Systems, Information Systems, and Technical Services. Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Sales and Service Revenues Aerospace Systems $ 2,592 $ 2,842 $ 5,328 $ 5,538 Electronic Systems 1,791 1,984 3,599 3,866 Information Systems 2,031 2,123 4,056 4,187 Technical Services 656 801 1,344 1,564 Intersegment eliminations (510 ) (495 ) (1,033 ) (986 ) Total sales and service revenues $ 6,560 $ 7,255 $ 13,294 $ 14,169 Operating Income Aerospace Systems $ 331 $ 335 $ 632 $ 631 Electronic Systems 284 264 521 490 Information Systems 189 205 383 388 Technical Services 51 52 105 101 Intersegment eliminations (71 ) (65 ) (136 ) (113 ) Total Segment Operating Income $ 784 $ 791 $ 1,505 $ 1,497 Non-segment factors affecting operating income Unallocated corporate expenses (38 ) (40 ) (48 ) (65 ) Net pension adjustment 99 1 202 3 Royalty income adjustment (4 ) (2 ) (7 ) (6 ) Total operating income $ 841 $ 750 $ 1,652 $ 1,429 Sales and Service Revenues Period-to-period sales reflect performance under new and ongoing contracts. Changes in sales and service revenues are typically expressed in terms of volume. Unless otherwise described, volume generally refers to increases (or decreases) in reported revenues incurred due to varying production activity levels, delivery rates, or service levels on individual contracts. Volume changes will typically carry a corresponding operating income change based on the margin rate for a particular contract. Segment Operating Income Segment operating income reflects the aggregate performance results of contracts within a business area or segment. Excluded from this measure are certain costs not directly associated with contract performance, including the portion of corporate expenses such as management and administration, legal, environmental, certain compensation costs and other retiree benefits, and other expenses not considered allowable or allocable under applicable CAS regulations and the FAR, and therefore not allocated to the segments. Changes in segment operating income are typically expressed in terms of volume, as discussed above, or performance. Performance refers to changes in contract margin rates for the period. These changes typically relate to profit recognition associated with revisions to total estimated costs at completion of the contract (EAC) that reflect improved (or deteriorated) operating performance on a particular contract. Operating income changes are accounted for on a cumulative to date basis at the time an EAC change is recorded. We identify favorable and unfavorable adjustments above a minimal threshold level to determine our qualitative discussion of performance results and, where material, we disclose the effects of such adjustments on a contract or program basis. Overall, our contract performance -28--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION adjustments generally reflect margin improvements over the life of a contract as performance risks are reduced or eliminated. Thus we would expect that our aggregate cumulative adjustments would be favorable. Operating income may also be affected by, among other things, the effects of workforce stoppages, natural disasters such as earthquakes, resolution of disputed items with the customer, recovery of insurance proceeds, and other discrete events. At the completion of a long-term contract, any originally estimated costs not incurred or reserves not fully utilized (such as warranty reserves) could also impact contract earnings. Where such items have occurred, and the effects are material, a separate description is provided. Contract Descriptions For convenience, a brief description of certain programs discussed in this Form 10-Q is included in the "Glossary of Programs" section that follows. AEROSPACE SYSTEMS Business Description Aerospace Systems is a leading designer, developer, integrator, and producer of manned and unmanned aircraft, spacecraft, high-energy laser systems, microelectronics and other systems and subsystems critical to maintaining the nation's security and leadership in technology. Aerospace Systems' customers, which are primarily government agencies, use these systems in many different mission areas, including: intelligence, surveillance and reconnaissance (ISR); communications; battle management; strike operations; electronic warfare; missile defense; earth observation; space science; and space exploration. The segment consists of four business areas: Strike & Surveillance Systems (S&SS); Space Systems (SS); Battle Management & Engagement Systems (BM&ES); and Advanced Programs & Technology (AP&T). Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Sales and service revenues $ 2,592 $ 2,842 $ 5,328 $ 5,538 Segment operating income 331 335 632 631 As a percentage of segment sales 12.8 % 11.8 % 11.9 % 11.4 % Sales and Service Revenues Aerospace Systems revenue for the three months ended June 30, 2011, decreased $250 million, or 9 percent, as compared with the same period in 2010. The decrease is primarily due to $139 million lower sales in S&SS, $99 million lower sales in SS, and $25 million lower sales in BM&ES; partially offset by higher sales in AP&T. The lower sales in S&SS are primarily due to lower volume on F-35 and F/A-18 manned aircraft programs. The lower sales in SS are primarily due to lower volume on National Polar-orbiting Operational Environmental Satellite System (NPOESS) due to a program restructure and lower volume on restricted programs. The lower sales in BM&ES are primarily due to lower volume on E-2 Hawkeye, partially offset by ramping up on Long Endurance Multi-Intelligence Vehicle (LEMV). Aerospace Systems revenue for the six months ended June 30, 2011, decreased $210 million, or 4 percent, as compared with the same period in 2010. The decrease is primarily due to $128 million lower sales in SS&S and $165 million lower sales in SS, partially offset by $62 million higher sales in BM&ES and $22 million higher sales in AP&T. The lower sales in S&SS are primarily due to lower volume on F-35 and restricted programs. The lower sales in SS are primarily due to lower volume on NPOESS due to a program restructure and lower volume on James Webb Space Telescope due to a program re-plan. The higher sales in BM&ES are primarily due to increased activity on LEMV and higher volume on Broad Area Maritime Surveillance Unmanned Aircraft Systems and Joint Surveillance Target Attack Radar System programs, partially offset by lower volume on the E-2 Hawkeye program. The higher sales in AP&T are primarily due to higher volume on restricted programs, partially offset by lower volume on the Navy Unmanned Combat Air Systems program. -29--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION Segment Operating Income Operating income at Aerospace Systems for the three months ended June 30, 2011, decreased $4 million, or 1 percent, as compared with the same period in 2010, and operating income as a percentage of sales was 12.8 percent, up from 11.8 percent in the same period in 2010. The lower operating income and increase as a percentage of sales is primarily due to lower sales volume at S&SS, SS, and BM&ES, offset by program performance improvements principally due to a program restructure on NPOESS. In addition, operating income in 2010 benefited from favorable performance improvements on several programs at S&SS. Operating income at Aerospace Systems for the six months ended June 30, 2011, increased $1 million, consistent with the same period in 2010, and operating income as a percentage of sales was 11.9 percent, up from 11.4 percent in the same period in 2010. The slightly higher operating income and increase as a percentage of sales is due to program performance improvements principally due to a program restructure on NPOESS. In addition, operating income in 2010 benefited from favorable performance improvements on several programs at S&SS. ELECTRONIC SYSTEMS Business Description Electronic Systems is a leader in the design, development, manufacture, and support of solutions for sensing, understanding, anticipating, and controlling the environment for our global military, civil, and commercial customers and their operations. Electronic Systems provides a variety of defense electronics and systems, airborne fire control radars, situational awareness systems, early warning systems, airspace management systems, navigation systems, communications systems, marine systems, space systems, and logistics services. The segment consists of five business areas: Intelligence, Surveillance & Reconnaissance Systems; Land & Self Protection Systems; Naval & Marine Systems; Navigation Systems; and Targeting Systems. Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Sales and service revenues $ 1,791 $ 1,984 $ 3,599 $ 3,866 Segment operating income 284 264 521 490 As a percentage of segment sales 15.9 % 13.3 % 14.5 % 12.7 % Sales and Service Revenues Electronic Systems revenue for the three months ended June 30, 2011, decreased $193 million, or 10 percent, as compared with the same period in 2010. The decrease is primarily due to $145 million lower sales in Land & Self Protection Systems and $36 million lower sales in Targeting Systems. The lower sales in Land & Self Protection Systems are primarily due to lower indefinite delivery indefinite quantity (IDIQ) volume on Large Aircraft Infrared Countermeasures (LAIRCM) and Vehicular Intercommunications Systems (VIS) programs as a result of fewer deliveries. The lower sales in Targeting Systems are primarily due to lower volume on F-16 International activities. Electronic Systems revenue for the six months ended June 30, 2011, decreased $267 million, or 7 percent, as compared with the same period in 2010. The decrease is primarily due to $289 million lower sales in Land & Self Protection Systems, partially offset by $18 million higher sales in Targeting Systems. The lower sales in Land & Self Protection Systems are primarily due to lower IDIQ volume on LAIRCM and VIS programs as a result of fewer deliveries. The higher sales in Targeting Systems are primarily due to higher volume on LITENING Gen 4 program as a result of increased deliveries and other restricted programs. Segment Operating Income Operating income at Electronic Systems for the three months ended June 30, 2011, increased $20 million, or 8 percent, as compared with the same period in 2010, and operating income as a percentage of sales increased to -30--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION 15.9 percent from 13.3 percent in the same period in 2010. The higher operating income and increase as a percentage of sales is due to performance improvements on several contracts nearing completion at Land & Self Protection Systems and Targeting Systems, and performance improvements at Intelligence, Surveillance & Reconnaissance Systems, partially offset by the sales volume decreases described above. Operating income at Electronic Systems for the six months ended June 30, 2011, increased $31 million, or 6 percent, as compared with the same period in 2010, and operating income as a percentage of sales increased to 14.5 percent from 12.7 percent in the same period in 2010. The higher operating income and increase as a percentage of sales is due to performance improvements on several contracts nearing completion at Land & Self Protection Systems and Intelligence, Surveillance & Reconnaissance Systems, partially offset by the sales volume decreases described above. INFORMATION SYSTEMS Business Description Information Systems is a leading global provider of advanced solutions for the DoD, intelligence, federal civilian, state and local agencies, and international customers. Products and services are focused on the fields of command, control, communications, computers and intelligence; air and missile defense; airborne reconnaissance; intelligence processing; decision support systems; cybersecurity; information technology; and systems engineering and systems integration. The segment consists of three business areas: Defense Systems, Intelligence Systems, and Civil Systems. Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Sales and service revenues $ 2,031 $ 2,123 $ 4,056 $ 4,187 Segment operating income 189 205 383 388 As a percentage of segment sales 9.3 % 9.7 % 9.4 % 9.3 % Sales and Service Revenues Information Systems revenue for the three months ended June 30, 2011, decreased $92 million, or 4 percent, as compared with the same period in 2010. The decrease is primarily due to lower sales in Defense Systems primarily due to lower volume on Saudi Arabian American Oil Company (ARAMCO), Network Centric Solutions Defense Knowledge Online (Netcents DKO), Multi-Role Tactical Command Data Link (MRTCDL), and several other programs, partially offset by higher volume on Navy Anti-Terrorism Force Protection and Encore II programs. Information Systems revenue for the six months ended June 30, 2011, decreased $131 million, or 3 percent, as compared with the same period in 2010. The decrease is primarily due to $73 million lower sales in Defense Systems. The lower sales in Defense Systems are primarily due to lower volume on Systems and Software Engineering Support, ARAMCO, MRTCDL programs, and several other programs, partially offset by higher volume on Encore II and Trailer Mounted Support System programs. Segment Operating Income Operating income at Information Systems for the three months ended June 30, 2011, decreased $16 million, or 8 percent, as compared with the same period in 2010, and operating income as a percentage of sales decreased to 9.3 percent from 9.7 percent for the same period in 2010. The lower operating income is primarily due to lower sales volume at Defense Systems. The decrease as a percentage of sales is primarily due to the effects of a favorable performance improvement in 2010 on the New York City Wireless (NYCWiN) program, partially offset by a gain related to the sale of a Civil Systems contract in May 2011. -31- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION Operating income at Information Systems for the six months ended June 30, 2011, decreased $5 million, or 1 percent, as compared with the same period in 2010, and operating income as a percentage of sales increased to 9.4 percent from 9.3 percent for the same period in 2010. The lower operating income is primarily due to lower sales volume at Defense Systems. The increase as a percentage of sales is primarily due to improved performance on several Civil Systems programs and a gain related to the sale of a Civil Systems contract in May 2011, partially offset by the effects of a favorable performance improvement in 2010 on the NYCWiN program. TECHNICAL SERVICES Business Description Technical Services is a leading provider of logistics, infrastructure, and sustainment support, and also provides a wide array of technical services, including training and simulation. The segment consists of three business areas: Defense and Government Services Division (DGSD); Training Solutions Division (TSD); and Integrated Logistics and Modernization Division (ILMD). Three Months Ended Six Months Ended $ in millions 2011 2010 2011 2010 Sales and service revenues $ 656 $ 801 $ 1,344 $ 1,564 Segment operating income 51 52 105 101 As a percentage of segment sales 7.8 % 6.5 % 7.8 % 6.5 % Sales and Service Revenues Technical Services revenue for the three months ended June 30, 2011, decreased $145 million, or 18 percent, as compared with the same period in 2010. The decrease is primarily due to $169 million lower sales in DGSD and $30 million lower sales in TSD, partially offset by $54 million higher sales in ILMD. The lower sales in DGSD are primarily due to the reduced participation in the NSTec joint venture. Effective January 1, 2011, the company reduced its participation in this joint venture, resulting in no sales recorded for the joint venture in the three months ended June 30, 2011, compared with sales of $152 million for the same period in 2010. The lower sales in TSD are primarily due to lower sales volume demand on Joint Warfighting Center (JWFC) and Africa Contingency Operations Training & Assistance (ACOTA) programs. The higher sales in ILMD are primarily due to increased activity on the KC-10 Contractor Logistics Support (KC-10) program, which began in February 2010. Technical Services revenue for the six months ended June 30, 2011, decreased $220 million, or 14 percent, as compared with the same period in 2010. The decrease is primarily due to $308 million lower sales in DGSD and $46 million lower sales in TSD, partially offset by $134 million higher sales in ILMD. The lower sales in DGSD are primarily due to the reduced participation in the NSTec joint venture. Effective January 1, 2011, the company reduced its participation in this joint venture, resulting in no sales recorded for the joint venture in the six months ended June 30, 2011, compared with sales of $288 million for the same period in 2010. The lower sales in TSD are primarily due to lower sales volume demand on JWFC and ACOTA programs. The higher sales in ILMD are primarily due to increased activity on the KC-10 program, which began in February 2010. Segment Operating Income Operating income at Technical Services for the three months ended June 30, 2011, decreased $1 million, or 2 percent, as compared with the same period in 2010, and operating income as a percentage of sales increased to 7.8 percent from 6.5 percent for the same period in 2010. The increase as a percentage of sales is primarily due to improved program performance across various programs and the effects of the change in participation in the NSTec joint venture, partially offset by the sales volume decreases described above. Operating income at Technical Services for the six months ended June 30, 2011, increased $4 million, or 4 percent, as compared with the same period in 2010, and operating income as a percentage of sales increased to 7.8 percent from 6.5 percent for the same period in 2010. The higher operating income and increase as a -32- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION percentage of sales is primarily due to improved program performance across various programs and the effects of the change in participation in the NSTec joint venture, partially offset by the sales volume decreases described above. BACKLOG Definition Total backlog at June 30, 2011, was approximately $41.8 billion. Total backlog includes both funded backlog (firm orders for which funding is contractually obligated by the customer) and unfunded backlog (firm orders for which funding is not currently contractually obligated by the customer). Unfunded backlog excludes unexercised contract options and unfunded IDIQ orders. For multi-year services contracts with non-federal government customers having no stated contract values, backlog includes only the amounts committed by the customer. Backlog is converted into sales as work is performed or deliveries are made. Backlog consisted of the following at June 30, 2011, and December 31, 2010: June 30, 2011 December 31, 2010 Total Total $ in millions Funded Unfunded Backlog Funded Unfunded Backlog Aerospace Systems $ 8,750 $ 10,355 $ 19,105 $ 9,185 $ 11,683 $ 20,868 Electronic Systems 7,701 1,806 9,507 8,093 2,054 10,147 Information Systems 4,369 5,497 9,866 4,711 5,879 10,590 Technical Services 2,561 765 3,326 2,763 2,474 5,237 Total backlog $ 23,381 $ 18,423 $ 41,804 $ 24,752 $ 22,090 $ 46,842 New Awards The estimated value of contract awards included in backlog during the six months ended June 30, 2011, is $10.4 billion. Significant new awards during this period include $492 million for the Global Hawk HALE program, $427 million for Defense Weather Satellite System program, and $401 million for the B-2 Stealth Bomber program. Backlog Adjustment Total backlog as of June 30, 2011, was reduced by $1,745 million to reflect a change in the company's participation in the NSTec joint venture effective January 1, 2011, at which time the NSTec joint venture results were no longer consolidated into the company's consolidated financial statements, as well as $409 million to reflect the restructure of the NPOESS program. LIQUIDITY AND CAPITAL RESOURCES We endeavor to ensure the most efficient conversion of operating results into cash for deployment in growing our businesses and maximizing shareholder value. We actively manage our capital resources through working capital improvements, capital expenditures, strategic business acquisitions and divestitures, debt issuance and repayment, required and voluntary pension contributions, and returning cash to our shareholders through dividend payments and repurchases of common stock. We use various financial measures to assist in capital deployment decision-making, including net cash provided by operations, free cash flow, net debt-to-equity, and net debt-to-capital. We believe these measures are useful to investors in assessing our financial performance. -33--------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION The table below summarizes key components of cash flow (used in) provided by operating activities from continuing operations: Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Net earnings $ 520 $ 711 $ 1,050 $ 1,180 Net earnings from discontinued operations 29 (34 ) (30 ) Other non-cash items(1) 215 166 379 340 Retiree benefit funding in excess of expense (474 ) (220 ) (440 ) (135 ) Trade working capital increase (295 ) (134 ) (877 ) (1,255 ) Cash (used in) provided by continuing operations $ (34 ) $ 552 $ 78 $ 100 (1) Includes depreciation and amortization, stock-based compensation expense, realized gain on sale of investment, and deferred income taxes. Free Cash Flow From Continuing Operations Free cash flow from continuing operations represents cash (used in) provided by operating activities from continuing operations less capital expenditures and outsourcing contract and related software costs. Outsourcing contract and related software costs are similar to capital expenditures in that the contract costs represent incremental external costs or certain specific internal costs that are directly related to the contract acquisition and transition/set-up. These outsourcing contract and related software costs are deferred and expensed over the contract life. We believe free cash flow from continuing operations is a useful measure for investors to consider. This measure is a key factor in our planning for and consideration of strategic acquisitions, stock repurchases and the payment of dividends. Free cash flow from continuing operations is not a measure of financial performance under GAAP, and may not be defined and calculated by other companies in the same manner. This measure should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to operating results presented in accordance with GAAP as indicators of performance. For 2011 and beyond, cash generated from continuing operations supplemented by borrowings under credit facilities and/or in the capital markets, if needed, is expected to be sufficient to service debt and contractual obligations, finance capital expenditures, fund required and voluntary pension contributions, continue acquisition of shares under our share repurchase program, and continue paying dividends to our shareholders. We continue to assess potential ramifications of the U.S. Government's inability to meet its obligations to us if the debt ceiling is not increased. We believe our cash resources and committed revolver capacity will be available to provide sufficient liquidity in the event that the U.S. Government fails to pay its obligations for a period of time. Depending on the severity of the economic fallout of the government's actions, we expect that we may also be able to access additional bank and capital market financing if the government stops payments for an extended period, however such additional financing is not currently committed and there can be no assurance that it would be available if needed. Nevertheless, an extended delay in the timely payment of billings by the U.S. Government would likely result in a material adverse effect on our financial position, results of operations and cash flows. -34- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION The table below reconciles cash (used in) provided by continuing operations to free cash flow from continuing operations: Three Months Six Months Ended June 30 Ended June 30 $ in millions 2011 2010 2011 2010 Cash (used in) provided by continuing operations $ (34 ) $ 552 $ 78 $ 100 Less: Capital expenditures (94 ) (75 ) (216 ) (178 ) Outsourcing contract and related software costs (1 ) (1 ) (4 ) Free cash flow from continuing operations $ (128 ) $ 476 $ (139 ) $ (82 ) Cash Flows The following is a discussion of our major operating, investing and financing activities from continuing operations for the six months ended June 30, 2011 and 2010, respectively, as classified in the condensed consolidated statements of cash flows in Part I, Item 1. Operating Activities - Cash provided by continuing operations for the six months ended June 30, 2011, was $78 million, as compared with $100 million for the same period in 2010. The decrease of $22 million in cash provided by continuing operations is primarily due to higher pension contributions in the 2011 period, partially offset by the sale of marketable securities. Investing Activities - Net cash provided by investing activities from continuing operations for the six months ended June 30, 2011, was $1,253 million, as compared with $159 million cash used in the same period of 2010. The $1,412 million increase in net cash provided by investing activities from continuing operations is primarily due to the contribution received from the spin-off of the Shipbuilding business in 2011. Financing Activities - Net cash used in financing activities for the six months ended June 30, 2011, was $1,927 million, as compared with $1,101 million in the same period of 2010. The $826 million increase in net cash used in financing activities is primarily due to higher debt repayments and common stock repurchases in 2011. ACCOUNTING STANDARDS UPDATES See Note 2 to the condensed consolidated financial statements in Part I, Item 1 for information related to accounting standards updates. FORWARD-LOOKING STATEMENTS AND PROJECTIONS This Form 10-Q and the information we are incorporating by reference contain statements, other than statements of historical fact, that constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "expect," "intend," "may," "could," "plan," "project," "forecast," "believe," "estimate," "outlook," "anticipate," "trends" and similar expressions generally identify these forward-looking statements. Forward-looking statements are based upon assumptions, expectations, plans and projections that we believe to be reasonable when made. These statements are not guarantees of future performance and inherently involve a wide range of risks and uncertainties that are difficult to predict. Specific factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements include, but are not limited to, those identified under Risk Factors in our Form 10-Q for the quarter ended March 31, 2011, those identified in this report under Part II, Item 1A and other important factors disclosed in this report, and from time to time in our other filings with the SEC. -35- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION You are urged to consider the limitations on, and risks associated with, forward-looking statements and not unduly rely on the accuracy of predictions contained in such forward-looking statements. The forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law. CONTRACTUAL OBLIGATIONS There have been no material changes to our contractual obligations from those discussed in our Form 8-K dated June 17, 2011, that recast certain portions of our 2010 Form 10-K to reflect the effects of the spin-off of the Shipbuilding business. GLOSSARY OF PROGRAMS Listed below are brief descriptions of the programs mentioned in this Form 10-Q. Program Name Program Description Africa Contingency Provide peacekeeping training to militaries in African Operations Training & nations via the Department of State. The program is Assistance (ACOTA) designed to improve the ability of African governments to respond quickly to crises by providing selected militaries with the training and equipment required to execute humanitarian or peace support operations. B-2 Stealth Bomber Maintain and upgrade the fleet of strategic, long-range multi-role bomber with war-fighting capability that combines long range, large payload, all-aspect stealth, and near- precision weapons in one aircraft. Broad Area Maritime A maritime derivative of the Global Hawk that provides Surveillance (BAMS) persistent maritime ISR data collection and Unmanned Aircraft dissemination capability to the Maritime Patrol and System Reconnaissance Force. Defense Weather Design, develop, integrate, test and operate two Satellite System satellites with sensors that will provide global and (DWSS) regional weather and environmental data for the DoD. E-2 Hawkeye The U.S. Navy's airborne battle management command and control mission system platform providing airborne early warning detection, identification, tracking, targeting, and communication capabilities. The company is developing the next generation capability including radar, mission computer, vehicle, and other system enhancements, to support the U.S Naval Battle Groups and Joint Forces, called the E-2D Advanced Hawkeye. Recently the Navy approved Milestone C for Low Rate Initial Production. Encore II Provide Military Agencies, DoD, and other agencies of the Federal Government IT services and associated enabling products to satisfy IT activities at all operating levels, including hardware and software incidental to an overall IT solution. F/A-18 Produce the center and aft fuselage sections, twin vertical stabilizers, and integrate all associated subsystems for the F/A-18 Hornet strike fighters. F-16 International F-16 fire control radar providing increased air-to-air detection and high-resolution ground mapping, sold in various configurations to international customers. -36- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION Program Name Program Description F-35 Design, integration, and/or development of the center fuselage and weapons bay, communications, navigations, identification subsystem, systems engineering, and mission systems software and sensors, as well as provide ground and flight test support, modeling, simulation activities, and training courseware. Global Hawk Develop, deliver and sustain the Global Hawk HALE High-Altitude unmanned aerial system and its derivatives to both Long-Endurance (HALE) domestic and international customers for ISR including Systems deployment of assets to support the global war on terror. The Global Hawk system has a central role in ISR missions supporting operations in Afghanistan and Iraq. James Webb Space Design, develop, integrate and test a space-based Telescope (JWST) infrared telescope satellite to observe the formation of the first stars and galaxies in the universe. Joint Surveillance Joint STARS detects, locates, classifies, tracks and Target Attack Radar targets hostile ground movements, communicating System (Joint STARS) real-time information through secure data links with U.S. Air Force and Army command posts. Joint Warfighting Provide non-personal general and technical support to Center (JWFC) the USJFCOM Joint Force Trainer / JWFC to ensure the successful worldwide execution of the Joint Training and Transformation missions. KC-10 Contractor Contractor Logistics Services (CLS) contract Logistics Support supporting the U.S. Air Force KC-10 tanker fleet (KC-10) including depot maintenance, supply chain management, maintenance and management at locations in the United States and worldwide. Large Aircraft Infrared countermeasures systems for C-17 and C-130 Infrared aircraft. The IDIQ contract will further allow for the Countermeasures purchase of LAIRCM hardware for foreign military sales (LAIRCM) and other government agencies. LITENING Gen 4 Self-contained multi-sensor targeting and surveillance system that enables aircrews to detect, acquire, auto-track and identify targets at extremely long ranges for weapons delivery and non-traditional ISR missions. Long Endurance Contract awarded by the U.S. Army Space and Missile Multi-Intelligence Defense Command for the development, fabrication, Vehicle (LEMV) integration, certification and performance of one LEMV system. It is a state-of-the-art, lighter-than-air airship designed to provide ground troops with persistent surveillance. Development and demonstration of the first airship is scheduled to be completed December 2011. The contract also includes options for two additional airships and in-country support. Multi-Role Tactical Provide war fighters with critical real-time Common Data Link networking connectivity by enabling extremely fast (MRTCDL) exchange of data via ground, airborne and satellite networks. National Design, develop, integrate, test, and operate an Polar-orbiting integrated system comprised of two satellites with Operational mission sensors and associated ground elements for Environmental providing global and regional weather and Satellite System environmental data. (NPOESS) -37- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION Program Name Program Description National Security Participate in a joint venture that manages and Technologies (NSTec) operates the Nevada National Security Site, providing infrastructure support, including oversight of the nuclear explosives safety team, supporting hazardous chemical spill testing, emergency response training and conventional weapons testing. Navy Anti-Terrorism Provide command and control (C2), dispatch systems, Force Protection and security and force protection systems procurement, (ATFP) installation and sustainment at Naval facilities worldwide. Navy UCAS (N-UCAS) Design, develop and demonstrate the first unmanned jet aircraft able to take off and land aboard an aircraft carrier. N-UCAS will demonstrate that a long-range, low-observable, unmanned aircraft can operate safely from aircraft carriers and refuel in-flight to achieve ultra-long endurance for several missions including strike and ISR. Network Centric Maintain and enhance key user services such as Portal, Solutions Defense E-mail, IM, Directory, Search, Go Mobile, SSO, Knowledge Online Database, Army Home Page in support of the 2.3 million (Netcents DKO) Army and DoD users. New York City Provide New York City's broadband public-safety Wireless (NYCWiN) wireless network. Postal Automation Supports sequencing and sorting of letters and flats with the United States Postal Service (USPS) and both letters and flats within the international market. Postal Automation also supports the USPS to ensure the safety of the mail through its Biohazard Detection equipment. Saudi Arabian Provide an integrated security system at multiple American Oil Company sites with C2 connectivity to various regional C2 (ARAMCO) centers within Saudi Arabia. Systems and Software Provide life cycle software solutions and services Engineering Support that enable warfighting superiority and information (SSES) dominance across the enterprise, by providing systems and software engineering and scientific support for a wide variety of Army and DoD customers. Trailer Mounted Trailer Mounted Support System is a key part of the Support System (TMSS) Army's Standard Integrated Command Post System program providing workspace, power distribution, lighting, environmental conditioning (heating and cooling) tables and a common grounding system for commanders and staff at all echelons. Vehicular Provide clear and noise-free communications between Intercommunications crewmembers inside combat vehicles and externally over Systems (VIS) as many as six combat net radios for the Army. The active noise- reduction features of VIS provide significant improvement in speech intelligibility, hearing protection, and vehicle crew performance. -38- -------------------------------------------------------------------------------- Table of Contents NORTHROP GRUMMAN CORPORATION [ Back To TMCnet.com's Homepage ]